Navigating the tax complexities of naming a trust or estate as IRA beneficiary is not for the faint of heart.
Inherited IRAs and Required Minimum Distribution Rules
A couple of background rules are helpful. The IRA beneficiary designation identifies who receives the balance of the decedent’s IRA (commonly known as an “inherited IRA”) at death. If a spouse is named as beneficiary, she or he can roll over the IRA into the spouse’s own IRA and then designate a new set of beneficiaries. See Treasury Regulation § 1.408-8, A-5(a). If an individual other than a spouse is named as beneficiary, the individual may stagger distributions of the inherited IRA over the individual’s life expectancy, based on tables provided by the IRS. See Code Sections 401(a)(9) and 408(a)(6). This is often referred to as a “stretch IRA.” The minimum amount that must be withdrawn each year is known as the “required minimum distribution,” or RMD. (The beneficiary can always take more than the RMD, but not less.) Example: The life expectancy for a 60 year-old beneficiary is 25.2 years. This means the individual must take a RMD from the inherited IRA of roughly 1/25th of the IRA in Year 1, 1/24th in Year 2, 1/23rd in Year 3, etc., until the individual’s death. The owner of the inherited IRA on the records of the custodian will be “John Smith, deceased, for the benefit of Robert Smith.”
If a Trust is Beneficiary
If a trust is named as beneficiary, the same “stretch IRA” benefits are available so long as an individual is the beneficiary of the trust. See Treasury Regulation § 1.401(a)(9)-4, A-5(b)(3). The RMD is based on the beneficiary’s life expectancy. The owner of the inherited IRA on the records of the custodian will be “John Smith, deceased, for the benefit of James Johnson, Trustee of the Robert Smith Trust.” Mechanically, however, the arrangement is awkward. In order to qualify for “stretch IRA” treatment, the trust agreement must require the trustee to distribute to the beneficiary no less than the RMD each year. In other words, the trustee cannot accumulate any of the RMD; if he does, there is a penalty equal to 50% of the accumulation. See Code Section 4974(a). Another burden is that the trust must to file federal and state income tax returns each year, whereas this is unnecessary if an individual is the named beneficiary. Finally, what happens when the beneficiary reaches the specified age (21, 25, 30, etc.) and the trust terminates? The tax laws allow the trustee to assign its beneficial interest in the inherited IRA to the beneficiary (i.e., to his or her separate inherited IRA account) without accelerating the embedded income. See Treasury Regulation § 1.691(a)-4(b)(3). This means the IRA remains intact and the only change is that there is a new inherited IRA account. (Note: this is different than distributing the IRA and paying the proceeds to the beneficiaries.) However, more often than not, the IRA custodian will flatly refuse to set up new inherited IRA accounts for the individual beneficiaries. Instead, the custodian will insist that the trustee make a taxable distribution of the entire IRA, and pay the proceeds to the beneficiary. From a custodian’s perspective, creative solutions mean extra work generating no fees, so there is no motivation to accommodate them. From a tax perspective, a taxable distribution is a disaster since it accelerates income that might otherwise be deferred for decades. Also, the bunching of income in a single year may capture the highest marginal tax rates. If the IRA custodian will not cooperate, the trustee’s only alternative is to move the funds to a more user friendly IRA custodian. In my experience, Vanguard and Fidelity are reasonably cooperative on these types of requests.
If Estate is Beneficiary
What if the “estate” is the designated beneficiary? This is usually the worst of all worlds, and typically occurs when the owner fails to designate any beneficiary and the “estate” is the default beneficiary under the account agreement. In general, if the decedent was over 70 1/2, the inherited IRA must be distributed to the estate over the decedent’s remaining life expectancy. See Treasury Regulation § 1.401(a)(9)-5, A-5(a)(2). (The estate will pay the tax on each IRA distribution, and the funds remaining will be paid to the beneficiaries under the will.) This is dysfunctional. If the decedent is elderly, the IRA must be distributed over a relatively short period. A bigger problem is that it is usually impracticable to continue a probate proceeding for 5, 10 or 15 years. Courts will try to force the executor to close the estate and get the case off the docket. Further, keeping the estate open causes ongoing filing fees, attorney and accounting fees. Thus, the executor will be tempted (or forced by the court) to withdraw the entire IRA at once, thereby ensuring it is subject to the maximum amount of tax. There is at least one partial fix. Instead of withdrawing the IRA in a taxable distribution, the executor can assign the estate’s beneficial interest in the IRA to the beneficiaries under the will. As in the trust example above, the inherited IRA will remain intact and individuals will be substituted in place of the estate as the new beneficiaries. See, e.g., Private Letter Ruling 2005-20004. The new beneficiaries will be relegated to withdrawing the IRA over the decedent’s remaining life expectancy, but this is almost always better than the alternative. (For example, the life expectancy of an 80 year-old individual is 10.2 years.) The trick is to get the custodian to cooperate, which is usually an uphill battle.
In conclusion, an abundance of caution should be exercised when naming a trust (or worse yet, an estate) as IRA beneficiary. If you find yourself charged with administering an IRA for which a trust or estate is the named beneficiary, there is no substitute for an experienced lawyer.