Many owners of substantial IRAs hope their IRAs become nest eggs for their children or grandchildren. Their estate plans include strategies that let the IRAs, when inherited, compound for as long as possible – perhaps decades. That means selecting the right beneficiaries, and being sure the beneficiaries are well-advised about their options.
Unfortunately, beneficiaries often do not follow the plan. More often than not, they cannot wait to spend the inherited IRA. Sometimes the money is well-spent. Other times, the money is spent frivolously. Sometimes an inherited IRA goes to ex-spouses or creditors of the heirs. Some beneficiaries mismanage the investments and lose most of its value.
The beneficiaries often do not realize until it is too late that the money they take out is taxed as ordinary income. The taxes give the IRS a big chunk of inherited IRAs.
IRA owners who want their IRA surpluses to provide their children’s or grandchildren’s retirement can prevent these problems. One solution is to set up an ira trust.
An IRA trust is created either in the owner’s will or while the owner is alive. The trust is named as beneficiary of the IRA.
After the owner’s death, required distributions must be made from the IRA. If the estate follows the procedures, the required distributions are based on the life expectancy of the oldest beneficiary of the trust. If the beneficiary is relatively young, the distributions will be low. They could even be less than the annual income and gains of the IRA, allowing the IRA to increase for years despite the distributions.
The advantage of the IRA trust is that the distributions are controlled by the trustee instead of the beneficiary. The trustee, of course, can withdraw more than the required distribution from the IRA any time he wants to.
The rules of the trust determine when distributions are made to the beneficiary. The trustee can choose to distribute the required distribution or a larger amount. A smaller distribution might be possible, but the IRS disagrees, as we’ll discuss shortly. Or the trustee can be given discretion to distribute whatever amount he believes is appropriate each year.
A common arrangement is for the trustee to pay out the minimum distributions until the beneficiary reaches a certain age. Then, the beneficiary is allowed full control of the distributions.
The tax law discourages having the trustee accumulate the RMDs instead of distributing them to the beneficiary. A trust is taxed on income it does not distribute to beneficiaries. Trusts have compressed income tax brackets. In 2006 they pay the top rate of 35% when income exceeds $10,050. There also might be state income taxes. If much income is accumulated in the trust, it will be taxed away rapidly.
That is why in most cases it is best for the trustee to take the required minimum distribution from the IRA each year and distribute that to the beneficiary.
Another option is to convert an ordinary IRA to a Roth IRA, if the owner is eligible. Minimum distributions still will be required from the Roth IRA after it is inherited, but the Roth distributions won’t be taxable income. (See the November 2005 issue or the IRA Watch section of the web site Archive for details on converting to a Roth IRA.)
The trustee obviously prevents the beneficiary from wasting the assets. But the IRA trust has other advantages.
The trustee or another person named in the trustee agreement will manage the IRA investments. That minimizes the beneficiary’s ability to dissipate the IRA’s value through poor investments.
The trust also protects the IRA from creditors, bankruptcy, and divorce.
To minimize the required distributions, the trustee and estate administrator must file required paperwork with the IRA custodian by Oct. 31 of the year following the year in which the IRA owner died. The paperwork lists the trust as the Designated Beneficiary.
Failure to file the paperwork on time greatly accelerates distributions from the IRA. If the original owner of the IRA had not already begun required minimum distributions, the entire IRA must be distributed within five years. If RMDs already began, then the distributions continue on the schedule established by the owner. In either case, the distributions are likely to be larger than if a trust of which a younger person is beneficiary is the Designated Beneficiary.
If you decide to name a trust as beneficiary, be sure to work with an experienced estate planner. IRS regulations provide conditions a trust must meet to qualify as a Designated Beneficiary. Fail to meet the conditions, and required distributions will be accelerated.
The four key conditions are that the trust must be legally enforceable under state law; the IRA custodian must have a copy of the trust agreement by the first 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.
The last condition is the trickiest. Some standard trust language could disqualify the trust. That is why you need an experienced estate planner.
In addition, a 2003 private letter ruling from the IRS indicates that a trust does not qualify unless all required distributions are passed through to the beneficiary each year. A private ruling applies only to the taxpayer to whom it was issued, but it also indicates the IRS’s thinking. Until there are clearer rules, you probably want the trust to require distribution of at least all RMDs.
The special rules for trusts as IRA beneficiaries were covered in more detail in our December 2002 and November 2003 issues. These articles are in the Estate Watch section of the web site Archive.
A variation of the IRA trust is known as a trusteed IRA. The IRA is put into a special trust by the IRA custodian. Not all IRA custodians or trust companies offer trusteed IRAs. Those that do offer it charge high set up and annual fees, making it a viable option only if the IRA is at least $500,000.
The trusteed IRA can provide some extra protection for the wealth, but it costs more and has less flexibility.
Another option is to empty your IRA early, pay all the taxes, and then leave the money in a regular trust. Or you can make the charitable contributions in your will using the IRA and leave other assets to your heirs.
A trust as IRA beneficiary can bring you a step closer to achieving estate planning goals. It can ensure that most of your IRA wealth is preserved until your heirs are older, perhaps until their retirement. But it does cost more to set up and have other pitfalls. Consider the pitfalls and the alternatives before making your choice.