What to Know About Trusts as IRA Beneficiaries
By Paul Cullen, QKA, CISP, CHSP
What is a trust and why would someone name a trust as an IRA beneficiary?
A trust is a legal document established by an individual or corporation, known as a grantor. The trust holds property or assets for a specific person or group, called the trust beneficiary or beneficiaries. A trustee maintains control of the trust. Naming a trust as an IRA beneficiary is becoming more common and is often used in estate planning for a number of reasons. The most common reasons are to reduce estate taxes, control assets after death, avoid the probate process, and avoid family conflict over assets. Trusts can be set up in a variety of ways and drafted by attorneys, individuals, or, sometimes online. Many trusts are not even created until an IRA owner dies (testamentary trust).
What distribution options does a trust beneficiary of an IRA have?
For IRA beneficiary purposes, there generally are two types of trusts: one that meets certain IRS requirements is often called a qualified trust, also known as a “look-through” trust, and one that does not meet the IRS requirements if often called a nonqualified trust.
Qualified Trust
To be considered a qualified trust, the trust must
be valid under state law;
be irrevocable or, if revocable while the IRA owner is alive, must become irrevocable upon the IRA owner’s death; and
have identifiable beneficiaries (generally people) listed.
The trustee of the trust must provide the financial organization with either a copy of the trust instrument or qualifying documentation of the trust by October 31 of the calendar year immediately following the year of death. The documentation must show who the beneficiaries are as of September 30 of the year following the year of death.
If an IRA owner names a qualified trust as an IRA beneficiary, the trustee of the trust may elect to have the trust receive payments over the single life expectancy of the trust’s oldest beneficiary.
Example: Jane Smith names the “Jane Smith Family Trust” as her IRA beneficiary. The underlying beneficiaries of the Jane Smith Family Trust are Dan, age 45, Robin, age 32, and Ryan, age 27. If the trust is qualified, the Jane Smith Family Trust can take single life expectancy payments based on Dan’s (the oldest trust beneficiary) age.
Nonqualified Trust
A trust that does not meet the requirements above is generally considered a nonqualified trust. Because a nonqualified trust is generally considered a nonperson beneficiary, the distribution options are limited, and the age of the oldest underlying beneficiary of the trust can no longer be used to calculate payments. A nonqualified trust is limited to pay out according to the five-year rule (death before the IRA owner’s required beginning date) or single life expectancy payments based on the decedent’s age (death after the IRA owner’s required beginning date).
How are distributions to a trust reported to the IRS?
Distributions to a trust are reported on IRS Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., in the trust’s name and tax identification number (TIN) using code 4, Death.
As mentioned earlier, many trusts are not created until the IRA owner has died, so often the trust may not have a TIN at the time the IRA owner is naming the trust as the IRA beneficiary. When the IRA owner dies, then the trustee generally is required to get a TIN for the trust. A common issue that comes up is that the underlying beneficiaries of the trust want the money distributed to them directly. But remember, the trust is the beneficiary, and it’s up to the trustee or custodian to disburse the IRA assets to the underlying beneficiaries of the trust based on the terms of the trust.
Can the underlying beneficiaries of a trust set up their own beneficiary or inherited IRAs?
This is a complicated question. Nothing under the Internal Revenue Code or Treasury regulations specifically allows a trust to set up inherited IRAs for the trust’s beneficiaries. But there have been a number of IRS private letter rulings (PLRs) that have allowed this, on the condition that 1) the underlying beneficiaries have an unlimited right to the assets, and 2) the distribution period is not extended. Keep in mind that only the taxpayer who applied for the PLR can rely on that ruling. For a fee (currently $10,000), any taxpayer can request a ruling from the IRS addressing their specific situation, and the IRS will evaluate and respond in writing to allow or disallow.
As a trustee or custodian organization, you should establish your own policy and procedures for allowing underlying beneficiaries of a trust to set up their own beneficiary IRAs. Will you require formal IRS approval for the client making the request (such as a PLR)? Will you take direction from the client or his legal representative in the absence of an IRS approval? If your organization chooses to allow a trust to set up beneficiary IRAs, what documentation will be required? Will you require a hold-harmless agreement or indemnification in the absence of IRS approval?
Sooner or later, your organization is likely to encounter trust beneficiary issues. Having policies and procedures in place will reduce the risk of uncertainty and potential mishandling of such issues when they do arise.
