To Trust an IRA... Or Not

Authors: Thomas C. Hoffman, II and Nadia A. Havard

Originally published in October 2014

Copyright © 2014 Knox McLaughlin Gornall & Sennett, P.C.

Should a Trust be a beneficiary?

The purpose for creating a trust and the language used in the trust document shall set the legal basis for having the trust named as the trust beneficiary. In drafting trusts which are intended to qualify as the trust beneficiaries, special care needs to be taken to determine who is the trust beneficiary for purposes of the retirement accounts (a spouse, children, or charities, or a class to be determined by exercise of power of appointment). A spendthrift clause does not create an issue with regards to minimum required distributions to beneficiaries. However, the trustee shall determine whether certain classes of income are directed to be distributed to certain beneficiaries (for example, investment income to be distributed to the life beneficiary). The trust agreement shall clearly address situations dealing with funding of the marital bequest by using or avoiding retirement accounts as well as the way the funding of the charitable gifts by use or foregoing retirement accounts.

See-Through and Accumulation Trusts

Treasury Regulation § 1.401(a)(9)-4, A-5(b) See-Through Trust

The IRS provided in Treasury Regulation § 1.401(a)(9)-4, A-5(b) certain rules that must be met in order for the trust to qualify as a see-through trust beneficiary. The minimum required distribution rules set forth by the IRS in the Treasury Regulation section allow the IRS to look through the trust, and treat the trust beneficiaries as the beneficiaries of the retirement account held by the participant. The IRS will treat such beneficiaries as if they had been named directly as beneficiaries of the retirement plan.

Trust must be valid under state law: Treasury Regulation § 1.401(a)(9)-4, A-5(b)(1) provides that the trust must be a valid trust under state law, or would be but for the fact that there is no corpus. A testamentary trust can pass this test as further set forth in Regs. § 1.401(a)(9)-5, A-7(c)(3), examples 1 and 2. Apparently, there is no requirement that the trust be in existence or be funded at the time it is named as beneficiary. Similarly, there is no such requirement for the trust to be in existence or be funded at the death of the retirement account participant. What is important is that after the trust is funded with the retirement assets, subsequent to the death of the participant, such trust must be valid under state law.

Trust must be irrevocable: Treasury Regulation § 1.401(c)(9)-4, A-5(b)(2); and Treasury Regulation § 1.408-8, A-1(b), provides that the trust is irrevocable or will, by its terms, become irrevocable upon the death of the retirement account owner. Under Pennsylvania law, Section 20 Pa.C.S.A. § 7752(a), provides that “the settlor may revoke or amend a trust unless the trust instrument expressly provides that a trust is irrevocable.” Therefore, if a trust is created during the lifetime and funded upon death, it still would be important to include the language in the document stating clearly that upon the settlor’s death, the trust would become irrevocable, if during the lifetime it is desirable for the trust to be revocable. Section 20 Pa.C.S.A. § 7752(b) provides that if “a revocable trust is created or funded by more than one settlor” depending, whether the trust consists of community property or property other than community property, either one or each settlor may revoke or amend the trust with respect to the portion of the trust property attributable to that settlor’s contribution. Again, it would be prudent to include a very clear statement in the trust agreement that upon the settlor’s death, the share of the trust that would be funded with the retirement account benefits becomes irrevocable.

Beneficiaries must be identifiable: § 1.401(a)(9)-4, A-5(b)(3) provides that “the beneficiaries of the trust who are beneficiaries with respect to the trust’s interest in the employee’s benefit” must be “identifiable within the meaning of A-1 of Section 1.401(a)(9)-4, A-5(b)(3) from the trust instrument. The regulations further define the word “identifiable” as “a designated beneficiary … not … specified by name in the plan or by the employee to the plan . . . so long as the individual who is to be the beneficiary is identifiable under the plan. The members of a class of beneficiaries capable of expansion or contraction will be treated as being identifiable if it is possible to identify the class member with the shortest life expectancy.” (Treasury Regulation § 1.401(a)(9)-4, A-1). In the IRS private letter rulings, the IRS determined that if a remainder interest is subject to power of appointment upon the death of the life beneficiary of the trust, all potential appointees, as well as those who would take in default of exercise their power, are considered “beneficiaries” unless they can be disregarded under certain rules provided by the IRS. Under a see-through trust for a single beneficiary, the trust remainder beneficiaries are disregarded. Thus, the see-through beneficiary (or the trustee or anyone) can be given the power to appoint the trust remaining at the beneficiary’s death who is the sole beneficiary of the see-through trust, to anyone, even to a charity, to a non see-through trust, an estate, or an old individual, and the trust will still qualify as a see-through trust based on the see-through beneficiary’s life expectancy (PLR 200620026). If, however, the trust is an accumulation trust, the remainder beneficiaries generally must be counted. Therefore, if such an accumulation trust is other than 100% grantor trust, all such potential appointees of the beneficiary as well as those who will take in default of exercise of the power, should be identifiable, individuals, who are younger than the beneficiary whose life expectancy is the one the participant wants to use to determine the minimum required distributions.

Documentation: Treasury Regulation § 1.401(a)(9)-4, A-5(b)(4) requires the beneficiary to supply certain documentation to the plan administrator. Section 1.408-8, A‑1(b) of the Treasury Regulations, gives examples of plan administrators who must receive certain document records (the IRA trustee, custodian, or issuer of the IRA). Such documentation must be provided no later than October 31st of the year subsequent to the year the decedent passed away. The regulations give an option of what documentation must be, such as a final list of all beneficiaries of the trust (including contingent and remainder beneficiaries with inscription of the conditions and other entitlement) as of September 30th of the following calendar year of the employee’s death, or a copy of the actual trust document for the trust that is named as a beneficiary of the plan as of the employee’s date of death.

All beneficiaries must be individuals: If an estate is named as the beneficiary of the account, that needs to be addressed by September 30th of the calendar year following the calendar year of the employee’s death. If a trust provides that the trust must or may contribute funds to the decedent’s estate for payment of the decedent’s debts, expenses or taxes, then the estate will be considered a potential trust beneficiary, and therefore will fail the rule requiring all beneficiaries to be individuals.

Separate Accounts

Separate accounts treatment is never available for purposes of determining the payout period for benefits paid to multiple beneficiaries through a single trust that is named as beneficiary. A trust cannot exercise the power to roll over even if it is a see-through trust (§ 1.408-8, A-5(a)).

Estate Planning with Trusts as IRA Beneficiaries

Trust for Disabled Beneficiary

The choice of the trust (whether it is a see-through trust or an accumulation trust) depends on whether the beneficiary must qualify for the need-based governmental programs and whether it is possible to ascertain the remainder beneficiaries. If the need-based qualification is not a goal, then the trust can be a see-through trust (i.e. a conduit trust), requiring the trustee to distribute all minimum required distributions as well as any other distributions received from the IRA, to the disabled beneficiary. Such distributions would be considered available income or assets to the beneficiary. This type of trust is suitable if (i) the family intended to provide for the disabled beneficiary anyway, and (ii) the remainder of the trust will be left to a charity. If the need-based qualification is a goal, then the accumulation trust is a better choice. The accumulation trust will grant a trustee discretion to distribute the trust funds to the disabled beneficiary or for such beneficiary's benefit except for such beneficiary’s support and medical care. The remainder beneficiaries must be individuals, preferably close in age to the disabled beneficiary. If the donor is charitably inclined and the disabled beneficiary needs to qualify for the needs-based governmental programs, a charitable remainder trust (CRT) should be used as an IRA beneficiary. Upon the participant’s death, the IRA will be paid out to the CRT without triggering income tax liability. The trustee may reinvest the received funds and the annuity or unitrust payments can be paid to the special needs trust for the benefit of a disable beneficiary with the remainder to be paid to a charity (Rev. Rul. 2002-20, 2002-1 I.R.B. 794).

Trust for Minors

Determine whether the “stretch” payout method is preferred over spending most of the funds during the minor’s childhood for education and care. If a minor is named as an outright beneficiary of the IRA, then the IRA provider may release the benefits only to the minor’s legal guardian. If the IRA assets are not substantial or if they are not intended to be used during the childhood, then the see-through (the conduit) trust is preferred. Even though the IRA distributions will be paid out for the minor’s benefit (or to the minor’s guardian or custodian), the amounts will be rather small. If the IRA assets would be primarily used during the minor’s childhood to provide for education and care, then accumulation trust is preferred. If there is more than one (1) child, it would be better to provide that the last child remaining alive should receive the trust assets outright and free of trust. That will avoid the problem of determining the remainder beneficiaries of the trust.

Trust for Spouse

It is important to discuss with the client the impact of income tax consequences between the IRA assets being left to a trust for the benefit of a spouse versus the IRA assets being left to the spouse outright and free of trust. If the marital deduction is important and to preclude the spouse spending all the IRA assets shortly after the participant’s death, the IRA assets should be left to a qualified terminable interest property (QTIP) trust with the spouse being the sole beneficiary of the trust. If the surviving spouse lives long, all of the IRA benefits will be paid out to the QTIP trust (and the spouse as the sole beneficiary) with no IRA assets passing to the next generation. If the donor is charitably inclined, consider creating a charitable remainder trust for the benefit of the spouse and the charity. The IRA assets will be paid out to the CRT without triggering the income tax consequences. The spouse will be receiving either the unitrust or annuity payments and the remainder will be left to a charity.

Income Tax on the Retirement Benefits Payable to the Trust

Income Tax Consequences When the IRA Distributions Are Distributed to the Trust

The distributions are included in the trust’s gross income. The see-through status determines only when the trust must take IRA distributions and not whether such distributions are included in the trust’s gross income. The trust’s fiduciary income may be reduced by distributions made to the beneficiaries. The trust’s fiduciary income is not subject to the reduction of itemized deductions. The trust pays the highest income tax (39.6% for 2014) with the income over $12,150.

How the Trust Can Reduce its Tax Liability on IRA distributions

The IRA distribution is paid out from the trust to the beneficiary and included in the trust’s distributable net income (DNI). The inclusion in the DNI will be allowed if either the trust income is required to be distributed or is actually distributed in the year when the income is received by the trust (including 65 days election under Section 663(b)). The formula pecuniary bequest is not considered a bequest of a specific sum of money and can carry out DNI (Treasury Regulations § 1.663(a)-1(b)(1)).

Latest Case Law and Private Letter Rulings on the IRA and the Beneficiaries

Clark v Rameker, 537 U.S. (2014). The US Supreme Court ruled that IRAs inherited by 3rd parties ( in this instance, a daughter of the decedent) constitute a “pot of money” freely available for current consumption rather than retirement funds. Therefore, the inherited IRA is not exempt from creditors’ claims in Chapter 7 bankruptcy.

PLR 201430029. The IRS ruled that the surviving spouse could roll over the IRA proceeds that she received from the revocable trust which was the beneficiary of her deceased spouse’s IRA. The IRS confirmed that because the spouse was the sole trustee and had the sole discretion and authority to distribute the IRA proceeds to herself, she could roll over such proceeds within 60 days from the date such distribution was made from the IRA.

PLR 201430027. The IRS ruled that the surviving spouse could roll over the IRA proceeds which were paid to the decedent’s estate, because under the decedent’s will the surviving spouse was the sole executrix and the sole estate beneficiary.

PLR 201430026. The IRS ruled that the surviving spouse, acting as the sole trustee of the joint revocable trust with the sole discretion to distribute the IRA proceeds to herself, may roll over such proceeds to her own IRA within 60 days from the date such proceeds are paid to the trust.

PLR 201423043. The IRS ruled that a surviving spouse could roll over her deceased spouse’s Roth IRA, payable to a trust of which she was sole trustee and beneficiary, into her own Roth IRA.

Perpetual Trusts

Generation Skipping Tax (GST) Exempt Trusts

Leaving the IRA to a GST exempt trust is desirable if it is a Roth IRA or if the client has no other assets suitable for a generation-skipping gift.

If it is a traditional IRA, it is better to leave it to a non-GST exempt trust. (Otherwise paying income taxes on the IRA distributions will waste GST exemption allocated to the trust.)

Contributing Authors:

Authors: Thomas C. Hoffman, II and Nadia A. Havard

Originally published in October 2014

Copyright © 2014 Knox McLaughlin Gornall & Sennett, P.C.