IRA Designated Beneficiary Trusts
by: Gary A. Loftsgard, CFP®
Taxpayers who have funded Individual Retirement Accounts (IRAs) (and to a certain degree, other qualified retirement accounts) may utilize remarkable estate planning strategies when optimizing the (a) required minimum distribution (RMD) rules1 with (b) the recalculation allowances for mandated beneficiary distributions and (c) the IRS’ acquiescence in allowing an appointed trustee to receive and allocate minimum distributions on behalf of a designated beneficiary. By blending these options into resourceful estate-planning modes with a properly designed (qualifying) trust, IRA owners will be able to employ far reaching post-mortem restrictive control on beneficiary withdrawal rights not otherwise obtainable without a trust.
Recalculations Make It Possible
The IRS Publication 590 Uniform Lifetime Table applies the RMD rules only for the IRA owner. However, separate periodical distribution terms can now be recalculated for the IRA’s designated beneficiary using the Single Life Table, regardless of the IRA owner’s age at his or her death. The ability to use separate tables eliminates the former requirement for the IRA owner to make an up front (sometimes undesirable), joint-life-expectancy-election for payout purposes, which became irrevocable at death.
As a result of the recalculation rules, IRA owners may now “enforce” the deferral benefit for the IRA beneficiaries through the use of a trust and the single-life recalculations and increased divisor numbers that equate to longer tax-deferred growth periods with applicable divisor2 structuring. Moreover, the recalculation allowances are good news for those planning their estates since the provisions can be selectively applied to each respective beneficiary of a trust, and thus controlled by the terms of the trust. That is because of the government’s permission to allow an IRA administrator to “see through the trustee” to the trust’s beneficiary(s).
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 and drafted properly, RLTs will always become “qualified” trusts after the death of the grantor(s) for RMD purposes (as discussed later).
Contrary to popular belief, it is not necessary to establish a separate trust (in addition to a RLT) to create a qualified trust3. All IRAs can be payable to any trust, including “non-qualified” trusts. But “qualified trusts” will generally be able to take advantage of the favorable RMD rules so that the IRA administrator will be allowed to “see through the trustee” for the purposes of making minimum distributions to the trust’s beneficiaries as provided within the trust’s terms.
Trusts that allow an IRA administrator to see through the trustee4 for the purposes of employing the RMDs for the designated beneficiaries, and that satisfy the four qualifying terms (as discussed later) prescribed under Treasury Regs. §1.401(a)(9) are commonly referred to as Designated Beneficiary Trusts (DBTs).
NOTE: If a trust does not qualify as a DBT by not meeting one or more of the qualifying terms, then the life expectancy of the account owner would be used to determine the payout terms of the retirement account to the trust if the account owner has already reached his Required Beginning Date (RBD) at his death. Or, if the account owner has not reached his RBD at the time of his death then the account would be distributed to the non-qualified trust under the five-year rule. Also, notwithstanding that a trust may qualify as a designated beneficiary, certain terms (or lack thereof) under which a certain IRA administrator may be required to process the distributions of the IRA could inhibit (or even prohibit) distributions to a DBT for purposes of optimizing the RMDs.
A trust cannot actually own an IRA (or any qualified retirement plan, for that matter) 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 discreet planning, a DBT can impose age-based allocation restrictions over an IRA in tandem with the current RMD 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.
The resulting difference between an IRA invoking the default five-year-rule distribution method (or even a lump-sum withdrawal) compared to one making distributions over the lifetime of a young designated beneficiary is quite obvious. Only the creator of a DBT using restrictive withdrawal terms in the DBT can effectively apply the recalculated divisors for minimum distributions purposes in lieu of the designated beneficiary’s own discretion.
Control is the Goal with Trusts
Avoiding probate is a worthy objective when transferring any asset. But probate avoidance is rarely 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, especially now in light of the see-through4 allowances that can be used in combination with the new RMD recalculation options.
As pointed out, a deceased IRA owner’s child/beneficiary may utilize the benefit of the RMD minimal withdrawal terms over the beneficiary’s life expectancy; however, there is no guarantee that the beneficiary will utilize the minimal distribution terms when left to personal discretion. Indeed, the vested beneficiary is confronted with a weighty decision (because there is a choice) of whether or not to make an immediate, complete withdrawal of the entire IRA. Without a trust, or some type of annuity payout arrangement, there is no controlling instrument to ensure that the beneficiary will not take more than the allowable minimum distributions, or even withdraw the entire account all at once.
NOTE: When focusing on RMD rules as they pertain to naming trusts as beneficiaries of IRAs, the attention is primarily on IRAs. It’s not that non-IRA plans do not have a designated beneficiary provision (they usually do), but most employers are not going to incorporate optimal RMD provisions into an employee IRA contract. The differences usually turn on matters of economics rather than separate applications of law because of associated administrative costs. As a result, non-IRA accounts are usually paid to the beneficiary(s) – the same as would be done with a trust if it were the beneficiary – as a lump sum distribution or over a five-year period. The default terms of most non-IRA plan distribution arrangements are probably quite different than the average participant’s distribution objectives. That is one reason why many participants eventually roll their IRAs over to an IRA upon retirement.
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 certain 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 for up to a term equal in length to the designated beneficiary’s actuarial lifetime (if so arranged in the DBT) as allowed under the RMD rules.
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.
Although the RMDs are generally applicable only to natural persons, trusts are an exception to that requirement. A trust may qualify to receive MINIMUM distributions under the favorable RMD terms 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 secure the use of the recalculation and RMDs rules for the other natural beneficiaries.
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.
Two Separate Account-Designation Methods
After making the determination that a (qualified) trust is to be a designated beneficiary of an IRA, a choice must be made as to how the IRA accounts are to be received and managed by the trust to utilize the minimum required distribution terms. There are two such accounting methods of choice that can generate results quite different from one another and should be individually analyzed before a decision is made.
Either accounting method, for purposes of identifying the actual beneficiary(s) of the IRA, must employ an “intermediary” approach between the IRA administrator and the trustee of the trust. The beneficiary appointments should be clarified with the administrator at the IRA level, not just by the trust. Let’s look at each method.
The Singular Method
The Singular Designation Method identifies the trustee as the effective designated beneficiary of the IRA in proxy for the beneficiaries of the DBT. As a result, the life expectancy of the oldest living beneficiary of the trust who is living at the time of the grantor’s death will be used regardless of the other beneficiaries’ ages. IRS Private Letter Ruling 9809059 states that IRA benefit(s) cannot be considered as being divided into separate accounts for the beneficiaries simply because the trust is partitioned in separate shares, and not separate trusts.
When using this Singular Accounting Method – where the trustee is always the designated payee and separate trusts were not created for each beneficiary at the grantor’s death – the oldest beneficiary’s age will be used as the divisor in recalculating the minimum distribution payouts to all beneficiaries of the trust. If the beneficiaries of the trust are close in age (for example, 14, 12 and 10) then using this method would not create a significant loss in deferred earnings for the younger beneficiaries in such case, and therefore has no real disadvantage.
The Multipart Method
The Multipart Designation Method requires the establishment of separate trusts for each qualified beneficiary of the trust – rather than just separate shares – to meet the separate accounts rule5 as described under Treasury Reg. (TR) 1.401(a)(9)-8, A-2(a)(2). By applying the TR-1.401 separate accounts rule to the (remainder) IRA interest in the trust, the trustee will effectively recast individual share designations into separate trusts for minimum distribution purposes, but only as to the IRA’s remainder interest. Using this method, each beneficiary’s life expectancy may be applied instead of the oldest beneficiary’s age in calculating respective minimum distributions.
To create separate trusts for accounting purposes, the trustee needs to perform two essential administrative procedures. One is to establish separate accounts for each beneficiary at the IRA level. That arrangement should be made with the IRA provider immediately after the death of the participant/grantor, per the stipulations of the grantor trust. The second is to establish separate Tax ID numbers for each trust account, and administer accordingly using separate accounting ledgers, 1041 returns, et cetera.
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.
Footnotes
1. The Required Minimum Distribution rules as described under Internal Revenue Code (IRC) Section 401(a)(9) oblige minimum, gradual distributions from the death benefit of a qualified retirement account to a payee (designated beneficiary) so as to deplete, or nearly deplete, the payee’s vested (inherited) tax-deferred account over his or her actuarial lifetime. RMDs effectively describe the terms to compute how an IRA account is to be distributed out in any given year to a payee with a (codified) declining life expectancy. RMDs also apply to Roth IRAs as they pertain to beneficiary distributions. Since a Roth IRA is not governed by the Required Beginning Date (RBD) rules, the beneficiary must take distributions per the RMDs as though the Roth IRA owner never attained his RBD.
2. The applicable divisor is a number (as applied to the Single Life Table) equal to the remaining number of years that a designated beneficiary is expected to live. For example, assume a beneficiary of age 18 has an actuarial life expectancy of 60 years. The number 60 will be the applicable divisor for a beneficiary in the year he reaches 18. If he becomes vested with a retirement account at age 18 as a result of the owner’s death, then the value of the account will be divided by 60 and the dividend is the minimum amount that must be paid to the beneficiary.
3. For a trust to be deemed a qualified trust for minimum distribution purposes, it must ultimately have and properly identify “qualified beneficiaries” with distinguishable shares or percentage allocations. The trust must also be registered with the IRA provider by October 31st of the year following the year of the account owner’s death. The qualified trust must always meet the four primary tests as described in this article. Such a trust is also known as a Designated Beneficiary Trust (DBT).
4. The so-called see through the trustee rules allow a trust to become a Designated Beneficiary Trust (if it meets certain conditions) so the IRA administrator can “see through the trustee” to the trust’s beneficiaries. As a result, the trust beneficiaries alone (and not the trust) will be treated as the qualified designated beneficiaries of the IRA. The see-through rules simply allow the IRA administrator to allocate the IRA distributions to the trustee through the utilization of the favorable RMD rules.
5. Treasury Reg. 1.401(a)(9)-8, A-2(a)(2) describes the application of separate accounting rules for required distributions which would pertain to trusts as beneficiaries of qualified plans. Nothing in the regulations indicates that the “separate-interests rules” cannot be applied to trusts with (qualified) beneficiaries where the trust effectively creates separate trusts/accounts for each beneficiary. A copy of the trust – which identifies the see-through beneficiaries of the account (established by September 30th) for separate accounting purposes – must be provided to the account administrator by October 31st of the year following the year of the account owner’s death.
Taxpayers who have funded Individual Retirement Accounts (IRAs) (and to a certain degree, other qualified retirement accounts) may utilize remarkable estate planning strategies when optimizing the (a) required minimum distribution (RMD) rules1 with (b) the recalculation allowances for mandated beneficiary distributions and (c) the IRS’ acquiescence in allowing an appointed trustee to receive and allocate minimum distributions on behalf of a designated beneficiary. By blending these options into resourceful estate-planning modes with a properly designed (qualifying) trust, IRA owners will be able to employ far reaching post-mortem restrictive control on beneficiary withdrawal rights not otherwise obtainable without a trust.
Recalculations Make It Possible
The IRS Publication 590 Uniform Lifetime Table applies the RMD rules only for the IRA owner. However, separate periodical distribution terms can now be recalculated for the IRA’s designated beneficiary using the Single Life Table, regardless of the IRA owner’s age at his or her death. The ability to use separate tables eliminates the former requirement for the IRA owner to make an up front (sometimes undesirable), joint-life-expectancy-election for payout purposes, which became irrevocable at death.
As a result of the recalculation rules, IRA owners may now “enforce” the deferral benefit for the IRA beneficiaries through the use of a trust and the single-life recalculations and increased divisor numbers that equate to longer tax-deferred growth periods with applicable divisor2 structuring. Moreover, the recalculation allowances are good news for those planning their estates since the provisions can be selectively applied to each respective beneficiary of a trust, and thus controlled by the terms of the trust. That is because of the government’s permission to allow an IRA administrator to “see through the trustee” to the trust’s beneficiary(s).
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 and drafted properly, RLTs will always become “qualified” trusts after the death of the grantor(s) for RMD purposes (as discussed later).
Contrary to popular belief, it is not necessary to establish a separate trust (in addition to a RLT) to create a qualified trust3. All IRAs can be payable to any trust, including “non-qualified” trusts. But “qualified trusts” will generally be able to take advantage of the favorable RMD rules so that the IRA administrator will be allowed to “see through the trustee” for the purposes of making minimum distributions to the trust’s beneficiaries as provided within the trust’s terms.
Trusts that allow an IRA administrator to see through the trustee4 for the purposes of employing the RMDs for the designated beneficiaries, and that satisfy the four qualifying terms (as discussed later) prescribed under Treasury Regs. §1.401(a)(9) are commonly referred to as Designated Beneficiary Trusts (DBTs).
NOTE: If a trust does not qualify as a DBT by not meeting one or more of the qualifying terms, then the life expectancy of the account owner would be used to determine the payout terms of the retirement account to the trust if the account owner has already reached his Required Beginning Date (RBD) at his death. Or, if the account owner has not reached his RBD at the time of his death then the account would be distributed to the non-qualified trust under the five-year rule. Also, notwithstanding that a trust may qualify as a designated beneficiary, certain terms (or lack thereof) under which a certain IRA administrator may be required to process the distributions of the IRA could inhibit (or even prohibit) distributions to a DBT for purposes of optimizing the RMDs.
A trust cannot actually own an IRA (or any qualified retirement plan, for that matter) 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 discreet planning, a DBT can impose age-based allocation restrictions over an IRA in tandem with the current RMD 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.
The resulting difference between an IRA invoking the default five-year-rule distribution method (or even a lump-sum withdrawal) compared to one making distributions over the lifetime of a young designated beneficiary is quite obvious. Only the creator of a DBT using restrictive withdrawal terms in the DBT can effectively apply the recalculated divisors for minimum distributions purposes in lieu of the designated beneficiary’s own discretion.
Control is the Goal with Trusts
Avoiding probate is a worthy objective when transferring any asset. But probate avoidance is rarely 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, especially now in light of the see-through4 allowances that can be used in combination with the new RMD recalculation options.
As pointed out, a deceased IRA owner’s child/beneficiary may utilize the benefit of the RMD minimal withdrawal terms over the beneficiary’s life expectancy; however, there is no guarantee that the beneficiary will utilize the minimal distribution terms when left to personal discretion. Indeed, the vested beneficiary is confronted with a weighty decision (because there is a choice) of whether or not to make an immediate, complete withdrawal of the entire IRA. Without a trust, or some type of annuity payout arrangement, there is no controlling instrument to ensure that the beneficiary will not take more than the allowable minimum distributions, or even withdraw the entire account all at once.
NOTE: When focusing on RMD rules as they pertain to naming trusts as beneficiaries of IRAs, the attention is primarily on IRAs. It’s not that non-IRA plans do not have a designated beneficiary provision (they usually do), but most employers are not going to incorporate optimal RMD provisions into an employee IRA contract. The differences usually turn on matters of economics rather than separate applications of law because of associated administrative costs. As a result, non-IRA accounts are usually paid to the beneficiary(s) – the same as would be done with a trust if it were the beneficiary – as a lump sum distribution or over a five-year period. The default terms of most non-IRA plan distribution arrangements are probably quite different than the average participant’s distribution objectives. That is one reason why many participants eventually roll their IRAs over to an IRA upon retirement.
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 certain 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 for up to a term equal in length to the designated beneficiary’s actuarial lifetime (if so arranged in the DBT) as allowed under the RMD rules.
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.
Although the RMDs are generally applicable only to natural persons, trusts are an exception to that requirement. A trust may qualify to receive MINIMUM distributions under the favorable RMD terms 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 secure the use of the recalculation and RMDs rules for the other natural beneficiaries.
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.
Two Separate Account-Designation Methods
After making the determination that a (qualified) trust is to be a designated beneficiary of an IRA, a choice must be made as to how the IRA accounts are to be received and managed by the trust to utilize the minimum required distribution terms. There are two such accounting methods of choice that can generate results quite different from one another and should be individually analyzed before a decision is made.
Either accounting method, for purposes of identifying the actual beneficiary(s) of the IRA, must employ an “intermediary” approach between the IRA administrator and the trustee of the trust. The beneficiary appointments should be clarified with the administrator at the IRA level, not just by the trust. Let’s look at each method.
The Singular Method
The Singular Designation Method identifies the trustee as the effective designated beneficiary of the IRA in proxy for the beneficiaries of the DBT. As a result, the life expectancy of the oldest living beneficiary of the trust who is living at the time of the grantor’s death will be used regardless of the other beneficiaries’ ages. IRS Private Letter Ruling 9809059 states that IRA benefit(s) cannot be considered as being divided into separate accounts for the beneficiaries simply because the trust is partitioned in separate shares, and not separate trusts.
When using this Singular Accounting Method – where the trustee is always the designated payee and separate trusts were not created for each beneficiary at the grantor’s death – the oldest beneficiary’s age will be used as the divisor in recalculating the minimum distribution payouts to all beneficiaries of the trust. If the beneficiaries of the trust are close in age (for example, 14, 12 and 10) then using this method would not create a significant loss in deferred earnings for the younger beneficiaries in such case, and therefore has no real disadvantage.
The Multipart Method
The Multipart Designation Method requires the establishment of separate trusts for each qualified beneficiary of the trust – rather than just separate shares – to meet the separate accounts rule5 as described under Treasury Reg. (TR) 1.401(a)(9)-8, A-2(a)(2). By applying the TR-1.401 separate accounts rule to the (remainder) IRA interest in the trust, the trustee will effectively recast individual share designations into separate trusts for minimum distribution purposes, but only as to the IRA’s remainder interest. Using this method, each beneficiary’s life expectancy may be applied instead of the oldest beneficiary’s age in calculating respective minimum distributions.
To create separate trusts for accounting purposes, the trustee needs to perform two essential administrative procedures. One is to establish separate accounts for each beneficiary at the IRA level. That arrangement should be made with the IRA provider immediately after the death of the participant/grantor, per the stipulations of the grantor trust. The second is to establish separate Tax ID numbers for each trust account, and administer accordingly using separate accounting ledgers, 1041 returns, et cetera.
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.
Footnotes
1. The Required Minimum Distribution rules as described under Internal Revenue Code (IRC) Section 401(a)(9) oblige minimum, gradual distributions from the death benefit of a qualified retirement account to a payee (designated beneficiary) so as to deplete, or nearly deplete, the payee’s vested (inherited) tax-deferred account over his or her actuarial lifetime. RMDs effectively describe the terms to compute how an IRA account is to be distributed out in any given year to a payee with a (codified) declining life expectancy. RMDs also apply to Roth IRAs as they pertain to beneficiary distributions. Since a Roth IRA is not governed by the Required Beginning Date (RBD) rules, the beneficiary must take distributions per the RMDs as though the Roth IRA owner never attained his RBD.
2. The applicable divisor is a number (as applied to the Single Life Table) equal to the remaining number of years that a designated beneficiary is expected to live. For example, assume a beneficiary of age 18 has an actuarial life expectancy of 60 years. The number 60 will be the applicable divisor for a beneficiary in the year he reaches 18. If he becomes vested with a retirement account at age 18 as a result of the owner’s death, then the value of the account will be divided by 60 and the dividend is the minimum amount that must be paid to the beneficiary.
3. For a trust to be deemed a qualified trust for minimum distribution purposes, it must ultimately have and properly identify “qualified beneficiaries” with distinguishable shares or percentage allocations. The trust must also be registered with the IRA provider by October 31st of the year following the year of the account owner’s death. The qualified trust must always meet the four primary tests as described in this article. Such a trust is also known as a Designated Beneficiary Trust (DBT).
4. The so-called see through the trustee rules allow a trust to become a Designated Beneficiary Trust (if it meets certain conditions) so the IRA administrator can “see through the trustee” to the trust’s beneficiaries. As a result, the trust beneficiaries alone (and not the trust) will be treated as the qualified designated beneficiaries of the IRA. The see-through rules simply allow the IRA administrator to allocate the IRA distributions to the trustee through the utilization of the favorable RMD rules.
5. Treasury Reg. 1.401(a)(9)-8, A-2(a)(2) describes the application of separate accounting rules for required distributions which would pertain to trusts as beneficiaries of qualified plans. Nothing in the regulations indicates that the “separate-interests rules” cannot be applied to trusts with (qualified) beneficiaries where the trust effectively creates separate trusts/accounts for each beneficiary. A copy of the trust – which identifies the see-through beneficiaries of the account (established by September 30th) for separate accounting purposes – must be provided to the account administrator by October 31st of the year following the year of the account owner’s death.