Federal Employees News Digest

Employees Need to Understand the Rules for Inherited IRAs - Part IV

As many Federal employees are currently receiving, or perhaps will receive in the future inherited IRA accounts from deceased relatives, they need to understand the rules associated with inherited IRAs. In the fourth of four columns discussing rules associated with inherited IRAs, this week’s column discusses the rules for naming trusts as IRA beneficiaries.

Before discussing the specifics of naming a trust as an IRA beneficiary, it is important to review the ultimate purpose of IRA beneficiary designations. Perhaps the main purpose for having beneficiary designations for either a traditional IRA or a Roth IRA is to ensure that the assets in the IRA will be “stretched” over the lives of the beneficiaries. In so doing, any income taxes due upon required inherited traditional IRA withdrawals will be minimized and the traditional and Roth IRA assets can be preserved for as long as possible. For typical family situations, making one’s spouse as the primary beneficiary and children or siblings as contingent beneficiaries is the recommended structure to achieve the goal of the “stretched” IRA

But there are situations in which an IRA owner may have good reason to prevent IRA beneficiaries from directly receiving inherited IRA assets .For example, if the beneficiaries are minor children, or if adult children are spendthrifts. Adult children in a difficult marital situation can also be a reason not to name an adult child as an IRA beneficiary. Second marriages may also cause problems for the recommended spousal beneficiary designation, especially when a new spouse does not get along with the other spouse’s children.

In these just mentioned situations, naming a trust as an IRA beneficiary may seem like the most logical and practical alternative. In short, a trust allows an IRA owner at his or her death to control the distribution of the IRA assets and ensures that the IRA meets his or her “stretch” objectives.

The IRS has specific rules detailing what a qualified trust is, and these rules are listed here:

• The trust must be valid under state law;
• The trust is irrevocable or becomes irrevocable upon the trust owner’s death;
• The trust’s beneficiaries are identifiable from the trust document; and
• The trust’s trustee provides the necessary documents to the IRA custodian.

Even if all the rules for naming a trust as IRA beneficiary are followed, there are two potential traps for the IRA owner, which are now discussed.

Only individuals may be considered as designated beneficiaries for purposes of taking advantage of the “stretch” IRA provisions. A trust is not an “individual” and because of that cannot be considered as a “beneficiary”. As such, if an entity other than an individual is named as a beneficiary of the trust, then the IRA is treated as having no designated beneficiary. The entire IRA would be required to be distributed within five years of the date of death of the IRA owner if the owner had not reached the age of 70.5. If the deceased IRA owner had reached age 70.5, then the remaining assets would have to be paid out over the remaining life of the IRA owner. In both cases, the IRA payout arrangement does not allow for lifetime distributions based on the life expectancy of the IRA beneficiaries, resulting in no “stretch”.

Another trap involves the requirement that the trust be considered a “conduit” trust in order to take advantage of the “stretch” IRA provisions. To be considered as a “conduit” trust, the trust document should specifically state that amounts distributed from the IRA as required minimum distributions be distributed and paid out to the trust beneficiaries. If this trust provision is not included, then the trust is assumed to be able to accumulate the IRA distributions instead of paying them out as required.

In the latter situation, since a trust cannot be a designated beneficiary, the IRS will count all potential beneficiaries of the trust as beneficiaries of the IRA for determining the life expectancy to use when calculating minimum required distributions.  In fact, the IRS may have to look “far down the line” of trust beneficiaries. If an individual in the line of trust beneficiaries is much older than the other beneficiaries, the IRA required minimum distributions will have to be taken more rapidly over the person’s shorter life expectancy, thus shortening the IRA “stretch”.  

While it is permissible and sometimes desirable to name a trust as the beneficiary of a traditional or Roth IRA, great care should be taken in making this decision. It is highly recommended that interested IRA owners first discuss the idea of naming of trust as IRA beneficiary with a qualified estate attorney. Most importantly, the issue of whether naming a trust as an IRA beneficiary truly fits into the IRA owner’s overall estate planning goals should be thoroughly addressed and investigated.

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