Bulletins

Individual Retirement Accounts - Part 3

by Dennis W. Donnelly, CPA, PFS

Dear clients and friends,

In our last installment, we found that It is important that primary and contingent beneficiaries be current. We also stated that most married individuals name their spouse as their sole designated beneficiary of their IRA, which enables them to treat the IRA as their own and to postpone required distributions until they are 70 1/2. Naming a non-spouse as your beneficiary requires the individual to distribute the IRA within five years. In this installment we will discuss 'Look-Through Trusts', the - Timetable for Naming Beneficiaries - and we will review a 'Beneficiary Checklist.'

If you missed Part 1, click here to jump to that article. If you missed Part 2, click here to jump to that article.

Look-Through Trusts

Generally for distribution at death requirements, a trust cannot be considered as a designated beneficiary. The law does allow for an exception known as a "look-through" rule. If the trust meets certain requirements, the tax law will "look-through" the trust to the trust beneficiary. That beneficiary, assuming he or she is a natural person, will be treated as the designated beneficiary for the distribution of the IRA assets. The IRA owner may under the look-through rule, name a trust as beneficiary and still take advantage of a longer distribution period for the beneficiary.

Look-through trusts must meet the following requirements:

  • The trust must be valid under state law, which means that its terms are enforceable.
  • The trust must be irrevocable or becomes irrevocable upon the death of the owner, so that the terms cannot be changed or canceled.
  • All of the beneficiaries of the trust must be natural persons. If one of the beneficiaries is not an individual (such as a charity), there will be no designated beneficiary for IRA distribution purposes.
  • The IRA custodian must be given a copy of the trust document listing all of the beneficiaries of the trust by October 31 of the year after the IRA owner death along with a detailed description of the each beneficiary's share.

If a trust meets these requirements, the underlying trust beneficiary can be treated as a designated beneficiary for purposes of computing required distributions. If the trust does not meet these requirements, the trust's beneficiary loses the ability to use his or her own life expectancy for computing post-death required distributions. Instead, the IRA will be paid out within five years after the IRA owner's death or over the deceased IRA owner's remaining life expectancy, if the owner dies on or after his or her required beginning date.

Why would an IRA owner name a trust as beneficiary instead of simply naming a beneficiary outright? The primary reason for doing so is to maintain post-death control. For example, if an IRA owner wishes to restrict a beneficiary's access to IRA assets, a trust may be an appropriate tool.

An IRA owner may also want to name a trust as the beneficiary of an IRA in the following situations:

  • The IRA beneficiary is a minor child. Individuals under age 18 or 20, depending on the state, cannot legally make certain decisions regarding IRA distributions. Consequently, a guardian would likely be appointed by a probate court if a child is directly named beneficiary. However, the entire IRA would belong to the child once he or she reached the age of majority, with no restrictions on how such assets were spent.
  • The IRA beneficiary is physically or mentally disabled. A trust may be necessary to ensure that a disabled or incompetent beneficiary is properly cared for after an IRA owner dies.
  • The IRA beneficiary may require assistance in managing the IRA assets. If a beneficiary may require help managing an inherited IRA, particularly if it is quite large. Having a trust can ensure that trustees and other professional advisors will manage the assets prudently. Naming a trust can also protect an unsophisticated beneficiary from creditors. An IRA owner who does not trust his or her beneficiaries to take of advantage of a stretch IRA option, an strategy we'll discuss in later installments - might also establish a trust, which forces the beneficiary to take distributions per the trustee's directives.
  • The IRA owner is in a second marriage and wants to leave income to a spouse for life, with the remainder passing to the owner's children (rather than to the surviving spouse's heirs). A qualified terminal interest trust (known as a Q-TIP trust) is commonly used to meet this objective. A trust can also ensure that if a surviving spouse remarries, the IRA will pass to the owners children at the surviving spouses death rather than to his or her new husband or wife.

Also keep in mind that an IRA owner can remove a trust as IRA beneficiary at any time. For example, an IRA owner might initially leave a young child's share of an IRA in trust. Once the child reaches a certain age, the IRA owner can change the beneficiary form and remove the trust as IRA beneficiary. In other words, a trust is not required to remain a beneficiary forever, unless this is the owner's wishes.

Another important factor to consider is that separate accounts cannot be created for IRA distribution purposes when a look-through trust is named as beneficiary of an IRA. In other words, if there is more than one trust beneficiary, the age of the oldest trust beneficiary must be used when determining the timeframe over which IRA assets must be distributed. A younger beneficiary would therefore be prevented from using his or her age to calculate the required minimum distribution but would be forced to use the age of the oldest beneficiary.

Timetable for Determining Beneficiaries

For purposes of the distribution at death rules and the consequent distribution timeline that applies to a decedent's IRA assets, the designated beneficiary is determined on September 30 of the year following the year of the owner's death. For example, if an IRA owner died in 2012, the designated beneficiary will be determined on September 30, 2013. Any person who was a beneficiary on the owner's date of death, but is not a beneficiary on the following September 30 will not be taken into account in determining how post death distributions will be calculated.

In other words, if a person is not a designated beneficiary as of September 30, perhaps because he or she cashed out of the IRA or disclaimed his or her interest, that person will not factor into how benefits are calculated and distributed after the IRA owner's death. The IRS allows beneficiaries to use this extended deadline so that they can do some post-mortem planning, essentially, to make administration of the IRA easier or to rectify a disadvantageous situation that existed at the owner's death.

In some cases, it makes sense for a beneficiary to cash out his or her interest for distribution planning purposes. Cashing out means that the beneficiary receives a total distribution of his or her share from the IRA (and not a partial distribution, in which case the person would remain a beneficiary) For example, if one of an IRA's beneficiaries is a non-designated beneficiary, such as a charity or non-qualifying trust, the charity or trust could cash out its entire interest before September 30 of the year following the owner's death. Otherwise, the IRA will not have a designated beneficiary, and the remaining beneficiaries cannot stretch out distributions over their life expectancies.

In other cases a beneficiary might disclaim his or her interest so that another beneficiary can be the sole beneficiary. For example, let's say that Arthur names his spouse as primary beneficiary and his son as contingent beneficiary of his IRA. After Arthur's death, his spouse decides she has sufficient assets to live on and does not need her deceased husband's IRA. In this case, she might disclaim her interest in the IRA, which simply means that she is giving up her legal right to the IRA proceeds. The full amount of the IRA would then pass to the son as contingent beneficiary. The son, rather than the spouse would be the designated beneficiary of the IRA.

The disclaimer rules is a legal way of declining a property interest that a beneficiary has received. A person can disclaim all or part of an IRA that has been inherited, and the disclaimer must be executed within nine months of the date of the owner's death. Note that the September 30 date for determining designated beneficiaries does not extend the nine-month period that a person has for disclaiming an IRA inheritance. In addition, a beneficiary cannot use any of the IRA assets that have been disclaimed. In other words, the beneficiary cannot roll over the IRA or take possession of the assets and then decide to disclaim his or her interest in the IRA.

Beneficiary Checklist

The following reminders can help ensure that IRA assets pass as the owner intended:

  • Choose designated beneficiaries with income and tax consequences in mind. For example, if a spouse needs income after the owner's death, the spouse should be named primary beneficiary, and no estate tax will be due at death. A charity might be a suitable beneficiary, on the other hand, if the owner has no heirs or is charitably inclined and has other assets to leave family members.
  • A contingent beneficiary should be named in case the primary beneficiary dies before the IRA owner.
  • Designate a younger person as beneficiary if a spouse won't need the retirement accounts. Or, a younger person can be designated as contingent beneficiary if the spouse may need the money. This, of course, gives the beneficiary some additional flexibility in case the spouse wishes to disclaim the assets in favor of a child or grandchild. And, the younger the beneficiary, the longer the period that assets can continue growing tax deferred after the owner dies.
  • If a person owns both traditional and Roth IRA assets, consider leaving the Roth account to the youngest beneficiary. The beneficiary's life expectancy will govern the rate at which withdrawals must be taken. A younger beneficiary will therefore have a greater number of years during which assets can compound tax free in a Roth IRA.
  • Complete beneficiary forms for each IRA account owned. Remember, the beneficiary form is like a will for a IRA. If an owner doesn't have a beneficiary form, a state court could decide that he or she failed to designate a beneficiary and will name one for the owner. Or, the IRA may revert to whatever the IRA's default option is, which means that the assets will be distributed pursuant to the plan's terms, not the owner's. And, even if a person has spelled out his or her wishes in a will, a beneficiary form will take precedence over the terms of a will.
  • Keep multiple copies of all beneficiary forms, and be sure to review the forms whenever a significant life event occurs. For example, if the owner gets divorced, remarries, or has named a beneficiary who has died, the beneficiary form should be updated to reflect the owner's current wishes.

In our next chapter, we will review 'After Death Distribution Rules.'

Very truly yours,

Dennis W. Donnelly, CPA, PFS
Daniel A. Kosmatka, CPA, PFS, CFF, CGMA
Michael R. Gohde, CPA, PFS