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Retirement Perspectives

This advanced beneficiary-planning strategy has a myriad of rules that you need to know.

Part 1 of a 2 part series

A year ago, we wrote a column about designating a trust as an individual retirement account (IRA) beneficiary—and it has become one of the most popular articles on our website. So I figured now is a good time to revisit this important retirement strategy.

Essentially, the owner of an IRA can name anyone they desire to be their designated beneficiary of their retirement account. Increasingly, clients are relying on their advisors for advanced beneficiary-planning strategies, such as naming a trust as the beneficiary of a retirement account. Designating a "look-through" trust as an IRA beneficiary is tricky and complicated, with potentially significant tax consequences if not implemented and executed according to the myriad of IRA rules and regulations. Therefore, advisors and their clients need to be aware of the nuances and appropriateness of these arrangements.  For those who are considering naming a trust beneficiary, it’s crucial to hire a seasoned attorney that is familiar with drafting a qualifying trust and retirement plan distribution rules.

Typically, qualified retirement plans and IRAs are not subject to probate. Instead, retirement assets are distributed according to account owners’ current beneficiary designation. Naming rules are liberal, thus offering IRA owners a number of options in designating a beneficiary; in fact, any individual (spouse, sibling, children, grandchildren, etc.) and/or non-individual (charity, estate, or trust) can be a named beneficiary. However, the regulations require post-death required minimum distributions (RMDs), forcing the account beneficiary to liquidate the account over the course of time.

Tip: Naming a trust as an IRA beneficiary is allowed. However, if IRA assets are mistakenly moved (distributed) into a trust while (account owner) is alive a distribution subject to immediate taxation has therefore occurred. In addition, the “stretch” payout option has been eliminated! Instead, simply name the trust as beneficiary on the IRA beneficiary paperwork.

Post-death rules allow RMDs to be distributed gradually over the life expectancy of beneficiary—known as a “stretch" IRA or payout. However, receiving this payout option requires the named beneficiary to be a “designated” beneficiary—defined as a human being with a life expectancy. This inevitably leads to the question: Can a retirement account be left to a trust beneficiary (e.g. non-living entity without a life expectancy) “stretch” post-death RMDs? Yes, in certain circumstances. IRS rules permit a qualifying IRA trust to be treated as a “designated” (human) beneficiary, thus allowing stretch post-death RMDs by “looking through” the trust to the underlying beneficiaries and therefore using their beneficiaries instead.

 

Why would the owner of an IRA want or need to name a trust, rather than a person, as his or her beneficiary? The primary reason is to exert control over post-death distributions (sometimes referred to as “control from the grave”), thus limiting or restricting access to an inheritance.

 

Tip: Your trust can be as rigid or liberal as you like, as long as your IRA distributes the annual requirement minimum distribution.

Reasons to Name a Trust Beneficiary

An owner of a retirement plan/account has a lot of latitude in naming a beneficiary. He/she could name a spouse, child, grandchild, friend, charity, estate, trust, or some combination. Is a trust, though, right for you? When, then, should someone consider naming a trust beneficiary? Although each family situation is particular to them, fairly common reasons for naming a trust beneficiary include: the beneficiary is a minor; a disabled (“special needs”) individual; second marriages; creditor protection; estate taxes; or a beneficiary doesn’t have the financial acumen to manage his or her inheritance effectively. In addition, consider naming a trust when the client has beneficiary “trust” concerns—a trust can protect a beneficiary from rapidly depleting an inheritance by including a spendthrift provision. Keep in mind, trusts do not save on taxes; instead, the primary reason to name a trust as beneficiary is to control (post-death) distributions to beneficiaries.

 

There are a few common reasons to name a trust as a beneficiary:
  • Minor beneficiary
  • Disabled beneficiary
  • Second marriage
  • Spendthrift beneficiary
  • Beneficiary needs assistance managing the IRA investments, and implementing a “stretch” payout

 

Assuming that naming a trust fits a client’s overall objective, advisors must verify (with an attorney) that the trust qualifies as a “look-through” or “see-through” trust. In other words, the IRS will look through the trust and treat the trust’s beneficiary as the IRA’s direct beneficiary, although the trust remains the direct owner of the IRA (actually an inherited IRA). A qualifying “look-through” trust therefore becomes eligible to receive designated beneficiary treatment where post-death minimum distributions are determined (calculated) based on the life expectancy of the oldest of the trust’s underlying beneficiaries. This allows heirs to take advantage of favorable minimum-distribution rules that apply to individual designated beneficiaries (e.g., those beneficiaries that have a life expectancy).

To qualify as a “look-through,” the trust must meet all of the following requirements

1. Must be a valid trust under state law.

2. Must be irrevocable upon death of the account owner or contains language to the effect it becomes irrevocable upon the death of the IRA owner. A revocable trust will not be able to utilize stretch provisions.

3. Individual beneficiaries of the trust must be identifiable from the trust document. This generally means that beneficiaries should be identified by name, or as members of a class (e.g. my children).

In addition, only individuals (i.e., those with a life expectancy) may be considered “designated beneficiaries” by the IRS for purposes of taking advantage of the stretch IRA provisions. A beneficiary that is not an individual, such as an estate or a charitable organization, may not be a designated beneficiary, and the option to stretch minimum payouts will be forfeited.

4. Required trust documentation must have been provided to the IRA custodian no later than October 31 of the year following the IRA owner’s death. The trustee is responsible for providing trust documentation to the IRA custodian. The trustee also is responsible for determining that the trust is a look-through trust. However, most likely, the trustee will need to hire a professional (e.g., attorney) for assistance.

Tip: Although naming a trust as an IRA beneficiary is permissible, not all IRA custodians permit trusts to be a named beneficiary. It is imperative that you receive confirmation from an IRA custodian that will allow you to name a trust as a beneficiary.

 

Importantly, you do not save on taxes by naming a trust. In fact, it’s quite possible to pay more in taxes even if the trust is designed properly. Therefore, you would only use trusts for personal (non-tax) reasons.

 

A properly designed “look-through” trust is deemed a non-spouse beneficiary and thus must follow post-death RMD rules. This is true even if the spouse is the sole beneficiary of the trust. Why? The trust inherited the IRA. After the owner dies, the IRA balance should not be distributed to a trust. Instead, after the IRA owner’s death, only the RMD has to be paid from the (inherited) IRA to the trust.

In other words, when a trust is named beneficiary, minimum distributions are required to be made from the IRA to the trust. Bypassing (the trust) is not allowed. Instead, distributions are then made to trust beneficiaries, following the rules set forth in the trust.

Suppose there are multiple trust beneficiaries. Whose life expectancy is used to determine minimum distributions? Separate accounts, also known as “splitting,” generally cannot be created when a trust is named as an IRA beneficiary. Why? The trust itself is considered the beneficiary rather than the underlying individual trust beneficiaries.

Generally, unless separate trusts are established for each beneficiary, the oldest beneficiary—the one with the shortest life expectancy among the beneficiaries—will be used to determine the amount of the required withdrawal, which is then divided among the beneficiaries. This is why the IRA owner should name beneficiaries that are relatively close in age. Why? Because the life expectancy of the oldest beneficiary determines the “stretch” payout following inherited IRA RMD rules. In other words, naming a trust as beneficiary generally eliminates the ability for each trust beneficiary to use his or her own life expectancy when determining annual distributions. Notably, it may be possible to “split” beneficiary accounts if the trust created separate “subtrusts” for each trust beneficiary named on the beneficiary form.

What happens if the trust fails to qualify as a “look-through”? Generally, only a living person can “stretch” inherited IRA distributions; an exception would be a “look-through” trust, whereby the trust can “stretch” using the life expectancy of the oldest trust beneficiary. If the trust fails to qualify as a “look-through,” the trust then has no life expectancy, thus the IRA distributions must be paid generally in five years after death.

Part 2 covers trust mechanics, trust tax rules, and why leaving a Roth account to a trust is appealing.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

GLOSSARY OF TERMS

Trusts are often written to provide flexible provisions of how trust assets may be distributed.

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

A SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

A simplified employee pension plan (SEP IRA) is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee’s SEP IRA.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

A 403(b) plan is a retirement savings plan that allows employees of public schools, nonprofit, and 501(c)(3) tax-exempt organizations to invest on a pretax and or Roth aftertax basis. Contributions to a 403(b) plan are conveniently deducted directly from your paycheck. In addition, your employer may elect to make a contribution on your behalf.

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