Even though there are no tax benefits, there may be circumstances when clients should name a trust as their IRA beneficiary. Trusts, however, create unique problems and tax complications even when executed perfectly. IRA beneficiary trusts cannot provide the answers for tax and personal solutions that many IRA owners are looking for. And quite often trusts are poorly drafted and cause more problems than they are worth.
IRA owners can name trusts as IRA beneficiaries as a way to better control post-death IRA distributions and restrict access for IRA beneficiaries who might otherwise squander large inherited IRAs.
Instead of naming a person (for example a child or grandchild) as a direct beneficiary on the account, a trust would be named. The trust beneficiary would be the child, grandchild, or other person that the IRA owner wants to receive the IRA.
An adult IRA beneficiary may need help with managing the IRA funds and taking required distributions. The trust could be used to protect your beneficiary from unscrupulous people who might take advantage of him or her, or from creditor problems, although most states (but not all) already protect IRAs from creditors without a trust.
Or suppose that you want to control the ultimate disposition of your IRA. In a typical second marriage situation (or even with some first marriages), you may want to leave your spouse the annual IRA income, but after survivor’s death you want to make sure that the IRA goes to the children and not to the children from the spouse's first marriage.
Or suppose you fear that if you leave your IRA outright to your son, his spouse, whom you dislike, will find a way to get at the IRA. Even though the IRA inheritance is legally your son’s separate property, could his spouse talk him into liquidating the IRA. If you name a trust as the IRA beneficiary, your son won’t be able to liquidate the IRA even if he wants to.
A trust can be used to hold money for estate taxes if there is a risk that the IRA beneficiary will take the money and run without paying his share of the estate tax. When an individual is a direct beneficiary of an IRA, the entire IRA goes to that person at death. There is usually a clause in the will called the "tax apportionment clause" which spells out who is responsible for the estate tax, both on items that pass through the will and on property that passes outside the will, such as an IRA or life insurance. But even if the will's tax clause states that the IRA beneficiary must pay his or her share of the estate tax from the IRA proceeds, it may be too late if the beneficiary has already fled with the newly inherited funds. A trust could escrow a portion of the IRA for estate taxes. This would not apply to a nontaxable estate, where assets are under $2 million (for 2006-2008).
If the trust is appropriate, it must qualify under the various IRS rules in order for the trust beneficiaries to be able to use their own life expectancy for calculating post-death required distributions. If the trust does not qualify, the stretch IRA option is lost.
The IRS requirements for a trust to qualify as a designated IRA beneficiary are:
- The trust must be a valid trust under state law
- The trust must be irrevocable at death
- The beneficiaries of the trust must be identifiable
- A copy of the trust document must be provided to the plan by October 31 of the year following the year of the IRA owner’s death
If these requirements are met, then the trust qualifies as a designated IRA beneficiary, and the trust beneficiary’s life expectancy can be used to calculate post-death required minimum distributions. If the trust fails to qualify, then there is no designated beneficiary and trust beneficiaries will not be able to stretch post-death required distributions over their life expectancy. In that case, the IRA will be paid out either under the 5-year rule (if the IRA owner dies before his Required Beginning Date) or over the remaining life expectancy of the deceased IRA owner (if the IRA owner dies after his required beginning date).