With regard to a trust-based estate plan, you should re-title most of your assets to your trust. This process known as “trust funding” includes transferring your bank accounts, taxable investment accounts, stocks, and real properties such as your residence to your trust. One key exception is your retirement plans: if you make the mistake of transferring title to your IRA or other qualified defined contribution plan such as a 401(k) or 403(b) plan while you are living, the IRS will take the position that you just cashed out your plan. Come April 15 you will have a very unpleasant surprise in the form of a major tax bill.
Instead of transferring title of your IRA to your trust while you are living, you should name specific beneficiaries of your IRA’s through each financial institution where you hold a retirement plan. Upon your death, you IRA’s will be transferred to your named beneficiaries without probate, assuming that your named beneficiaries survive you. Retirement plans have unique features that are governed under complex tax rules which make the identity of your named beneficiaries of paramount importance. Careful and thoughtful planning is necessary.
IRA’s and other similar retirement plans involve special tax rules that are designed to encourage you to save for retirement. For example, with a traditional IRA, you get a tax deduction for a contribution into the IRA, the investments grow in a tax-deferred manner, and you are taxed on the portion that you withdraw from the plan. With a few exceptions, you are not allowed to withdraw from the plan prior to age 59.5 because the purpose of the tax benefits is to save for retirement. However, once you reach age 70.5, you are required to start taking “Required Minimum Distributions,” or “RMD’s,” so that the IRS gets a portion of its tax back. RMD’s are based upon your life expectancy in accordance with various life expectancy tables published by the IRS. The younger you are, the less you have to withdraw; the older you are, the more you have to withdraw.
After your death, your named beneficiaries will be subject to RMD’s no matter how young they are. If they qualify as “Designated Beneficiaries,” they will be able to “stretch” their RMD’s over their lifetimes. If they are younger than you are, this can be a significant advantage as they will enjoy years of tax-deferred growth on the portion of the inherited IRA that is not subject to RMD’s. However, not all named beneficiaries qualify as “Designated Beneficiaries” within the meaning of the rules.
First, if you fail to name a surviving individual beneficiary, then your “estate” is considered to be your beneficiary and your entire IRA will have to be distributed within 5 years if you died before age 70.5 or over the course of your remaining life expectancy if you died after age 70.5. This can result in dramatic accelerated tax which is unnecessary if you had simply taken the time to ensure that you named beneficiaries who qualified as “Designated Beneficiaries” under the rules.
Second, if you name your trust as a beneficiary of your IRA, you could jeopardize the “Designated Beneficiary” status unless certain conditions are met. However, it may be preferable to name your trust as the beneficiary of your IRA (1) if your beneficiary is unable to manage his/her inheritance due to immaturity or irresponsibility; (2) if you want to benefit someone for life but want to control how the remainder is distributed; (3) if you want to have greater control over the contingent beneficiaries; or (4) if you want to provide significant divorce and creditor protection for your beneficiaries.
The IRS will “look through” your trust and allow the beneficiaries of your trust to be considered “Designated Beneficiaries” if your trust satisfies the following four elements:
(1) The trust is a valid trust under state law.
(2) The trust is irrevocable, or will, by its terms, becomes irrevocable on your death.
(3) The beneficiaries of the trust are identifiable from the trust instrument.
(4) A copy of the trust instrument and a list of all of the beneficiaries of the trust is provided to the plan administrator by October 31 of the year following the year of death.
If your trust satisfies the aforementioned four elements, then the beneficiaries of your trust are considered “Designated Beneficiaries.” They will be able to “stretch” out distributions over a longer period of time than if they did not have “Designated Beneficiary” status. This is far preferable to the rapid withdrawal of your IRA’s if the trust did not satisfy the four elements listed above.
However, RMD’s must be based upon the life expectancy of the oldest trust beneficiary. This rule creates two further issues: (1) How is the “oldest trust beneficiary” determined? (2) Can anything be done to prevent the younger beneficiaries from having to use the oldest trust beneficiary’s life expectancy?
These two questions are critical and involve further nuanced rules. I will address both of these key questions along with other important planning considerations when naming trusts as IRA beneficiaries in my next article.
KRASA LAW, Inc. is located at 704-D Forest Avenue, Pacific Grove, California and Kyle may be reached at 831-920-0205.
Disclaimer: This article is for general information only. Reading this article does not establish an attorney-client relationship. Before acting on any of the information presented in this article, you should consult a competent attorney who is licensed to practice law in your community.