For many investors an IRA is a substantial portion of their entire wealth. Getting the beneficiary designation correct is crucial.
Over the years, the rules governing Individual Retirement Accounts have changed dramatically. The biggest change has been the introduction of the “inherited IRA”. With this new vehicle, children or other non-spousal beneficiaries are allowed to stretch IRA distributions over their lifetimes, just as the spouse has always been able to do. Prior to this new legislation, many IRA owners named their spouse as primary beneficiary and their revocable trust as contingent beneficiary. IRA owners that named a trust need to make sure the trust is drafted properly so that distributions occur as intended.
Children or other non-spousal individuals named individually as beneficiaries may elect to take IRA distributions over each of their individual lifetimes. They also may elect to take the IRA benefits immediately or in a fashion much faster than a lifetime distribution. If an IRA owner has concerns about the financial decisions that his or her beneficiaries might make, the owner may name a trust as beneficiary.
If the trust is drafted properly, payouts from the IRA can be stretched out over the life of the oldest living named trust beneficiary. In order to stretch out IRA distributions, a trust needs to be carefully drafted and meet certain requirements, one of which is that the trust be irrevocable or irrevocable upon the IRA owner’s death (don’t name the child’s revocable trust as beneficiary).
This can be an effective estate and tax-planning tool in the right family situations such as when minor children are the beneficiaries or in the case of second marriages. In addition, delaying payouts to beneficiaries also means delaying the income taxes that go along with the payouts. Sometimes, an IRA owner will name his or her spouse as the primary beneficiary of the IRA and the trust as the secondary or contingent beneficiary. The advantage of this is that at the IRA owner’s death, the spouse has the option of taking the IRA or disclaiming it so it can pass to the beneficiaries contained in the trust, often times the children of the owner and spouse. By exercising a spousal disclaimer, the beneficiaries of the IRA are now a generation or further down, providing a longer payout period and further delaying recognition of taxable income within the family. Removal of certain beneficiaries, such as spouses, will allow a longer life expectancy distribution as the payout calculation is based upon the age of the oldest living beneficiary.
An additional and very important requirement for the trust to qualify as a designated beneficiary is the correct naming of beneficiaries within the trust itself. The qualified beneficiaries are determined by those who are still living as of September 30th of the calendar year following the calendar year of the IRA owner’s death. Only actual persons should be included as beneficiaries as of this date as all beneficiaries must have a measurable life expectancy for the trust to qualify. Should there be a bequest to a charity or other entity in the trust document, this gift needs to be made by September 30th of the year following the IRA owner’s death. The existence of a non-person beneficiary past this date will taint the entire trust from qualifying as a designated beneficiary. However, if the bequest is satisfied by the September 30th date, the charity is disregarded for distribution purposes, and the IRA will be payable over the life expectancy of the oldest beneficiary.
The failure to name only qualified designated beneficiaries can lead to a substantial loss of tax-deferred growth. The required time frame to payout the IRA in this situation would be based upon either the IRA owner’s life expectancy or within five years of date of death. Allowing the assets to continue to grow in a tax-deferred environment for the designated beneficiaries’ life span can provide tremendous wealth accumulation. Studies have shown that a $500,000 IRA with an 8% growth rate, a 35% federal income tax rate, and a 15% federal capital gains rate would provide over $3,665,000 in distributions over 35 years.
IRA owners should consult with their attorney before naming a trust as an IRA beneficiary. Trust language needs to be drafted carefully to meet IRS rules and also be consistent with the owner’s intent on how the funds should be distributed after his or her death. As a side note, a recent private letter ruling reminds all of us that the IRS requires the trust to have the appropriate language in it prior to the owner’s death and that the trust cannot be corrected after death.
Please give us a call if you would like to discuss your situation, make a change to your current beneficiary designation or have questions.