Estate Planning Strategies: Trusts And Your IRAs

Trusts can solve many problems, making them a vital estate planning tool. When an IRA is involved, however, trusts must be used with great care. The IRS changed the rules to make things easier, but all the rules still aren’t clear and traps remain.

Trusts are a good way to leave wealth to those who might mismanage or waste it. A trust can ensure professional management of the IRA. A trust also makes certain that the wealth ultimately goes to the intended heirs. Trusts offer the wealth some protection from creditors of the heirs in most states. Not the least of a trust’s potential benefits are savings in estate, gift, and income taxes.

For years the unfortunate truth was that trusts couldn’t safely be used with IRAs. In most cases, naming a trust as beneficiary of an IRA forced the IRA to distribute all of its assets shortly after the death of the original owner. The IRS changed the rules in January 2001, with some amendments in June 2002. These rules make it easier to compute mandatory IRA distributions and to stretch out the life of an IRA. We covered those aspects in detail in past visits (See the September 2001 and June 2002 issues or the Estate Watch and Grandkids’ Watch sections of the Archive on the web site.)

Now, let’s take a look at how the latest rules affect naming a trust as beneficiary of an IRA.

The mechanics of naming a trust as an IRA beneficiary are very simple. You decide who should be the first beneficiary of the account and who should be the contingent beneficiaries who get the wealth after the primary beneficiary passes away. Suppose your spouse is the primary beneficiary and your children are the contingent beneficiaries. You could simply complete the IRA beneficiary designation form that way. If you do, your spouse can rollover the IRA to a new IRA and name new contingent beneficiaries at any time. Also, your spouse and then your children will manage the account.

An Estate Planning Strategy alternative is to draft a trust agreement that names your spouse as primary beneficiary and the children as contingent beneficiaries. On the beneficiary designation form that is filed with the IRA custodian, the trust is named as the beneficiary. A trustee you name manages the IRA and makes distributions. The trustee even can determine the amount of distributions or the conditions under which distributions will be made, if you assign those powers.

As I said earlier, under the old rules naming a trust as beneficiary almost always required that the entire IRA be distributed within a short time after the owner’s death. That caused the entire IRA to be subject to income taxes. Now, trusts are more viable as IRA beneficiaries, though they still are not available in all situations and all the rules aren’t clear.

Unlike other assets in an estate, there are two taxes to avoid on inherited IRAs. One is the estate and gift tax. There is little to be done to avoid this tax, since the IRA is included in the estate. The tax is avoided only if the surviving spouse or a charity is named as beneficiary, qualifying the IRA for either the marital or charitable deduction.

The income tax is the other to avoid and can be the higher tax. The goal usually is to keep money in the IRA as long as possible to defer taxes on income and capital gains. That means reducing the required minimum distributions.

Naming a trust as beneficiary makes reducing required distributions more difficult. The general rule is that the age of the Designated Beneficiary determines the minimum distributions. In most cases, only human beings qualify as the Designated Beneficiary. When no Designated Beneficiary is named or the named beneficiary is a non-person, such as an estate or trust, then the IRA must be distributed quickly.

A trust can qualify as a Designated Beneficiary only if four conditions are met. When the conditions are met, the age of the oldest beneficiary of the trust determines the required minimum distribution schedule.

The four 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 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 requirement is the most difficult. Standard trust agreements often provide that the contingent beneficiaries include all children or grandchildren, including those that might be born after the IRA owner dies.  Another standard trust term, known as a power of appointment, allows each beneficiary to name who eventually gets the remainder of his or her share of the trust. These terms mean the eventual beneficiaries cannot be clearly identified. If it is even theoretically possible that some unknown person might get a share of the trust, then the requirement is not met.

The consequences of not qualifying the trust as Designated Beneficiary can be severe. If the 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 distributions based on his or her life expectancy at the time of death. If a person is the beneficiary, however, a new distribution schedule is established based on that person’s life expectancy.

If a trust is named as the beneficiary, it still inherits the IRA even if the trust does not qualify as Designated Beneficiary. All distributions from the IRA will go to the trust, and distributions from the trust to its beneficiaries will be based on whatever rules are in the trust agreement. IRA distributions retained in the trust will be taxed to the trust. Distributions from the trust to a beneficiary will be taxed to the beneficiary. This is important, because a trust gets into the highest tax bracket much faster than an individual does.

Let’s see how these rules apply to specific trusts. The two most common estate planning trusts are the credit shelter trust (also known as a bypass or A-B trust) and the qtip trust. They often are used together.

The credit shelter trust ensures that you are able to take full advantage of the lifetime estate and gift tax credit while providing for your spouse. The credit currently shelters up to $1 million of assets from estate and gift taxes. The standard estate planning strategy is to leave up to $1 million in a credit shelter trust. The spouse has access to this wealth during his or her lifetime, subject to any limits in the trust. Then your children or other heirs get whatever is left after the surviving spouse dies. The entire amount left in the trust avoids estate taxes because of the lifetime credit. The rest of the estate can avoid taxes by going directly to your spouse.

A credit shelter trust can be written so that it qualifies as a Designated Beneficiary. This requires taking out some of the standard trust language that allows afterborn children and grandchildren to inherit part of the IRA. The trust has to be very inflexible regarding who the beneficiaries are in different circumstances, and the lawyer drafting it must be very careful.

Keep in mind that IRA and other retirement plan assets should be the last choices for a credit shelter trust. Distributions from these assets will be subject to income taxes when distributed. That means up to 40% of the trust eventually will be taxed. Some consider that a waste of the lifetime credit. It is better to fund the trust with assets that will avoid both income and estate taxes. That way the trust can continue to grow and the heirs will get the maximum tax-free amount. A credit shelter trust should be an IRA beneficiary only if there aren’t enough other assets to take advantage of the lifetime credit.

The QTIP trust is very popular these days. When the trust is properly structured trust assets qualify for the marital deduction, avoiding estate taxes in the original owner’s estate. The QTIP trust must pay all its income each year to the surviving spouse, and the spouse can tap the trust for additional money if needed. After that spouse dies, the remainder of the trust goes to other beneficiaries named in the trust, usually the couple’s children. The QTIP is popular because it provides for the spouse but ensures that the wealth eventually goes to the couple’s children, not to objects of affection the surviving spouse develops later.

The QTIP, like the credit shelter trust, can be written so that it qualifies as a Designated Beneficiary.
The extra trick with naming a QTIP as beneficiary is the requirement that all the trust income each year be distributed to the spouse. There is some question whether income earned by the IRA counts as income earned by the trust. If it does, the trustee would be required to withdraw all income earned by the IRA and distribute it to the spouse, even if the income earned exceeds the required minimum distribution.

A recent IRS ruling indicates that the trustee needs to withdraw only the required minimum distributions, rather than all the income earned by the IRA. But this is a private ruling and cannot be relied on by taxpayers generally. The issue is not fully resolved, making estate planning difficult.

Many of you have Living Trusts that were formed primarily to avoid probate. The IRS consistently has ruled that these trusts essentially will be ignored when computing required minimum distributions. The age of the oldest beneficiary of the trust will be used to compute required minimum distributions.

Under the new rules, trust agreements can be written so that naming the trust as IRA beneficiary confers estate planning benefits and minimizes required distributions. There are a number of pitfalls to avoid, however, and some issues still are unresolved. Keep in mind that leaving the IRA to a surviving spouse almost always generates the best tax benefits. A trust should be used only when the non-tax benefits are overriding. Then, an experienced estate planning attorney is essential for success.