IRS Rules on Naming a Trust as a Beneficiary of an Inherited IRA
- Common reasons to name a trust as an IRA beneficiary are when assets are going to a non-spouse, to children or to special-needs heirs. Ordinarily, a non-spouse IRA beneficiary may elect to take a lump-sum distribution or liquidate the IRA account over five years. Or, if the original IRA owner was older than 70 ½, the beneficiary may receive distributions based on the same schedule as the owner. Depending on the size of the IRA, all these scenarios can result in hefty tax bills for non-spouse beneficiaries. The trust as beneficiary allows for IRA funds to be distributed over the lifetime of the oldest beneficiary instead of over a few years. This minimizes the tax bill, and allows funds to benefit from compound interest. It also allows the IRA owner to maintain control, from the grave, so to speak, over how IRA funds are distributed.
- When the trust is the IRA beneficiary, your heirs can't lump-sum liquidate your IRA. The trustee doles out IRA funds based on IRS calculations and trust directives. For example, the IRS will require a minimum distribution amount every year based on the life expectancy of the oldest heir. The trust instrument may designate that this amount be distributed to heirs that year, or accumulated within the trust until a later designated date, or for special-needs situations. Keep in mind, the trust must pay taxes on IRA distributions if they aren't directly funneled to heirs. Trusts tend to be taxed at a higher rate than individuals.
- A spouse who inherits an IRA, outside of a trust, is able to roll over the inherited IRA into her own IRA and wait to take withdrawals until she's 70 ½. Or, she can opt to take distributions based on the age of her late husband. The spouse is given much more latitude with inherited IRA funds than non-spouses. Since she can delay distributions, she can also delay paying taxes on those funds and allow the account to grow until she needs it. If the trust is an IRA beneficiary, she'll lose this latitude and likely be required to receive IRA distributions no later than a year after the owner's death. For this reason, you may not want to name a trust as IRA beneficiary if you want your spouse to receive your IRA.
- To be considered a designated beneficiary trust and for IRA funds to be distributed to it, the trust must comply with IRS rules. It must be valid according to state law. It must be irrevocable, or become irrevocable upon the trust grantor's death. The beneficiaries of the trust must be natural persons (not an estate or charitable organization) and clearly identified. And the IRA administrator must be provided with a copy of the trust, including a certified list of beneficiaries and an agreement that any amendments to the trust will be communicated promptly. This needs to be taken care of before Oct. 31 of the year following the death of the IRA owner. A lot of careful planning can be undone if IRS rules aren't followed after the IRA owner's death. Therefore, it's important to make sure the trustee and successor trustee understand their responsibilities in communicating with the IRA administrator.
- Trusts are complicated instruments and the IRS is a stickler for details. In addition to doing your own research, speak with a qualified estate planning attorney to best determine if establishing a trust as an IRA beneficiary makes sense for you.