Retirement Accounts: Trusts as Beneficiaries

| January 6, 2015 | 0 Comments

I hope you’ve enjoyed the holidays. As we ring in the New Year and start our client review cycle, one of the things that we do for our clients is to review the beneficiary designations of their retirement accounts (pensions, IRAs, etc.). This is important because the beneficiary designations that you elect control who gets the account when you pass away. Many people mistakenly believe that their Will or Trust determines who gets their retirement accounts. This can be a very costly mistake for your heirs.

The beneficiaries of retirement accounts are set when you open the accounts, and can be updated or changed as your circumstances change. One of the most common beneficiary strategies is for the IRA owner to name a spouse as the primary beneficiary and then to name the children as contingent beneficiaries. This is fairly straightforward and, since spouses receive very beneficial treatment when they inherit an IRA, it is often the recommended strategy.

Another strategy I see frequently is the use of a Trust as a contingent beneficiary. This is attractive if there are minor children who might receive the IRA proceeds on the death of the owner, or if there might be problems with creditors. It can also allow the IRA owner some additional control in deciding how and when the assets are ultimately distributed. However, this is not something to do casually, as there are very specific rules that need to be followed. Trusts needs to be carefully written in order to work well with IRA assets. Simply naming your Family Living Trust as an IRA beneficiary can cause significant pain for your beneficiaries.

Let’s start with a couple of very important concepts. The first is stretching out your distributions. Few people will want to distribute all of their IRA money at once; the tax bill would be horrendous. The people who inherit your IRA will probably have the same concern. If you plan correctly, money inherited from an IRA can be left to grow in the retirement account for the rest of your heir’s life, pulling out only a small required minimum distribution each year. This is called “stretching out” the IRA distributions.

In order to “stretch out” the distributions from an inherited IRA, there must be an actual person who is called a “designated beneficiary.” An entity like your estate, a company, or a charity cannot be a designated beneficiary. Any IRA beneficiary that is not a person, such as a company, can’t stretch out their distributions; they will have to withdraw the funds within five years, resulting in much higher taxes (and no tax-deferred growth) than necessary.

The challenge with naming a Trust as the beneficiary of an IRA is that it is considered an entity subject to the five year rule above. The IRS will allow a trust to pass through IRA funds if the only ultimate recipients are humans. However, most living trusts fail this test because there are provisions allowing for gifts to charity from the Trust assets or even a provision allowing the trust to pay final estate expenses. To use a Trust as an IRA beneficiary, it really should be a specially designed trust called a “Designated Beneficiary Trust.”

I’m not trying to talk you out of using a Trust as your retirement account beneficiary; I just want to make sure that you’ve discussed this strategy with an estate planning expert. It seems so simple on the surface, but this is really advanced planning that even the pros can get wrong sometimes.

Note: for ease I write about IRAs only, but the article really applies to all retirement plans.

This column is prepared by Rick Brooks, CFA, CFP®. Brooks is vice president for Investment Management with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Brooks can be reached at (858) 755-5166, or by email at Brooks and his family live in Mission Hills.

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