IRA Beneficiary Trusts

Legal Article

IRA Beneficiary Trusts

IRA Beneficiary Trusts

Many people use Individual Retirement Accounts (“IRAs”) as an investment tool when planning for retirement.  Like any other asset, IRA owners have the right to name whomever they wish to be the beneficiary of the account.  If you have significant assets, you might want to consider setting up a trust that is designated to be the beneficiary of your IRA after you pass away.

IRA Beneficiary Trusts Provide Protection for your Beneficiaries

Though IRAs are generally protected from creditor claims while the owner of the account is still living, once the account owner dies and a beneficiary inherits the assets, the assets will likely lose their protected status.  However, assets put into a trust for the benefit of a beneficiary will be protected, as long as the funds remain inside the trust and are only distributed upon the discretion of the trustee.

An IRA Beneficiary Trust will also protect a beneficiary from themselves.  Naming a trust as the beneficiary of your IRA account will protect your beneficiary from his or her own bad decisions, excessive spending habits, financial irresponsibility, and overreaching spouses.

IRA Goal: Stretching Account Assets

Most account owners designate a beneficiary with the intention of stretching the inherited assets over a prolonged period of time.  If your IRA is left directly to your beneficiaries outside of a trust, then your beneficiaries can immediately cash out your IRA account and spend the money as they want.  In this situation, the beneficiary loses the ability to stretch the assets and will incur a substantial tax liability for the amount withdrawn.  

However, if your IRA passes to your beneficiaries through an IRA trust, you can restrict beneficiary distributions and limit how your assets are spent. This will create an ongoing legacy for your family since the IRA assets that are not used during a beneficiary’s lifetime can continue in trust for the benefit of the beneficiary’s descendants. This will also be important if the beneficiary already has a taxable estate since the IRA Trust can be drafted to minimize or even eliminate estate taxes in the beneficiary’s estate through generation-skipping trust planning.

Creating an IRA Beneficiary Trust

In order to benefit from an IRA Beneficiary Trust, it is imperative that the trust is properly set up. The IRS only considers individuals to be “designated beneficiaries” for purposes of taking advantage of stretch IRA provisions.  This means that if your trust is not properly established, it will not be able to take advantage of the stretch IRA provisions and all assets will have to be distributed within five years of the owner’s death.  In order for your trust is to be regarded as designated beneficiary, your trust must meet for specific requirements:

The Trust Must Be Valid Under State Law.  

Your trust must be legally formed and meet any formal requirements imposed by your state.  Usually, this means the trust must not be handwritten and must be properly signed and executed as a trust.

The Trust Must Be Irrevocable, or be Irrevocable Upon the Death of the Original IRA Owner.

While the rules require that the trust be irrevocable (or become so upon death), IRA beneficiary designations themselves remain revocable until death.  This means even if an “irrevocable” trust is named as a beneficiary of an IRA, the IRA owner can still “change” the trust by simply creating a new irrevocable trust and changing the beneficiary designation from the “old” irrevocable trust to the “new” irrevocable trust (or alternatively, just get rid of the irrevocable trust altogether if desired).

The Trust’s Underlying Beneficiaries Must All be Eligible to be Designated Beneficiaries Themselves.

To be considered a designated beneficiary, the trust beneficiaries must be identified by name or class, such as “my children” or “my grandchildren.”  Importantly, each beneficiary must be a living, breathing human being.  If a charity or some other non-living entity is named as a trust beneficiary, then the trust will not be able to do a stretch over the life expectancy of the underlying beneficiaries because not all the underlying beneficiaries as designated beneficiaries with a life expectancy in the first place.

A Copy of the Trust Documentation Must be Provided to the IRA Custodian by October 31 of the Year Following the Year of the IRA Owner’s Death.

The Treasury Regulations mandate that the IRA custodian be provided with either a final list of all trust beneficiaries along with a certification by the trustee that all of the requirements for stretch distribution are met under the trust, or the trust provide a copy of the actual trust documents.

If these four requirements are met, your trust may qualify as a designated beneficiary of your IRA, allowing the post-death RMDs to be “stretched” based upon the life expectancy of the oldest trust beneficiary.