Cutter Family Finances: Trusts As Beneficiaries: Why?

Jeffrey CutterRichard Maclone Photography - Jeffrey Cutter

Often when I am performing a financial review for folks, I am asked whether they should name a trust as the beneficiary of an IRA. The first question I ask anyone who is thinking of naming a trust as an IRA beneficiary is . . . Why?

Naming a trust as an IRA beneficiary can create unique problems and tax complications even if executed perfectly. Therefore, it must only be done for the right reason and even then, I find that most beneficiary trusts are poorly drafted and cause more problems than they are worth. The consequences of an incorrect IRA beneficiary designation can have severe implications on your estate planning, especially when trusts are involved.

Generally, one of the advantages of a properly executed IRA beneficiary designation is the ability for a beneficiary to “stretch” required minimum distributions over the beneficiary’s lifetime. This strategy ensures that taxes are deferred as long as possible, thereby allowing the account to grow for a longer period of time and consequently giving the beneficiary a much larger stream of income.

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Most commonly, a spouse is named as the primary beneficiary of an IRA and any children are named as contingent beneficiaries. However, there are times when an IRA owner might not want a beneficiary to have control over the inherited asset. Some examples of this include when the beneficiary is a minor, when the IRA owner is involved in a second or a difficult marriage, or when there is a specials needs situation, just to name a few. One question I always ask, when a situation involves a second marriage, is if the kids get along with the second spouse. This is important because, without a trust, the spouse as primary beneficiary can make the entire IRA his or her own and disinherit your kids by changing the beneficiaries.

As mentioned above, there must be a good reason to leave an IRA to a trust (such as controlling access to the funds) because doing so will likely not make things easier or save on taxes.

Let’s take a look at some of the challenges when a trust is named as a beneficiary of an IRA. According to the IRS, only individuals may be considered designated beneficiaries for purposes of taking advantage of the stretch IRA provisions described above. A trust is not living and breathing so it does not have a lifespan. Therefore, if an entity is named as a beneficiary that is not an individual, then the IRA is treated as having no designated beneficiary. If this happens, and the IRA owner dies before his required beginning date (April 1 after the year he or she turned age 70 1/2), then the entire IRA must be distributed to the trust beneficiaries by December 31 of the fifth year after death. If the IRA owner is past his required beginning date when he or she dies, then the distributions are made over the deceased owner’s remaining life expectancy according to the IRS life expectancy tables. This is what happens if the trust is not a “look-through” trust.

Nevertheless, if a trust is structured as a “look through” trust, it may take advantage of the stretch IRA provisions. However, there are four requirements to be considered a look through trust. The trust must be valid under state law, it must be irrevocable at death, the beneficiaries must be identifiable (be as specific as possible), and the required trust documentation must be provided by the trustee of the trust to the IRA plan administrator no later than October 31 of the year following the year of death. Lastly the trust must have a provision to pay out all RMDs from the trust to the trust beneficiaries (known as a conduit trust). If the trust does not contain such a provision, then the trust is treated as though it accumulates IRA distributions, rather than pay them out. This causes a variety of issues.

In such a situation, the IRS will count all potential beneficiaries of the trust as beneficiaries of the IRA for purposes of determining the life expectancy to use when calculating required minimum distributions. If an individual in the line of trust beneficiaries is much older than the others, distributions may be taken out over that person’s shorter life expectancy. As an example, let’s say a trust names two children, ages 13 and 15, as 50 percent primary beneficiaries. The trust will hold (accumulate) the assets for the benefit of the children until they reach the age of 30, at which point they will receive the full distribution of their trust share. According to the provisions of the trust, if the children are not living when the IRA owner dies, the trust assets pass to Uncle Joe, the contingent beneficiary, who is 67 years old. In this case, the IRS would use Uncle Joe’s age of 67 to determine the appropriate IRA distribution, even if the trust assets are distributed to the primary beneficiaries of the trust, the children.

Trusts are often written to provide flexible provisions for the distribution of trust assets. But in the case of a trust that is deemed to accumulate IRA distributions (i.e., an accumulation trust), this could become a problem. If one of the trust provisions allows for charitable giving, then the trust would be viewed as having an entity (rather than an individual) as a beneficiary of the IRA (even if no specific charities are listed). Therefore, all distributions would need to be taken within five years of death, or over the life expectancy of the IRA owner, depending on when you died as explained above.

It may be desirable, and necessary, to name a trust as the beneficiary of an IRA account to control access to the funds after your death. However, great care should be taken in making this decision. Be sure to work with qualified professionals because, if you mess it up you will not get a chance to fix it . . . because you are probably already dead.

Be vigilant and stay alert, because you deserve more.

Jeffrey Cutter, CPA, PFS is the managing partner from Cutter Financial Group, LLC (www.cutterfinancialgroup.com) which provides private wealth and investment management through low risk, low volatility successful strategies. He can be reached at jeff@cutterfinancialgroup.com.
Investment advice is offered by Horter Investment Management, LLC, a Registered Investment Adviser. Insurance and annuity products are sold separately through Cutter Financial Group, LLC. Securities transactions for Horter Investment Management clients are placed through Pershing Advisor Solutions, Trust Company of America, Jefferson National Monument Advisor, Fidelity, Security Benefit Life, FC Stone, and Wells Fargo Bank, N.A.

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Cutter Financial Group, LLC, a family owned and operated company, was founded by retirement and investment specialists. We engage high quality, independent wealth managers who specialize in significantly reducing risk during times of volatility, while capturing a large majority of the gains of the upside. This strategy allows our clients to secure a better, and worry-free, retirement.

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