There seems to be a lot of misconceptions in the financial advisor community about naming trusts as beneficiaries of retirement accounts such as IRAs, 401(k)s, 403(b)s and 457(b)s. Even though the IRS issued final regulations regarding retirement account minimum distribution rules in 2002, I am still often questioned by financial advisors, tax preparers, banks and insurance agents if I meant to name a trust as the primary beneficiary of retirement accounts. Yes, I meant to do that!
When you have a trust, you have to make sure all of your assets are controlled by the instructions in your trust. This is called trust funding. Trust funding is completely and correctly designating your trust and individuals as owners, beneficiaries and insured parties of your assets. Basically, it’s putting your stuff in your trust. Your trust is a vehicle, a financial vehicle. It’s like that new car sitting in your driveway. It sure looks great, but it isn’t going anywhere unless you put fuel in it. The fuel for your trust is your assets. To properly fuel your trust, it must be funded with those assets.
The proper funding of your trust is critical in making your estate plan work and having the results you plan. Failure to properly fund your trusts may cause unintended results. These may include probate during your lifetime or after death; distributions not in accordance with your goals and objectives; additional taxes; and additional administrative, legal and other expenses. Your estate planner should be able to assist you with the funding of your trust.
Recently, we have seen a number of larger financial services firms acknowledge the use of trusts as retirement account beneficiaries. We are pleased to see these acknowledgements, but they are not as widespread as they could be. If you have a trust and have one or more retirement account, you should be aware of these misconceptions. Today, we will discuss the most common ones we encounter:
Misconception #1: Naming a trust will cause a payout over five years. The general rule is that when a non-individual, such as your trust is named as your retirement plan beneficiary, the distributions must be made within five years after your death, if death occurs before your required beginning date, which is generally age 70½. If your death occurs after your required beginning date, then your non-individual beneficiary could elect to take distributions over your life expectancy, as if you had lived.
There is an exception to this general rule called a designated beneficiary test. If your trust contains terms that assure that it meets the requirements of the designated beneficiary test, it allows your trustee to ignore the trust and look through to find and use the life expectancy of one of your trust beneficiaries when making distributions. This is just as if your trust beneficiary had been named directly a beneficiary of your IRA. This “stretch out” IRA concept still remains available to your trust and your beneficiaries and distributions can be made over a beneficiary’s lifetime. Not every trust out there qualifies as a designated beneficiary.
In our office, we make sure that trusts we draft are specifically designed to receive retirement plan distributions and meet the designated beneficiary test. In these cases, we name your trust as your primary beneficiary of these retirement accounts. If you are married, we name your spouse as your contingent beneficiary; and if your plan allows tertiary beneficiaries, we then can also name the kids. If you are single, we name the kids as your contingent beneficiaries. These beneficiary designations give your loved ones the most options after your death.
Misconception #2: You pay higher taxes when a trust is a beneficiary. Although individual and trust income tax rates are same, trust tax brackets are compressed. Trusts reach the 39.6% tax rate at $12,400 of taxable income in 2016, whereas individuals (other than married filing separate) reach the top rate a bit above the $400,000 range. So for any given income, trusts pay more taxes.
However, if a trust distributes that income to a trust beneficiary, the trust beneficiary pays the income taxes at their own rate. And you still keep creditor and other protections of the trust for the undistributed inherited IRA. Any distribution left in the trust does pays the higher tax, but many of our clients are willing to pay the higher tax to keep creditor and other protections of the trust for the distributions.
Misconception #3: There are no benefits to placing retirement accounts into a trust. The reason why most of our clients choose a trust versus a will and direct beneficiary designations is that you can have many instructions and protections for your loved ones in a trust that you cannot have in a will or be assured with direct beneficiary designations. These include divorce protection, re-marriage (Bambi & Thor) protection, addiction protection, disability protection, minor protection, pet trusts, cottage trusts, education trusts, incentive trusts and lack of money-management skills protection.
In addition, with a trust, you can protect what you leave to your loved ones from their creditors. Inherited IRAs are not protected from a beneficiary’s creditors. You can also protect your loved ones’ inheritance from Medicaid or other governmental benefit spend down, yet still maintain their qualification for those governmental benefits. Most of our clients like to leave inheritances in trust for their beneficiaries for life in order to provide them with these protections, while still maintaining the IRAs’ long-term income tax deferral.
Misconception #4: Naming your trust as the beneficiary will not allow us to rollover your IRA to your spouse. Although we do not name your spouse as a primary beneficiary of your retirement account, your spouse is generally named as contingent beneficiary after your trust. Sometimes there are no issues or concerns about remarriage protection, creditor protection or other protections for your surviving spouse. In those instances, after your death, your trust as primary beneficiary can “disclaim” or give a legal no thank-you to your IRA and allow the IRA to go directly to your surviving spouse as contingent beneficiary.
Through the use of this disclaimer, your surviving spouse can then roll it over into their own IRA. This is especially useful for young surviving spouses who are less than age 70½. The surviving spouse can then roll it over to their own IRA, distributions do not need to begin until their required beginning date at age 70½.
Misconception #5: The home office recommends, or we always name the spouse as a primary beneficiary. The likely reasons that the home office would recommend this is because either they are not familiar with the required minimum distribution rules with regard to trusts or do not want to do the increased workload of reviewing the trust As long as your trust is considered a designated beneficiary, then your beneficiaries can still get the same stretch-out of IRA distributions over their life expectancies just as if the beneficiaries were named directly.
If there is more than one individual beneficiary in the trust and the trust is named as a beneficiary, then you generally must use the life expectancy of the oldest beneficiary. However, if you named the separate trust for each of your individual beneficiaries as the beneficiary of your retirement account, then you could generally use the life expectancy of each beneficiary for each separate trust.
Misconception #6: You cannot change the beneficiaries of an IRA after the death of the participant. Although you cannot change the beneficiaries of your IRA after you are dead, if you name your trust as your primary beneficiary and you give the power to change beneficiaries of your trust to someone, then the ultimate beneficiaries of that IRA can also be changed. The power to change the beneficiaries of your trust is called a power of appointment. This tool allows your surviving spouse, other loved one or trustee to effectively amend your trust after your death to take into account post-death changes in circumstances that occur.
Before you name your trust as a beneficiary of your retirement account, have your trust reviewed by a knowledgeable legal specialist to ensure that it qualifies as a designated beneficiary. If you name your trust as a primary beneficiary and it does not qualify as a designated beneficiary, you will end up with the negative tax consequences of the five year pay-out. With proper planning and proper drafting, you can maximize the protections and benefits for your loved ones and minimize their overall tax burden.
By Matthew M. Wallace, CPA, JD
Published edited December 11, 2016 in The Times Herald newspaper Port Huron, Michigan as: Trusts as IRA beneficiaries