The following is for educational use only. This material is not intended to replace any tax or legal advice. The reader should obtain personal counsel before implementing any methods described herein. Masculine can mean feminine, and singular can mean plural.
Taxpayers who have funded Individual Retirement Accounts (IRAs) (and to a certain degree, other qualified retirement accounts) were earlier able to install remarkable estate planning strategies when optimizing the Minimum Required Distribution (MRD) rules with the recalculation allowances for mandated beneficiary distributions and the IRS’ acquiescence in allowing an appointed trustee to receive and allocate minimum distributions on behalf of a designated beneficiary. By blending those options into resourceful estate-planning modes with a properly designed (qualifying) trust, IRA owners were able to employ post-mortem control on beneficiary withdrawal rights not otherwise obtainable without a trust. However, the SECURE Act of 2020 has since resulted in significant changes concerning Inherited IRAs
Under the new rules, beneficiaries of Inherited IRAs will generally be required to take all respectively vested IRA benefits within 10 years of the IRA owner’s decease. But there are more options that can be used even though recalculations for lifetime distributions no longer apply. The withdrawals can be made (i) in 10 approximate equal portions each year, or (ii) at various times and amounts during the 10-year period without minimum (or maximum) limitations, and/or (iii) as a one-lump-sum distribution of the entire account at the end of the 10-year period.
IRAs Payable to Trusts
In this discussion, references to trusts are a general reference to Revocable Living Trusts (RLTs). When utilizing “qualified” terms relative to IRA allocations, properly drafted RLTs will become “qualified” “Designated Beneficiary Trusts” after the death of the grantor/owner of an IRA identifying the trust as the beneficiary.
Contrary to popular belief, it is not necessary to establish a separate trust (in addition to a RLT) to create a qualified trust. All IRAs can be payable to any trust, including “nonqualified” trusts. But “qualified trusts” will generally be able to take advantage of the favorable Inherited IRA rules so that the IRA administrator will be allowed to “see through the trustee” for the purposes of making distributions to the trust’s beneficiaries as provided within the trust’s terms and now within the terms of the SECURE Act.
A IRA owner’s living trust cannot actually take title to an IRA – unless held within a special “trusteed IRA” format – without triggering an income tax liability. But, as pointed out, a trust can be selected as either a primary or contingent beneficiary of an IRA for the purpose of receiving death-benefit payments. The choice generally turns on the IRA owner’s personal estate planning objectives, estate value, etc. Several matters may come under consideration when determining how to allocate distributions of a particular IRA to a particular trust, but there are two important issues that should never be ignored – estate taxes and control.
For example, if a couple has an aggregate estate value – including the value of the IRA – less than the value at which the federal estate tax rates are imposed (i.e., the current federal exemption equivalent amount), then the likely choice would be for the spouse to be the primary beneficiary and the trust to be the contingent beneficiary. This strategy would allow wife, assuming that she has not reached her RBD and that she survives her husband, to roll husband’s IRA over to her own IRA (such as her IRA) at his death. She could then make their trust the primary beneficiary of her IRA and thus have the trust control the IRA distributions that would be vested to their children at her death.
Conversely, if the wife wanted to maintain control of her plan to the exclusion of her husband in the event that she predeceases him, then naming a “non-spousal credit shelter trust” as the primary beneficiary of her IRA – with a specific provision excluding the surviving spouse as a beneficiary of the IRA assets – may be the most appropriate choice. In such event, wife’s interest in the IRA would be funded to the non-spousal credit shelter trust (which becomes irrevocable) at her death. This would assure that wife’s interests would ultimately benefit her own children rather than husband’s new spouse or his potential creditors.
Trusts are Flexible/Effective Planning Tools
Without question, trusts offer a combination of versatility and planning capabilities not otherwise available for the IRA owner. Here are three common examples on point: (i) any trust can be the beneficiary of multiple plans (including IRAs) belonging to one owner or of separate plans of one or both spouses, and thus help centralize certain common planning goals through the use of one structure; (ii) a trustee of a DBT can be named as the sole beneficiary of a self-directed IRA which may be important for families with young or incapacitated children, as the imminent death of the IRA owner may otherwise leave the account without an appointed fiduciary; and (iii) most state statutes provide “spend-thrift trust” judgment protection from creditor claims against non-grantor beneficiaries of a trust. This can lengthen the protection term of the IRA by virtue of the DBT restricting beneficiaries’ proclivities to making lump sum withdrawals from an account.
Through intentional planning, a DBT can impose age-based allocation restrictions over an IRA in tandem with the current SECURE Act rules. Such planning strategies can fulfill an IRA owner’s desire for post-mortem control using payout provisions that will “enforce” the minimal withdrawal terms allowed under the rules. When a longer withdrawal period is applied to an IRA, the funds will obviously realize tax-deferred accumulations for a longer period if the money stays in the account. Of course, the longer money stays in an account growing tax-deferred, the more the account may ultimately be worth to the beneficiary.
Control is the Goal with Trusts
Avoiding probate is a worthy objective when transferring any asset. But probate avoidance is not the reason for making IRAs payable to a trust, because distributions to designated beneficiaries – exclusive of a trust – usually avoid probate through payable-on-death terms included in IRA contracts. Trust planning with retirement accounts is primarily about the post-mortem control that a trust grantor can obtain.
Preserving managerial control over assets beyond the grave has always been one of the primary reasons for anyone to establish a trust. For example, naming a minor-aged child or a spendthrift child as a direct beneficiary of an equity account would not be wise planning. If a minor or incapacitated child were vested with a retirement account from a decedent who left no governing instrument, then a guardian’s court in the child’s state of domicile would likely have to establish a trust instrument – under that state’s statutory terms, with a state-appointed fiduciary – to receive the distributions on behalf of the minor or incapacitated child even though a guardian for the child had been appointed by the parent.
Trusts that Qualify as a Designated Beneficiary
There are requirements that trusts must satisfy to be deemed a Designated Beneficiary Trust (DBT). A properly drafted DBT will be authorized to receive IRA distributions on behalf of a designated beneficiary but within the terms of the SECURE Act.
NOTE: Unlike a trust, a probate estate cannot qualify as a designated beneficiary of a qualified IRA. [See Treasury Reg. §1.401(a)(9)-4 and Private Letter Ruling PLR 2001-26401]. That means that if an IRA owner dies before his RBD with a simple will or no will at all, without naming a qualified beneficiary(s) or a DBT as the beneficiary(s) of his IRA, the five- year payout rule automatically applies regardless of the ages of decedent’s heirs because his estate – which is a non-qualified beneficiary – will become the beneficiary of his IRA by default.
A trust may qualify as a DBT if it passes four tests: (1) be valid under state law; (2) be completely irrevocable (a RLT becomes irrevocable at the death of the grantor) including with regard to beneficiary changes (i.e., trustee cannot be granted powers to sprinkle assets in its discretion or to designate other beneficiaries); (3) have natural individuals as beneficiaries who are separately identifiable and are thus qualified to receive benefits from an IRA (estates, corporations, partnerships& charities or any other institutions as such do not qualify as beneficiaries of an IRA); and (4) be presented to the IRA administrator when created or enforced as an irrevocable trust (e.g., generally at the death of the grantor) by October 31st of the year following the owner/grantor’s death, in order to certify the beneficiaries of the trust as of September 30th of the same year.
Charities as Beneficiaries of DBTs
Grantors will often name their favorite charities as beneficiaries of their trusts. This can cause a non-qualifying trust problem if not addressed properly because a charity is not a qualified beneficiary. Although a comprehensive discussion of the subject is beyond the scope of this article, realize that it is possible for a grantor to name a non-qualifying beneficiary (e.g., a charity) in his trust and yet enable his RLT to function as a DBT.
A trust containing a charitable allocation may qualify as a DBT if (a) the charitable distribution from the trust occurs before September 30th of the year following the year of death of the grantor and is comprised only of non-IRA assets, and (b) the remainder of the trust – remaining after the charitable distribution(s) – is allocated in definitive shares (but not pecuniary/dollar amounts) to the natural beneficiaries.
Final Estate Planning Considerations
Regardless of whether a qualified plan owner designates his trust as a beneficiary of his plan, the value of the plan will be includable in his estate for transfer tax purposes. A prime example of the importance of choosing a proper designated beneficiary is with the realization that an IRA can qualify for the marital deduction if transferred to a spouse; or, it can be transferred under the shelter of the unified credit, up to a certain amount, when conveyed to non-spousal beneficiaries such as children. For a married retirement account owner who has a large estate, it may make sense to simply name his or her spouse as the primary beneficiary of the IRA, with the trust as contingent beneficiary. Naming the trust, rather than the spouse, as the primary beneficiary of a large retirement account could ultimately cause an unnecessary estate tax liability – in addition to the income tax liability – as a result of transferring the plan through the Credit Shelter Trust to non-spouse beneficiaries.
Conversely, if the account owner’s spouse receives a large distribution from the plan through the marital deduction, the participant’s unified credit will not be unnecessarily utilized to shelter any of deceased spouse’s qualified plan from transfer tax. However, with that method, the spouse may acquire an estate tax problem that previously did not exist. It is obvious that, for married participants with moderate to large estates, transfer tax planning with IRAs is important.
One last item for consideration with IRA dispositions is the doctrine of spousal rights. Court cases have surfaced regarding rights over a decedent spouse’s IRA. The tax planner would do well to have the participant and the participant’s spouse document in writing their intent as to how the IRA should be treated for ownership purposes. The participant cannot expect his IRA to pass entirely through a Credit Shelter Trust when designating his RLT as the beneficiary of his IRA if, in fact, he did not have outright (sole and separate) interest in the IRA under state law.