Estate Planning: IRAs and Trusts Part II

One year ago we thought the IRS cleared up the rules regarding trusts that inherit IRAs. It turns out the IRS was setting new traps for some taxpayers. Some taxpayers who named trusts as IRA beneficiaries might have to rewrite those trusts and reconsider their Estate Planning strategies.

A trust can provide an extra layer of protection for your wealth. An individual IRA beneficiary might waste or mismanage the IRA assets. To protect the wealth, you can name a trust as the IRA beneficiary and name your loved ones as beneficiaries of the trust. The trustee manages the investments and distributes money to the beneficiaries according to the instructions you put in the trust. The trust can provide for fixed annual payments, periodic payouts of principal, or almost any other payment schedule you want.

The IRS regularly issues private letter rulings to individual taxpayers who request them, giving legal guidance for specific individual situations. Because of Private Letter Rulings 200317043 and 200317044, some taxpayers might have to revise their estate plans to ensure the results they want.

When multiple beneficiaries are named for an IRA, under the 2002 regulations the inheriting beneficiaries can split the IRA into separate IRAs for each of them. That means each beneficiary uses his or her own life expectancy to compute required distributions from the IRA, and each individual gets to manage his own IRA. Most tax advisors assumed that also would be the case when a trust with multiple beneficiaries inherited an IRA. They believed the trust could be split into multiple trusts, one for each beneficiary and with separate minimum distribution schedules.

The IRS says that is not the rule. If a trust with multiple beneficiaries inherits the IRA, the trust cannot set up different distribution schedules. Distributions from the IRA must be based on the life expectancy of the oldest beneficiary of the original trust. That’s not a big problem if the beneficiaries are close in age. But if there is a big difference in the ages, this rule makes younger beneficiaries take distributions faster than under their own schedule.

Another wrinkle in the IRS rulings takes away a major advantage of using a trust in the first place. The IRS says a trust is not a valid beneficiary unless all required IRA distributions are passed through the trust to the trust beneficiary each year. That doesn’t do much good if your goal is to keep money from a wasteful heir or let it compound until the heir is older. The advantages of using the trust under this rule are that the trustee will manage the investments, and the trust property that exceeds required annual distributions is protected from the beneficiary. The trust can prevent the heir from taking distributions from the IRA exceeding the required minimums.

If you named a trust as an IRA beneficiary and it does not meet the new rules, it is time to visit your estate planner. Don’t name one trust with multiple beneficiaries as the IRA beneficiary. Instead, set up a separate trust for each of your beneficiaries, and name each of those trusts as a co-beneficiary of the IRA. An alternative is to split your IRA now and have a separate IRA for each beneficiary. Also, be sure the trusts state that all required distributions will be passed to the trust beneficiary each year.

Don’t forget the other rules in the 2002 changes. The trust must qualify as a Designated Beneficiary. The consequences of not qualifying the trust as Designated Beneficiary can be severe. If the original IRA owner had not already begun required minimum distributions at the time of death, then within five years of the owner’s death all of the IRA must be distributed to the trust where it will face income taxes. If the owner already started RMDs, the trust would continue taking distributions based on the owner’s life expectancy at the time of death.

A trust can qualify as a Designated Beneficiary by meeting four conditions: The trust must be legally enforceable under state law; the IRA custodian must have a copy of the trust agreement by the required distribution date; the trust must be irrevocable or become irrevocable upon the death of the IRA owner; and all possible beneficiaries who could enjoy the benefits of the IRA must be clearly identifiable from the trust document.

To meet the last requirement, a couple of common trust terms must be avoided. Trusts often name children or grandchildren as beneficiaries, including those not yet born. Many trusts also contain a “power of appointment.” This allows each beneficiary to name who eventually gets the remainder of his or her share of the trust. These standard trust provisions would prevent the trust from being a Designated Beneficiary of an IRA.

Keep in mind that there is no good remedy if you name a trust as beneficiary and it does not meet the IRS’s rules for a Designated Beneficiary. Legally, the trust still is beneficiary of the IRA. There won’t be anything your heirs could do to change that. The IRS rules would impose the harshest tax treatment on the IRA and the trust beneficiaries ? rapid distribution of the IRA balance.

More details about IRAs and trusts are in the December 2002 issue, which is in the Estate Watch section of the Archive on the web site.

If you have wasteful heirs, you might want to consider strategies other than leaving them the IRA through a trust. You can empty the IRA early, as suggested in the October 2003 issue. Then, leave the after-tax money to the heirs through a trust. Or you could make charitable contributions with the IRA and leave your heirs other assets.