Suppose a hypothetical high-income couple, both in their 50s, are reviewing estate planning documents. They've set up a revocable living trust and already have transferred some of their jointly held assets to the trust. Now they're wondering whether they should name their two children as primary beneficiaries of their IRAs-or whether the trust might be a better choice as beneficiary.
Of course, there's no definitive answer based on these bare-bones facts, but let's add one more fact. Like many people in their situation, they want to help their children by stretching the assets in their IRAs so that they will deliver steady income throughout the children's expected lifetimes. That would defer taxes for as long as possible and give investment earnings in the IRAs more time to compound before funds finally are withdrawn.
The traditional way to accomplish that goal is for the spouses to name one another as primary beneficiary of each other's IRA, with the children named as contingent beneficiaries for both. But that approach does little to protect the accounts' assets from outside threats. Spendthrift children might burn through the cash quickly, while creditors or a divorcing spouse might lay claim to the assets. What if there's a child with special needs, or a second marriage, and multiple families to complicate things?
Naming a trust as the IRA beneficiary could help resolve some of those issues. It allows the IRA owners to control how the assets are distributed and to ensure that the IRA continues to meet the "stretch" objective. Still, if a trust is used as an IRA beneficiary, other questions may need to be addressed.
One possible drawback is that only individuals who are designated beneficiaries may take advantage of the provisions allowing stretch IRAs. According to the IRS, non-individuals, such as an estate or a charitable organization, can't be designated beneficiaries. If they're named as such, the entire assets of an IRA will have to be distributed within five years of the date of death of the IRA owner (if the owner is not yet age 70??) or over the remaining life expectancy of the IRA owner (if the owner has reached age 70??). Those rules may discourage people from naming a charitable organization or a similar entity as a contingent beneficiary.
Another potential trap is that a trust must be considered a "conduit trust" to reap stretch IRA benefits. To qualify as such, a trust should mandate that "required minimum distributions" (RMDs) be paid out to the trust beneficiaries. Absent a provision for RMDs, the trust could be considered an accumulation trust. If that happens, the IRS will count all potential beneficiaries of the trust as IRA beneficiaries for purposes of determining the life expectancy used to calculate IRA distributions. Distributions might have to be made over the oldest beneficiary's shorter life expectancy.
Suppose that our hypothetical couple named their two children, ages 18 and 21, as beneficiaries of their trust. The trust holds the assets for the benefit of the children until they reach age 30. At that point, they'll be entitled to receive the full amount of their trust shares. But one of the children died before then, and that child's share of trust assets would pass to a favorite aunt, who is currently age 70. The IRS then would use the aunt's age to determine the appropriate IRA distribution, and her relatively short life expectancy would undermine the stretch IRA objective.
Trusts often are set up to provide flexibility for distributions. But in the case of an accumulation trust-not a conduit trust-that could be a problem if the trust is supposed to facilitate charitable giving, even if it doesn't specify particular charities that it will support. Because the charities are likely to be treated as contingent beneficiaries of the IRA, the IRS will say there is no designated beneficiary, and distributions will have to be paid out within five years of the death or over the life expectancy of the IRA owner.
There are certainly pros and cons of naming a trust as an IRA beneficiary. Depending on your situation, it may be advantageous, but you need to take all of the relevant factors into account, and also coordinate this decision with other aspects of your estate plan.
© 2011 Advisor Products Inc. All Rights Reserved.