Jump to Navigation

Utilizing Trusts As IRA Beneficiaries - Avoiding The Tax Traps

By Jack E. Stephens, Esq. (3/13/12)

The IRS has become more stringent on Trusts as beneficiaries of IRAs in allowing payouts over a beneficiary's life expectancy. If there are multiple beneficiaries in the Trust, the Trust must be qualified as a "designated beneficiary" in order to allow distribution over the life expectancy of the oldest Trust beneficiary.

Designating Living or Family Trusts as beneficiaries of IRAs are fraught with tax traps. Your Trust must be amended to qualify it as a designated beneficiary.

The much better way to go is an IRA Designated Beneficiary Trust (DBT) which is a separate Trust specifically designed to receive IRA funds for your beneficiaries. This type of Trust places the control of the distributions in the Trustee to avoid young or financially unsophisticated children/grandchildren from depleting the IRA account. It also provides creditor protection for the beneficiaries.

If the Trust qualifies as a "designated beneficiary," the Trust is considered to be a "look or see through" Trust and distributions are made over the life expectancy of the oldest Trust beneficiary. If "see through" status is not attained in the Trust, typically there is zero life expectancy allowed and the entire IRA must be distributed in the year after the owner's death creating a significant taxable event.

If the Trust provisions allow the Trustee to accumulate IRA distributions in the Trust known as an "accumulation Trust," all potential beneficiaries, including contingent beneficiaries, are scrutinized for the oldest Trust beneficiary. If a charity is a contingent beneficiary, a charity has no life expectancy and the result could be a zero life expectancy payout which means a lump sum distribution and tax on the entire IRA in the year after the IRA owner's death.

Problems have arisen with powers of appointment in which beneficiaries may appoint their share of the IRA fund to anyone they wish (general power) or to a limited class (limited power). If the appointment is or could be made to a person in an older generation, such person's life expectancy could be used under the oldest beneficiary test. This, of course, would limit the number of years all beneficiaries could take distribution which increases taxation.

All of this worry and stress can be avoided by converting the IRA Designated Beneficiary Trust (IRA DBT) from an "accumulation" Trust which you now have, to a conduit Trust. Basically, a conduit Trust requires the Trustee to distribute all IRA distributions to the beneficiaries on receipt by the Trustee. Thus, the term "conduit." The funds would only be protected from creditors while in the IRA but would no longer have creditor protection once they are distributed to the beneficiary.

If a conduit Trust is established, the oldest beneficiary test only includes the primary beneficiaries (usually your children). No contingent or remainder beneficiaries are considered for this purpose.

Second Consideration: Taking distributions over the life expectancy of each beneficiary.

In an effort to achieve this goal, we relied on a Private Letter Ruling (PLR) by the IRS a few years ago. Although PLRs can only be legally relied on by the taxpayer who obtained the ruling, they have been used as a gauge as to how the IRS would rule on a given case similar to facts in the PLR.

In that PLR, the IRS allowed for each beneficiary to take their individual share of the IRA over their individual life expectancy even though distributions came through a Trust. As part of the fact situation, the Trust was not designated as the beneficiary, but sub-Trusts for each beneficiary was so designated.

As a result, the IRS allowed an exception to the oldest beneficiary life expectancy rule because the Trust provisions qualified the sub-Trusts as a "designated beneficiary" and the designated beneficiary forms filed and accepted by the IRA institution designated the sub-Trusts as the beneficiaries.

The Problem: We have prepared these customized beneficiary forms designating sub-Trusts as beneficiaries for many of you but we have not received the acknowledgment of filing and acceptance from your IRA institution. We provided you a document to have the institution who is custodian of your IRA to acknowledge but very few have been completed.

As a result, the oldest Trust beneficiary's life expectancy will be utilized to take distribution. This will result in a grave disadvantage to a grandchild who is designated as a Trust beneficiary with children of the Trustor as such grandchild's distribution will be tied to that of the oldest child disallowing such grandchild years of IRA growth.

Action To Take:
We need to amend certain provisions of the IRA DBT to allow for a conduit feature for those of you who feel no need to accumulate IRA funds in the Trust. We also need to amend the powers of appointment provisions to ensure only descendants of the beneficiaries will become contingent beneficiaries should you desire to retain the accumulation feature.

Also, we need to confirm the acceptance of your customized beneficiary forms we prepared for you to file with your IRA institution so that sub-Trusts are accepted as the IRA beneficiaries to allow distributions over individual life expectancies.

Contact

Stephens Law Group
12526 High Bluff Dr.
Suite 200
San Diego, CA 92130
Phone: 858-792-0909
Fax: 858-792-0806
Map and Directions

Office Hours:
Monday-Thursday 9am-5pm
Friday 9am-1pm

Video of Jack Stephens' AV Preeminent Rating by Martindale-Hubbell