Even when it’s done correctly, naming a
trust as an IRA beneficiary can create more tax headaches than it solves.
A classic way to protect loved ones — from future creditors, predatory suitors and their own improvidence — is to leave their inheritance to a
trust for their benefit. When the inheritance in question is an individual retirement account, however, that sometimes presents unique challenges.
Unlike a human IRA beneficiary, a
trust has no life expectancy. So if it isn’t correctly drafted, it can’t stretch out IRA distributions, said Barry C. Picker, a certified public account and financial planner with Picker Weinberger & Auerbach CPAs PC in Brooklyn, N.Y. The result: If the IRA owner was under 70½ when he died, the account must be emptied within five years of his or her death.
If the IRA owner was over that age, it must be emptied on a schedule based on the owner’s remaining life expectancy as shown on the
Internal Revenue Service single life expectancy table.
Either way, the IRA is distributed much faster than it would have if it had been left to the heirs directly — so they’ll forfeit decades of potential tax-deferred investment growth.
DRAFTING THE TRUST DOCUMENT
A properly drafted
trust becomes a conduit; it can take IRA distributions based on the shortest life expectancy of the
trust beneficiaries. A
trust qualifies as a conduit if it is valid under state law, irrevocable at death and has identifiable beneficiaries, provided a copy of the
trust document goes to the IRA custodian by Oct. 31 of the year after the IRA owner’s death.
However, to avoid a whopping tax bill, the
trust must promptly pay all IRA distributions to the beneficiaries. Distributions that accumulate in the
trust aren’t taxed at the beneficiaries’ rates, Mr. Picker said. They’re taxed at
trust rates.
WHAT IS ‘TRUST INCOME’?
IRA distributions include both income and return of principal.
Under the Uniform Principal and Income Act, a
trust law adopted by some 40 states, only 10% of such distributions must be paid out to
trust beneficiaries unless the
trust language specifies otherwise, said Seymour Goldberg, a certified public accountant and tax attorney with Goldberg & Goldberg PC in Jericho, N.Y. Put simply, 90% of mandatory IRA distributions could remain taxable in the
trust if the document isn’t worded correctly.
You should make it clear that all IRA distributions must be promptly paid out to the
trust beneficiaries, Mr. Goldberg said. To avoid any confusion, he added, he eliminates all references to “income” when drafting an IRA
trust document. “I use ‘
required minimum distribution’ instead,” he said.
QTIP CONUNDRUM
A qualified terminable interest property
trust is a poor choice as an IRA beneficiary, even when the
trust document is carefully drafted, Mr. Goldberg said.
A QTIP
trust is designed to provide lifetime income to a surviving spouse, typically a widow. After her death, the
trust assets are distributed to beneficiaries chosen by her deceased husband. The QTIP qualifies for an unlimited marital estate tax deduction — postponing the tax on
trust assets until the death of the second spouse — provided no one but the surviving spouse is entitled to the
trust’s annual income. But the QTIP risks losing its unlimited marital deduction unless its governing document defines annual income much more generously than 10% of retirement account distributions, Mr. Goldberg said.
Take a 70-year-old beneficiary of a QTIP whose only asset is a $2 million IRA, he said. She has a 17-year life expectancy. In year one, $117,650 ($2 million divided by 17) will be transferred from the IRA to the
trust. Under
trust law in most states, the
trust’s income is deemed to be only $11,765, or 10% of $117,650.
The IRS won’t give the QTIP the unlimited deduction for that small a payout, Mr. Goldberg said, and the widow will probably sue the trustee for more money. The Uniform Principal and Income Act gives trustees power to adjust payments to income beneficiaries.
Regardless of these difficulties, an IRA isn’t an ideal asset to fund a QTIP, said Ed Slott, a Rockville Centre, N.Y., certified public accountant and IRA specialist. “An IRA is self-liquidating because of its required minimum distributions,” he said. “It has to be emptied over the surviving spouse’s life expectancy. And in a second marriage situation, the widow may be the same age as the kids. If she lives long enough, they could be disinherited.”
Mr. Goldberg agreed. “In my opinion, it’s too messy to fund a QTIP or a credit shelter
trust with an IRA,” he said. “It’s better to split the IRA between the spouse and the children during the client’s lifetime.”
