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Designating The Living Trust As IRA Beneficiary

By Dan Haut, CFP® CIMA®
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The majority of the time, an IRA owner will list individual(s) as their intended beneficiaries on the IRA beneficiary designation form. Aside from being the most common option, there is good reason for the IRA owner to elect this method a good portion of the time. By choosing the IRA beneficiary outright, the IRA  owner provides the beneficiaries with the option of tax-deferred growth in the form of “stretch” opportunities. Occasionally, however, an IRA owner will name their trust to be the intended beneficiary as opposed to an individual. While there may be well-intended reasons for the latter, oftentimes, this leads to unintended consequences.

Before going into some of the pitfalls of naming the living trust as your IRA beneficiary, it is first  important to go over the benefits of naming individual(s) as outright beneficiaries.

When a non-spousal IRA beneficiary inherits an IRA, she has two options. If the decedent passed away before beginning their mandatory distributions (RMD), the survivor can choose to take the funds from the IRA by December 31st of the fifth year following the IRA owner’s death. The first  option could result in quite a tax burden, whether taken in one lump sum or in five equal installments over five years. The second option – regardless of whether the decedent has begun mandatory distributions – is more tax beneficial. Option two allows the non-spousal beneficiary to open an inherited IRA and take out RMDs over her single life-expectancy. By opening up an inherited IRA, she can effectively “stretch” the IRA over her lifetime, and allow for potentially greater tax-deferred growth. https://www.irs.gov/retirement-plans/required-minimum-distributions-for-ira-beneficiaries

When a spousal beneficiary inherits an IRA, she has even more flexible options. Like for non-spousal beneficiaries, if the decedent had not started mandatory distributions, the surviving spouse can choose to take the funds by the end of the fifth year following the owner’s death. Like for non-spousal beneficiaries, she can also open an Inherited IRA. As spousal beneficiary, she can also take out RMDs based on when the owner would have turned age 70.5 or her single life expectancy, whichever is more preferable. However, unlike non-spousal beneficiaries, the surviving spouse can also choose to roll over the IRA into her own IRA and defer distributions altogether and until she is RMD eligible or age 70.5 years old. For this third option, if the spousal beneficiary is younger and doesn’t need the monies until at least age 59.5 years old (when 10% IRS penalty goes away), this may be the best option to suspend taxes. https://www.irs.gov/retirement-plans/required-minimum-distributions-for-ira-beneficiaries

However, as mentioned in the first paragraph, there are cases when the IRA owner has a valid reason to name the living trust as the beneficiary over an individual(s). I will list five valid hypothetical scenarios where the trust may serve as an appropriate beneficiary. First, “spendthrift” provisions within the trust may serve to prevent a troubled beneficiary from irresponsibly draining the account. Second, if the IRA owner is in a  second marriage, putting their IRA within a QTIP Trust (Qualified Terminable Interest Property) would allow for the dual purpose of providing “income” to their spouse and the “remainder” principal to  children. Third, if the IRA owner runs a small business and desires asset and credit protection from potential third party claims, naming the trust as beneficiary could be prudent. Unlike traditional IRAs which are ERISA protected, Inherited IRAs are not (Clark v. Rameker, 134 S.CT.2242). Fourth, if the IRA owner’s net worth is greater than the estate tax-exemption for couples ($10.9 million), perhaps funneling their IRA into a Bypass Trust best takes advantage of the tax credit. Last, if a beneficiary is on SSI or Medicaid, their eligibility could be better preserved in a carefully crafted special needs trust.

Indeed, it is possible that the reasons for naming a trust as the IRA beneficiary are valid for financial planning purposes (e.g. spendthrift provisions, beneficiary divorce protection, credit protection, estate planning, special needs planning, etc.). However, the irony is that while designating the trust as IRA beneficiary may be correct for financial planning purposes, it may be antithetical for tax or “stretch” purposes. How would one know whether this is the case? To determine the answer, it is first necessary to understand whether the named trust is a “conduit” or “accumulation” trust.

A conduit trust mandates that IRA distributions (including RMDs) which are paid out to the trust must pass through to the primary beneficiaries. Per Treasury Regulation 1.401(a)(9)-4,Q&A-5, the IRS proclaims that if a conduit trust is named as the IRA beneficiary in lieu of individual, it can still maintain “stretch” IRA treatment as long as it is a “see through” trust. Whether the RMD of a conduit trust is based on the single life expectancy or eldest beneficiary is contingent on whether there is one or multiple beneficiaries. Please check with your CPA. There are negatives to consider, however. For instance, since all IRA distributions in a conduit trust must automatically pass through to the beneficiary, one of the pitfalls is that the decedent could be unintentionally giving up their right to control distributions from beyond the grave.  In other words, the decedent’s intended goals of providing credit protection, spendthrift provisions, beneficiary divorce protection, special needs planning, and estate planning could be jeopardized under the auspices of a conduit trust.

An accumulation trust allows distributions from the IRA to be held inside or accumulate to the trust. In other words, the potential drawbacks of a conduit trust (e.g. loss of credit protection, special needs planning, spendthrift limitations, etc.) can be accomplished in an accumulation trust! However, there are negatives to consider. First, there is a great deal of cost and complexity to draft an accumulation trust that achieves “stretch” capabilities. Second, because the distributions in an accumulation trust are paid into the trust vs. outright to the beneficiary, the income taxes will be based on the much more compressed tax bracket at the trust vs. individual level. Case in point: In 2017, it will take as little as $12,500 of income at the trust level to be taxed at the 39.6% top tax-bracket! On the flip side, distributable net income (DNI) needs to be $470,700 at the individual level – 38x larger than at the trust level – to be taxed at the 39.6% top tax-bracket. https://www.irs.gov/pub/irs-prior/f1041es–2017.pdf. This is quite the juxtaposition!

In conclusion, before choosing the beneficiary of your IRA, ask yourself what your ultimate objectives are. Designating an individual to be the IRA beneficiary is the financially prudent thing to do the majority of the time. By electing an individual outright, the spousal and non-spousal beneficiaries will have the tax benefit of “stretching” their distributions over their single lifetimes. As an alternative, designating a trust to be the IRA beneficiary may be necessary if there is a need to implement various features within the IRA like those    mentioned above. If the latter is the case, find out whether your IRA is a conduit or accumulation trust. It is important to understand that an accumulation trust alone will accomplish these planning goals, and often at the expense of valuable “stretch” benefits. Please consult your tax-attorney or CPA before making any decisions. We are happy to work with your tax professionals along the way.

 

Dan Haut, CFP® CIMA®

Dan Haut, CFP® CIMA®

Daniel is a Portfolio Counselor for OPCM with nearly 15 years of experience in the financial services industry. Dan earned his Bachelor of Arts degree in Political Science from the University of California, Davis. He is a CERTIFIED FINANCIAL PLANNER practitioner and a CIMA® designee.
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