This month's Alert examines the importance of proper IRA beneficiary designations. The Alert examines a case in which the stretch of IRA distributions was not maximized because of the beneficiary designation.
A parent with a large retirement account often doesn't want to name a child as the direct beneficiary of the retirement plan. This might be because the child is a minor. It could be because the child has a disability and is receiving government assistance. Other reasons include the inability of the child to manage money, creditor protection, or divorce protection. The solution to this dilemma is often to name a trust for the child as the beneficiary for the retirement plan.
Often, another goal of a parent with a large retirement plan is to delay the income taxation of the retirement plan assets as long as possible. This can be achieved by "stretching" the payments from the retirement plan as long as possible, thereby deferring the recognition of the income to some later date and allowing the retirement plan to continue to grow tax-deferred for the longest time possible.
When a trust is named as beneficiary of a parent's retirement plan such as an Individual Retirement Account, the ability to "stretch" distributions from the retirement plan requires special planning. The default position of the IRS in its regulations is that a trust does not have a life expectancy. In this situation, the retirement plan must be paid out within five years of the parent's death ("the five year rule").
If the trust meets certain requirements designated by the IRS, it will be characterized as a "qualified retirement trust" or a "look-through trust." The requirements are: (1) the trust must be irrevocable, or become irrevocable at the death of the parent, (2) the trust must be valid under state law, (3) the beneficiaries must be identifiable, and (4) a copy of the trust and any amendments must be delivered to the retirement plan custodian no later than October 31 of the year after the death of the parent.
The requirement that often causes problems is the requirement that the beneficiary be identifiable. In Private Letter Ruling 201210045, husband had a wife and two children, presumably from a previous relationship. He created a trust that distributed one-third of the trust assets to his wife upon his death, with the other two-thirds being distributed equally to his two sons. Husband named his trust as the beneficiary of his IRA.
The children each desired to set up an "inherited IRA" for their share of the retirement account assets and take distributions over their respective life expectancies. The IRS noted that the beneficiary of the IRA was the trust and not the individual beneficiaries. The IRS determined that the trust was a qualified retirement trust. As a qualified retirement trust, the trust could be analyzed to identify the beneficiaries of the trust. It was determined the three trust beneficiaries were wife and two sons. As such, the IRS ruled that it was possible for wife to roll-over her share of the IRA into an IRA for herself (a spouse is the only person who can take control of the IRA assets and put them into his or her own name) and each of the sons could have his share distributed by trustee-to-trustee transfer to an inherited IRA account.
The IRS next looked at the request that each beneficiary be able to use his or her own life expectancy. The IRS noted that the beneficiary of the IRA was the trust itself and not any individual beneficiary. Because the wife could roll-over her share of the IRA, the IRA was now hers and distributions to her would be determined in the same manner as any other individual who owns an IRA. To determine the required minimum distributions for the inherited IRAs for the sons, the IRS must determine the identity of the oldest beneficiary of the trust (because the IRA was payable to the trust and not the individual beneficiaries). In this case, the IRS determined the oldest trust beneficiary was the wife, and so each son must take distributions from his inherited IRA based on wife's life expectancy and not his own life expectancy. This ruling is contrary to what the sons wanted because it forced distribution and income taxation of their inherited IRAs more quickly than if they could have used the sons' longer life expectancies. If, for instance, wife was age 75 and son was age 50, the minimum distribution from a $200,000 inherited IRA based on wife's life expectancy would be $14,925 -- almost three times more than the $5,847 minimum distribution if the minimum distribution was based on son's life expectancy.
In order to have the required minimum distributions based on each beneficiary's separate life expectancy, husband's estate plan would have had to have complied with the IRS' separate share rule. The easiest way to comply with that rule would have been for him to name his wife as a one-third beneficiary of his IRA, his first son as a one-third beneficiary of his IRA and his second son as a one-third beneficiary of his IRA. However, as discussed above, it is not always prudent or possible to name the individual persons as beneficiaries of the IRA.
In this case, husband should have named the sub-shares of his trust, and not the overall trust itself, as the IRA beneficiary. An example of a beneficiary designation to a trust that complies with the IRS' separate share rule would be: one-third of my IRA to be paid to the share for my wife, Donna Doe, under the Donald Doe Trust; one-third to the share for my son, Darren Doe, under the Donald Doe Trust; and one-third to the share for my son, Daniel Doe, under the Donald Doe Trust. Had the husband in PLR 201210045 named the sub-shares for his wife and sons under his trust as the beneficiary of his IRA and not the trust itself, his sons would have been able to calculate their required minimum distributions from their inherited IRAs using their respective life expectancies rather than the wife's shorter life expectancy.
As you can see, there are many moving parts and numerous regulations that must be complied with when doing estate planning involving a retirement plan made payable to a trust. Our office focuses on estate planning and the administration of estates and trusts, including planning for individuals with large retirement plans. As a member of the American Academy of Estate Planning Attorneys, our firm is kept up to date with information regarding income, gift, and estate taxes, including planning strategies involving the "stretch" of retirement plan benefits. You can get more information about a complimentary review of your clients' existing estate plans and our planning and administration services by calling or by visiting our website.