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How a Trust or Estate Can Transfer an IRA to a Beneficiary Tax-Free

Published on: Jul 20 2021

It is time to answer this question in the newsletter, because I have been receiving emails regularly asking about it.

I advise my readers not to name a trust or their estate as beneficiary of an IRA, except for certain types of specially designed trusts. They also shouldn’t fail to name a beneficiary, because that has the same effect as naming the estate as beneficiary.

These actions cause negative income tax consequences for the IRA beneficiaries, which I discuss later in this article.

For now, let’s focus on what can be done when the wrong type of trust or an estate is the beneficiary who inherits an IRA.

Except when the special type of trust was deliberately named the beneficiary, there’s usually no reason for the trust to remain beneficiary of the IRA, take distributions from the IRA and then pass them to the beneficiary of the trust. It is easier to transfer the IRA to the beneficiary, especially when the trustee is trying to wind down the trust.

Though a trust can have multiple beneficiaries, to keep the explanation simple, I will assume the trust has one beneficiary. The same rules apply to trusts with multiple beneficiaries.The first step is to examine the trust document. The document must empower the trustee to transfer the IRA to a beneficiary. In some trusts, the trustee might have to wait until the beneficiary reaches a certain age or other conditions are met.

Or the trust agreement might limit the trustee’s powers so that transferring the IRA isn’t allowed.

The trust agreement and state law also must authorize distributions of property in-kind and not restrict distributions to cash.

Once those conditions are met, the tax law allows a tax-free transfer of the IRA to the trust beneficiary. That’s what the IRS has told taxpayers in what it calls Private Letter Rulings, and that’s how most IRA experts and custodians interpret the tax code.

But the tax code doesn’t specifically say such transfers are allowed or tax free, so some IRA custodians say they aren’t allowed. If your custodian says that, you need to first move the IRA to another custodian and then transfer the IRA to the trust beneficiary.

As with other transfers of inherited IRAs, to avoid taxes on the transfer the right steps have to be taken.The beneficiary first must open an inherited IRA. The title of the account must include the decedent’s name and that the IRA is for the benefit of (or FBO) and then name the beneficiary.

An alternative is to list the beneficiary’s name followed by “as beneficiary of ” and then list the decedent’s name.Then, the IRA custodian must be told to make a direct, or trustee-to-trustee, transfer of the assets from the trust’s IRA to the new inherited IRA. T

he custodian shouldn’t treat the transfer as a reportable transaction on Form 1099-R, and the trustee might want to be sure that’s the custodian’s understanding.

The IRA will be fully taxable to the beneficiary when it is transferred if any other method is used to transfer the IRA.

The same rules apply when an estate inherits an IRA. The estate can transfer the IRA to a beneficiary or beneficiaries of the estate, as long as it is consistent with the will and state law.But there is a trick for estates and sometimes for trusts.

The IRA shouldn’t be transferred under the terms of what’s known as a pecuniary bequest or gift. A pecuniary bequest or gift is of a specific dollar amount or is determined by a formula in the will or trust agreement.

If the IRA is transferred as part of a pecuniary bequest or gift, then the IRS treats the transfer as a sale of the IRA. The estate or trust that transfers the IRA is fully taxable on the value of the IRA, and the account no longer is an IRA to the beneficiary.

The transfer of an inherited IRA should be made only when it is part of a residual bequest or gift.I recommend against naming a trust or estate as an IRA beneficiary (or not naming a beneficiary) because the IRA would have to be distributed and taxed within five years.

Usually, a beneficiary of an inherited IRA doesn’t have to distribute the IRA until 10 years have passed. There are some exceptions to the 10-year rule, such as for minor children, disabled or chronically ill individuals or surviving spouses.

The 10-year rule only applies to beneficiaries who are individuals. When a beneficiary is a non-individual, such as an estate or trust, the IRA must be distributed within five years of the original owner’s death.

When the original beneficiary was a trust or estate, the five-year rule is locked in. The five years begin when the estate or trust inherited the IRA, not when the IRA is transferred to the individual beneficiary of the estate or trust.

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