8/3/2009 - Beaufort, SC
Using a trust as an IRA beneficiary is a hot topic. Rather than the IRA owner naming a spouse, child, or grandchild as the direct IRA beneficiary, the owner instead names a trust for that person as the beneficiary. The trust may protect the beneficiary, achieve a tax result, or both.
In 2001 the IRS updated its regulations on how trusts could be used as IRA beneficiaries. Those regulations made IRA trusts a legitimate estate planning device. The recent combination of market turmoil, recession, and aging baby-boomers has made the IRA trust particularly attractive. In fact, several financial services companies have developed comprehensive programs for IRA trusts. These programs make IRA trusts more user friendly to both clients and their advisors.
Qualified plan distributions, like IRA distributions, can also be made to trusts. However, with qualified plans there are complexities that should be avoided. I will address only IRA trusts here.
Background IRAs must satisfy the minimum distribution rules when the IRA owner reaches age 70-1/2. Payments are spread over the owner's life expectancy. At the owner's death, distributions can be made over the life expectancy of the IRA's "designated beneficiary." These are referred to as "stretch IRAs."
If a trust is named as the IRA beneficiary, there can be a problem because a trust, unlike an individual, has no life expectancy over which post-death distributions can be calculated. However, if the trust meets IRS requirements, we can "look through" the trust and treat the trust beneficiary as the designated beneficiary of the IRA. We then use that beneficiary's life expectancy to calculate minimum distributions to the trust. Were it not for this "look through" rule, the IRA would have to be paid out over a much shorter period after the owner's death, thereby losing long term tax deferral.
Note: Here's how to understand the concept. The IRA is tax exempt. The IRA trust is not. The trust will have money from the IRA only briefly each year. The trustee withdraws the annual minimum distribution (or more, if desired) from the IRA and deposits the funds in the trust. The balance stays in the IRA for continued tax deferred growth. The trustee then distributes the funds from the trust to the trust beneficiary. The IRA trust may be empty until next's years minimum distribution is received.
Requirements for "Look Through" Trusts There are five simple requirements for a trust to qualify for "look through" status.
•1. The trust must be valid under state law.
•2. The trust must be irrevocable, or will, by its terms, become irrevocable at the death of the IRA owner.
•3. The trust beneficiaries must be identifiable from the trust instrument.
•4. Certain documents must be provided to the IRA custodian or administrator.
•5. The trust beneficiary must be an individual.
Four Scenarios for IRA Trusts There are at least four instances when you should consider a trust for an IRA.
1. Intended Beneficiary is a Child If the intended IRA beneficiary is a minor, using a trust is obvious. As long as the trust qualifies under the "look through" rules, the life expectancy of the child can be used for post-death minimum distributions.
For example, at grandfather's death he names an IRA trust as beneficiary of a $100,000 IRA. The grandson is the sole beneficiary of the trust. Under the IRS annuity tables the life expectancy of a 5 year old is 77.7 years. So, in the first year after the grandfather's death, the IRA must distribute only 1/77.7 to the trust (that's 1.287%, or $1,287). The balance of the fund remains in the IRA for continued tax deferred growth. In each subsequent year, the minimum distribution divisor is reduced by 1. The tax deferral opportunity is enormous. Of course, more than the minimum distribution can be withdrawn from the IRA at any time, such as when the grandson is in college.
2. Intended Beneficiary Is an Adult Who Needs Protection In this case the intended IRA beneficiary is an adult, but the adult has problems, is in a bad marriage, or does not have the financial self-discipline to take only the minimum distribution every year. The IRA trust, with an independent trustee, may protect the beneficiary from some of his creditors or himself.
3. Using a Credit Shelter Trust A married client has a large estate, much of it in IRAs. The client has no other "non-IRA" assets with which to fund the credit shelter trust for his wife in his will. The client could name his wife as the direct IRA beneficiary, but that would squander his otherwise available estate tax exemption (currently $3.5 million).
The client should establish a "look through" IRA trust naming his wife as beneficiary of the trust. IRA assets earmarked for the trust will not qualify for the estate tax marital deduction, but they will be covered by up to $3.5 million of the exemption. Minimum distributions calculated on the wife's life expectancy (and more, if necessary) will be taken from the IRA, put into the "look through" trust, and then paid to the wife each year. The rest stays in the IRA for continued tax deferred growth.
4. QTIP Trust for Wife in a Second Marriage In this example the IRA owner is married for the second time. He has substantial IRA assets. If his wife survives, he will need the estate tax marital deduction, but he does not want to name his current wife as outright IRA beneficiary. He needs to protect his wife during her lifetime, but after her death he wants the remaining IRA balance paid to his children from a previous marriage.
In this case the husband should use an IRA "look through" trust as beneficiary of his IRA. His wife would be the sole beneficiary of the trust. The trust can be drafted to qualify for the estate tax marital deduction if a "QTIP" election is made. The wife then lives off the IRA distributions made to the trust and paid out to her. At her death the remaining IRA assets pass to the husband's children.
Practical Considerations Here are some housekeeping tips when using a "look through" trust.
•· Roll qualified plan assets into an IRA. Many qualified plans do not permit payout options that would be needed for a "look through" trust to work. By contrast, IRAs offer every permissible payout arrangement.
•· Use a separate IRA trust for each intended designated beneficiary. If there is more than one trust beneficiary, you must use the life expectancy of the eldest.
•· I prefer to not co-mingle IRA distributions into a "look through" trust that is expected to receive non-IRA assets. When I use an IRA "look through" trust in a will, I segregate it from all other trusts in that will. There is no legal requirement for this, but I believe it minimizes the likelihood of mistakes when distributions are made from year to year.
•· Verify that the IRA beneficiary designation naming the IRA trust is properly filed with the IRA custodian and accurately identifies the intended IRA trust.
•· Do not confuse the client's general revocable "living trust" for a "look-through" trust. Many living trusts do not have the special provisions to qualify them as a "look through" trust after the client's death.
•· Finally, a word of caution. This memo is a general overview intended to illustrate the basics of "look through" trusts. There are many complexities I have not discussed, and the examples in this memo are simplistic.
Conclusion IRA "look through" trusts are an important estate planning tool. While certainly not for everyone, IRA trusts afford solutions to many clients' special circumstances. Setting up a "look through" trust requires careful planning, draftsmanship, and monitoring. It also requires close coordination with the client, his financial advisor, his CPA, and his estate planning attorney.
Eugene Parrs 2009