There are only a few instances your heirs aren’t penalized when you name a trust as the beneficiary of your IRA.
A recent IRS ruling gives an example, but the ruling also reveals the pitfalls of the strategy.
The general rule goes like this…
When an IRA beneficiary is not an individual, the IRA must be distributed fully within five years.
When a trust, your estate, or a business entity is named beneficiary, the IRA quickly must be distributed and taxed.
There’s an exception when you name a trust that qualifies as a “look-through” or “see-through” trust under IRS regulations.
(Retirement Watch members can refer to the June 2020 issue for details. You need an estate planner to draft this trust to make sure it avoids the five-year rule.)
Even then – under the look-through strategy (also known as see-through) — the IRA must be distributed to the trust within 10 years in most cases.
Another exception was discussed in a recent IRS ruling and shows there might not be a penalty when your spouse’s revocable living trust is named as the IRA beneficiary.
The ruling involved a married couple.
One spouse (I’ll say it was the husband) owned an IRA and had begun required minimum distributions (RMDs).
The husband passed away and had named a trust as sole beneficiary of the IRA.
His wife had previously established the trust. She was the sole beneficiary and sole trustee of the trust.
The wife had the right to amend or revoke the trust and could distribute all income and principal of the trust for her own benefit.
The wife, now a widow, wanted to exercise the spousal option for an inherited IRA.
She wanted to roll the IRA over to an IRA in her name.
This would give her a fresh start, allowing her to manage the IRA without reference to her late husband’s IRA.
She could start RMDs based on her own required beginning date and life expectancy. The widow also could name her own beneficiaries of the IRA.
The widow asked the IRS to rule that the IRA could be rolled over tax free into an IRA in her name.
She planned to have the IRA balance distributed directly to her, and she would roll it over to an IRA in her own name within 60 days.
The IRS ruled in the widow’s favor. It pointed out that the widow was the trustee and sole beneficiary of the trust.
She was entitled to all income and principal of the trust. Also, she was the surviving spouse of the deceased IRA owner.
In these circumstances, the widow was the sole person for whose benefit the IRA is maintained.
That allows her to take a distribution from the inherited IRA and roll it over to an IRA in her own name without having to include any of the distribution in gross income, provided the rollover was accomplished within 60 days of the distribution.
In past rulings, the IRS allowed a similar result when an IRA was payable to an estate and the surviving spouse was the sole primary beneficiary of the estate.
In each case, the surviving spouse effectively was the sole individual for whose benefit the IRA was maintained and intended.
While the widow had a happy result, you still might not want to name a living trust or your estate as the beneficiary of your IRA, even under similar circumstances.
The widow had to apply to the IRS for a private ruling to be sure of the tax results, which is an expensive and time-consuming process.
Also, the widow couldn’t have the IRA custodian transfer the inherited IRA directly to an IRA in her name.
That’s probably because the IRA custodian was unwilling to transfer the inherited IRA to any IRA other than one with the exact same legal title.
The general rule is that an inherited can be rolled over to another IRA tax free only if the two IRAs have the same name or title.
These complications are why it is best to review your IRA beneficiary designations every year or two.
Don’t leave extra work or stress for your family.
Be sure only individuals (and perhaps charities) are named as beneficiaries of your IRA and they are the ones you currently want to inherit the IRA.
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