IRA Beneficiaries: Trusts, Estates and Charities

Strategic Thinking IRA Beneficiaries: Trusts, Estates and Charities By Kenneth A. Johnson TRUSTS AS BENEFICIARY Frequently, people will desire and be advised to name a trust as beneficiary of their IRA. A trust can offer benefits by limiting distributions to the trust beneficiaries while also protecting the trust assets from the claims of the creditors of the beneficiaries. Trusts may be used for tax reasons, such as funding the applicable exemption, using the state estate tax exemption or utilizing the account owner s generation skipping tax, or GST, exemption. Despite its appeal for a variety of reasons, leaving an IRA to a trust requires satisfying a number of conditions to qualify the beneficiaries of the trust for treatment as designated beneficiaries. Such designation then enables them to take advantage of applicable favorable IRA distribution rules. continued

It is important with trusts as beneficiary of an IRA to have a look through rule apply so that it can be determined whether there is a designated beneficiary and the ultimate identity of the designated beneficiary. The four requirements that the trust must satisfy are as follows: 1. The trust must be a valid trust under state law or would be but for the fact that there is no corpus (principal). 2. The trust must be irrevocable or will, by its terms, become irrevocable upon the death of the account owner. 3. The beneficiaries of the trust who are beneficiaries with respect to the trust s interest in the account owner s benefit must be identifiable from the trust instrument. 4. Certain documentation must be provided to the plan administrator, which consists of (i) supplying a copy of the trust instrument and any amendments within a reasonable time, or (ii) supplying a list of all trust beneficiaries, including other details about contingent and remaindermen beneficiaries, as well as giving the plan administrator a copy of the trust instrument upon demand. If the trust meets all the conditions outlined above, then the beneficiaries of the trust are treated as designated beneficiaries, and RMDs will be determined based on the life expectancy of the trust beneficiary. If there are multiple beneficiaries of the trust, then the RMDs will be determined by the life expectancy of the oldest trust beneficiary. If the trust doesn t qualify, then the no designated beneficiary rule will be deemed to apply and RMDs will not be computed in relation to any beneficiary s life expectancy, thus causing RMDs to be accelerated over a short time period. At first blush, it seems relatively easy to satisfy the four conditions mentioned above and have the trust, through its beneficiaries, be treated as a designated beneficiary. Frequently, however, the trust, through its beneficiaries, will fail to qualify and thus be treated under the no designated beneficiary rule. This rule provides that (i) if the account owner dies after the RBD, then RMDs are determined by reference to the life expectancy factor in the Single Life Table for the owner s age as of their birthday in the year of their death (a period, however, not lasting more than 15.3 years), or (ii) if the account owner dies before their RBD, then all amounts must be distributed from the account no later than the end of the fifth year following the owner s death. 2 Selecting IRA Beneficiaries

The following section will examine some of the most common forms of trusts that are used as beneficiaries of IRAs and discuss their treatment under the rules. Conduit Trust This is probably the only kind of trust that, with certainty, will give rise to designated beneficiary treatment. A conduit trust is a trust which requires that all distributions from the IRA (not just RMDs) are paid out currently to a beneficiary and nothing is accumulated in the trust. The trust will last for the life of the beneficiary, or it will run until the beneficiary reaches a certain age whereupon the trust will terminate and distribute all assets to the beneficiary. The Trustee will have no power to accumulate or hold IRA distributions made into the trust. If there are multiple beneficiaries of the conduit trust, then the designated beneficiary will be the oldest of the beneficiaries, with RMDs determined by that beneficiary s life expectancy. The characteristics of a conduit trust make it an unacceptable choice for a person who wants to control distributions from the trust to the beneficiaries. It is also at variance with the usual goal of a trust arrangement, namely, to preserve capital for the benefit of the remaindermen. Nevertheless, this type of trust is the only kind that is guaranteed to be treated as a look through and thus get designated beneficiary treatment (and favorable RMD rules) as discussed above. A benefit of the conduit trust is that the balance of the IRA will be controlled by the trustee while not subject to the claims of creditors. Of course once RMDs are distributed to the trust beneficiary, those distributions will be reachable by the beneficiary s creditors. Credit Shelter Trust A credit shelter trust is typically a trust created under a person s estate plan that is meant to capture their applicable exemption (or state estate tax exemption) amount upon their death and shield these assets from inclusion in their surviving spouse s estate for estate tax purposes. Their design and terms can vary but usually provide that the beneficiaries consist of a class comprising the surviving spouse and the trust creator s children (and grandchildren). The Trustee may be given discretion to decide who gets distributions of income or principal, or to accumulate either. This type of trust will generally not be treated under the designated beneficiary rules, as it will fail to have beneficiaries that are identifiable from the trust instrument. Thus, the trust will be subject to the five-year distribution rule or the deceased owner s life expectancy method for RMDs outlined above. Notwithstanding the potential unfavorable distribution rules applicable to the credit shelter trust, it may still be an acceptable beneficiary choice if the account owner is more concerned about controlling IRA distributions than adverse income tax rules. In addition, and again as mentioned previously, this choice may be appropriate if the account owner needs to use the IRA to fund or utilize their applicable exemption but lacks other assets to accomplish this objective. Note: The federal estate tax has been repealed for 2010. The tax is scheduled to return in 2011 at rates up to 55%. As it stands now, in 2011, any amount can pass to a spouse free of estate tax (as has long been the case), but only up to $1 million of the decedent s assets may pass free of estate tax to someone other than the spouse. It is possible that Congress will act to change the federal estate tax law before the end of the 2010, possibly even retroactively. Selecting IRA Beneficiaries 3

Marital Trusts A marital trust is another potential IRA beneficiary that may hold an IRA account as part of an estate plan. Qualification for the marital deduction is important since the assets will be considered as having passed to the surviving spouse and thus will not be subject to estate tax in the estate of the account owner. The IRA benefits will qualify for the marital deduction if they are left to the spouse outright, discussed previously, or if set up as a QTIP or a General Power of Appointment Marital Trust, as discussed below. General Power of Appointment Marital Trust With this category of trust, surviving spouses are entitled to all the income from the trust and, in addition, may appoint the principal to themselves or to their estate. This type of trust will qualify for the marital deduction but is still subject to the RMD rules, depending on the type of trust involved. For example, a general power of appointment marital trust (here meaning wherein the spouse has the right to appoint the principal of the trust to himself or herself) can be structured as a conduit trust, and RMDs will be calculated based on the life expectancy of the surviving spouse. You should question whether this makes sense, considering that leaving the IRA directly to the surviving spouse outright will also qualify for the marital deduction while giving the spouse the opportunity to do a rollover and thus take advantage of further income tax deferral. If the general power of appointment marital trust gives the spouse the power to appoint the principal to their estate at death, then the trust will be deemed to have no designated beneficiary, and thus the RMD rules applicable to this type of trust will require distribution of the account balance over the life expectancy of the account owner if death occurs after the RBD, or by the end of the fifth year following death if death occurs before the RBD. Qualified Terminable Interest Property (QTIP) Trust This type of trust is a popular way of leaving assets to a surviving spouse though a trust, qualifying the trust assets for the marital deduction and controlling the ultimate disposition of the trust assets upon the death of the surviving spouse. The typical QTIP trust provides that during the lifetime of the surviving spouse they are entitled to all the income from the trust, and upon their death the principal will be paid to the account owner s children or other beneficiaries. This arrangement is in contrast with that of the general power of appointment marital trust described above, wherein the surviving spouse has control over the ultimate disposition of the principal. The nature of the QTIP trust makes it a logical choice for someone who has been married before and has children of that prior marriage whom the trust creator would like to see benefit upon the death of the surviving spouse. 4 Selecting IRA Beneficiaries

Leaving the IRA to a QTIP trust involves a similar income tax result as described above with respect to the general power of appointment marital trust. If the trust is structured as a conduit trust, then RMDs will be payable according to the life expectancy of the surviving spouse; but, this may frustrate one of the trust goals of the trust creator preserving those assets for their ultimate selected beneficiaries, e.g., their children. If the trust isn t considered to have a designated beneficiary, then the RMDs are accelerated as described above, forcing quicker distributions and accelerated income taxes. If the account owner is intent on having the control that a QTIP trust affords, they may want to consider using the IRA to fund a credit shelter trust, as described above, and use other assets to fund the QTIP trust. While this approach will also not be favorable from an income tax perspective because it subjects the credit shelter trust distributions to income tax, it may be preferable if the credit shelter trust is structured as a conduit trust in which the oldest beneficiary (child) of that trust may be used as the measuring life for purposes of RMDs thus permitting greater income tax deferral compared with the QTIP trust. Generation Skipping or Dynasty Trust A GST or dynasty trust is generally a trust which is situated, for trust jurisdiction purposes, in a state that allows trusts to last indefinitely, or in perpetuity. These trusts are intended to last for many generations and if structured correctly will not be subject to the generation skipping tax when created nor when succeeding generations become beneficiaries of the trust. For many of the same reasons described above, making a GST or dynasty trust the beneficiary is not usually the best course since part of the benefit of such a trust preserving trust principal for future generations will be negated because of the income taxes due on the distributions from the IRA. However, like the above scenarios describing credit shelter trusts and marital trusts, it may be necessary to use an IRA because of the lack of other non-ira assets to fund the trust. Selecting IRA Beneficiaries 5

Special or Supplemental Needs Trust This type of trust is generally established for the benefit of a disabled beneficiary. The trust is structured to accumulate the income of the trust and to provide benefits to the beneficiary to the extent those needs are not met by other government benefits available to the beneficiary. If the trust were structured as a conduit trust, all the RMDs would have to be distributed to the beneficiary and this would disqualify the beneficiary from receiving government benefits. For this reason, it is not recommended to have such a trust be the IRA beneficiary. Of course, the trust could still be structured to avoid disqualification, but then the RMDs would be accelerated on account of its no designated beneficiary status; income taxes would then erode the benefits of the trust purpose. Qualified Domestic Trust (QDOT) Assets left to a spouse who is not a U.S. citizen will not automatically qualify for the marital deduction. This is true with respect to IRA accounts as well. For the IRA transfer to qualify for the marital deduction, the account balance must be payable to a QDOT. The challenge here is twofold: to make sure that the QDOT satisfies the requirements for the marital deduction and to structure such a trust so that it utilizes RMDs based on the life expectancy of the surviving spouse. A QDOT, unlike a traditional general power of appointment marital trust or QTIP, imposes an estate tax on distributions of principal to the non-u.s. spouse. If the QDOT were a conduit trust then part of each distribution would be subject to estate taxes. At least two options are present here; first, a QDOT can be used but it would probably be subject to no designated beneficiary status, which would accelerate distributions and income tax; or second, a QDOT is not used, in which case the transfer does not qualify for the marital deduction and instead will be treated in the same manner as a credit shelter trust, described above. 6 Selecting IRA Beneficiaries

Charitable Remainder Trust (CRT) A charitable remainder trust is a trust which is typically set up in one of two ways. A charitable remainder unitrust (CRUT) provides that one or more non-charitable beneficiaries will receive a stated percentage of the value of the trust each year as long as they live or for a certain period of years. At the end of the payout period life or term the remainder of the trust assets will pass to one or more named charities. A charitable remainder annuity trust (CRAT) is very similar to a CRUT, except in this case the non-charitable beneficiaries will receive a stated amount or annuity from the trust each year rather than the percentage described with respect to the CRUT. A CRT is sometimes used as the named beneficiary of an IRA. In this case, the trust will be treated as subject to the no designated beneficiary rule requiring accelerated distributions from the IRA following the IRA account owner s death. This, however, should not matter because the CRT is exempt from income taxation. Instead, the trust beneficiaries will recognize taxable income (computed on the basis of a tier rule, but most likely it will be treated as ordinary income) as they receive the unitrust or annuity payments from the trust. The advantage of using the CRT as the beneficiary of the IRA is that the family may have additional funds to work with compared with receiving the IRA directly. This is because the value of the remainder interest that will ultimately pass to charity will be a charitable deduction on the estate tax return of the account owner. Complex tax rules must be complied with when considering whether it makes sense to use a CRT as an IRA beneficiary. In addition, there is the risk that a child beneficiary of the trust may not live out their full life expectancy, in which case the charity would receive their interest earlier than planned and the total amount passing to the child may be less than if the CRT route were not taken. Selecting IRA Beneficiaries 7

No Designated Beneficiary Estates, Non-Qualified Trusts and Charities The prior sections of this discussion concentrated on the benefits of achieving designated beneficiary status. In general, having a designated beneficiary means those RMDs will be calculated using the life expectancy tables for that beneficiary, allowing a greater period to stretch the distributions from the IRA and thus increasing income tax deferral. It was also pointed out what happens when there is no designated beneficiary subject to which RMD rules apply, depending on whether the account owner dies before or after their RBD. Estate It is not uncommon to find that account owners have named their estate as beneficiary of their IRA, or sometimes this occurs because no beneficiary is named at all and the IRA plan requires that the beneficiary defaults to the estate of the account owner. If the estate is the beneficiary then the no designated beneficiary rule applies. This rule provides that (i) if the account owner dies after the RBD then RMDs are determined by reference to the life expectancy factor in the Single Life Table for the owner s age as of their birthday in the year of their death (this period, however, may not last more than 15.3 years), or (ii) if the account owner dies before their RBD then all amounts must be distributed from the account no later than the end of the fifth year following the owner s death. It is important to recognize that an estate will be subject to the no designated beneficiary rule even if all the beneficiaries of the estate are individuals. In this case, the estate is not treated the same way as trusts as described above in which there is a look through to see if there is a designated beneficiary. This is true even if the executor transfers the IRA directly to the individual beneficiaries of the estate. Naming an estate as beneficiary is not advisable on account of the adverse RMD rules noted above. 8 Selecting IRA Beneficiaries

Non-Qualified Trusts The discussion above with respect to using trusts as beneficiaries of an IRA should be considered here. Put simply, if the trust does not qualify for the look through rule then it will be subject to the no designated beneficiary rule and RMDs will be calculated under the account owner s life expectancy or the five-year rule, depending on when the account owner dies. Charity A charity will not qualify as a designated beneficiary, but this is one type of beneficiary wherein the status doesn t matter. In this case, even though the IRA distributions cannot be stretched, this makes no difference to the charity because it will not pay income taxes on the distribution. In addition, the benefits paid to the charity will not be subject to estate taxes in the account owner s estate because of the charitable estate tax deduction. The charitable gift via it being a named beneficiary can be made directly to the charity, used to fund a private foundation that can be run by the account owner s family or be given to a donor advised Fund or community foundation. The preferential tax treatment given to a charity in receiving an IRA when compared with leaving the IRA to an individual should not be ignored. An IRA that is left to an individual beneficiary will (potentially, based on the size of the estate) be subject to estate taxes in the account owner s estate and then as distributions are made to the beneficiary also be subject to income taxes. Ultimately, only a small portion of the IRA may find its way into the beneficiary s hands on account of the application of these two taxes. The charity, on the other hand, will find the receipt of the IRA much more beneficial since they will have use of 100% of the funds. Consider the situation in which someone has an IRA with a balance of approximately $1,000,000 and their estate plan makes a bequest of this same amount of $1,000,000 to a specific charity. The IRA names the children of the account owner as beneficiaries of the IRA. In this case, it would be a better plan to name the charity as beneficiary of the IRA and have the children inherit other assets from the account owner worth $1,000,000. The charity doesn t care that it receives the IRA since it is exempt from taxes, and the children are better off because they will not pay income taxes on the bequest given to them. If a charitable remainder trust is considered as beneficiary, see the above discussion of CRTs in the Trusts as Beneficiaries section. Selecting IRA Beneficiaries 9

Roth IRAs The discussion to this point has focused on so-called traditional IRAs that consisted of deductible contributions made by the account owner during their lifetimes and, in particular, the RMD rules that apply based on the type of beneficiary selected. Depending on the nature of the beneficiary designated beneficiary or no designated beneficiary a different set of RMD rules are used that either allows a stretching of the RMD distributions over the lifetime of the beneficiary or acceleration over a shorter period. The distinction becomes important because the longer the required payout of the IRA the better off the IRA beneficiary will be. This is true because they will not have to pay income taxes on distributions until they actually receive them, allowing the corpus to grow in the meantime. The availability of deferral is considered advantageous as a general principle because the beneficiary will not have to pay taxes earlier and the funds will be allowed to stay in the IRA longer, allowing it to continue to grow on a tax-favored basis. Roth IRAs were introduced starting in 1998. In contrast to traditional IRAs, Roth IRAs represented two fundamental differences; Contributions were not deductible and distributions are normally income tax free. Roth IRAs have not been as popular among high-income investors because of the restrictions on their use imposed by qualifying income limitations. Beginning 2010, the income limits which prohibited ROTH IRA conversions by taxpayers with Modified AGI over 100,000 were repealed. The ability to convert traditional IRAs and distributions from qualified plans to Roth IRAs is expected to create many more Roth IRAs, so it is important to discuss beneficiary selections on these accounts. For federal income tax purposes, Roth IRAs are generally treated the same as traditional IRAs, with two important exceptions. First, unlike traditional IRAs discussed above, account owners are never required to take any distributions from their Roth IRA during their lifetime regardless of their age. In addition, if the Roth IRA passes to the account owner s surviving spouse and they roll over the account, they will not be required to take any distributions from the account. The absence of the requirement to take distributions during the account owner s lifetime. as well as during the surviving spouse s. allows the Roth IRA account balance to gain investment returns without the diminution of distributions as required by traditional IRAs. 10 Selecting IRA Beneficiaries

The other important distinction between a traditional IRA and a Roth IRA is that distributions from the Roth IRA are generally income tax free to the account owner and beneficiary. A special rule applies to distributions from a Roth IRA made within five years from a contribution to any Roth IRA maintained for the account owner. The cost of converting a traditional IRA to a Roth IRA is that, upon conversion, the account owner will be required to pay income taxes on the account balance as if they had received a distribution from the IRA. In light of the above discussion and the important benefits a Roth IRA provides, this question arises: Does a Roth IRA change the issues that need to be considered when naming beneficiaries? Well, yes and no. The answer is split because two things have to be kept in mind. First, the RMD rules are the same for Roth IRAs (except for the account owner and a spousal rollover) as applied to traditional IRAs; and, second, distributions to an account owner prior to reaching age 59½ are still subject to the 10% penalty unless an exception applies. The conditions that fit for Yes and for No are explained more fully below. Yes to different considerations Much of the previous discussion focused on whether or not the beneficiary qualified as a designated beneficiary. The importance of this designation lies in the frequency in which RMDs must be distributed from the account to the beneficiary; generally, the longer the period the distributions are allowed the more tax deferral that can be achieved. Since Roth IRA distributions are generally tax free, this is not as important. However, this distinction is particularly important with regard to naming a trust as a beneficiary. Achieving designated beneficiary status for a trust generally means designing the trust as a conduit trust, requiring all distributions from the traditional IRA to be paid out to the beneficiary, which robs the trust of the opportunity to accumulate the distributions for remaindermen beneficiaries. With a Roth IRA, even though the trust may not qualify as a designated beneficiary making RMDs accelerated for a shorter period this doesn t matter. It isn t relevant because the trust will not have to recognize taxable income on the distributions, and the trust will be free to accumulate or pay them out as the trust creator provides in the instrument. This advantage also holds true for credit shelter and marital trusts, even though they may not be designed as conduit trusts, since they may be needed to fund the applicable exemption or marital deduction of the account owner. Selecting IRA Beneficiaries 11

It will generally not make sense to have a Roth IRA paid to a charitable organization or a CRT as would be the case with a traditional IRA. The benefit of naming the charity in the traditional IRA is that the charity will not be concerned about the distributions, since it will not pay tax anyway, while the non-charitable beneficiary would prefer to receive assets not subject to an income tax. With a Roth IRA, the tax issue is removed, and it is not a beneficial trade-off to have the account owner convert a traditional IRA to a Roth IRA and pay income taxes on the conversion. No to different considerations Unless good reasons exist to the contrary, the Roth IRA account owner should still consider naming his or her spouse as primary beneficiary and children as contingent beneficiaries. The surviving spouse can elect to roll over the Roth IRA and will not be required to take RMDs during his or her lifetime. Once the Roth IRA is inherited by the children, they will be subject to RMDs that are based on their life expectancy, as discussed above, with respect to traditional IRAs. The stretch of RMDs over their lifetime will permit the Roth IRA assets that aren t distributed to grow tax free inside the Roth IRA. Disclaimers The last area of discussion when it comes to selecting beneficiaries of an IRA involves the use of disclaimers. A disclaimer is a refusal to accept a gift or inheritance. The federal tax law authorizes the use of qualified disclaimers. These disclaimers can be very useful in correcting or otherwise changing beneficiaries following an account owner s death. If a beneficiary executes a disclaimer of IRA benefits following an account owner s death, then the beneficiary is treated as if the beneficiary s death occurred before the account owner s and thus was never entitled to the benefits otherwise payable to that beneficiary. The requirements for a valid qualified disclaimer are as follows: 1. The disclaimer must be irrevocable, unconditional and in writing; 2. The person making the disclaimer must not have accepted the interest or any of the IRA s benefits. (The disclaimant can accept certain benefits such as MRD payments required by year-end); 3. The disclaimer must be delivered within nine months of the account owner s death; minor beneficiaries have an extension until the age of 21; 4. It must be delivered to the correct party; and 5. As a result of the disclaimer, the property must pass to someone other than the person disclaiming the property and without any direction on the part of that person. 12 Selecting IRA Beneficiaries

Disclaimers can be very useful in correcting mistakes or changing beneficiaries following an account owner s death. For example, assume a spouse is named as primary beneficiary and the children as contingent beneficiaries of an IRA. Following the account owner s death, it is determined that the owner did not have sufficient non-ira assets to fund their applicable exemption amount (the amount that can pass free of federal estate taxes). A disclaimer may be used by the surviving spouse to have part or all of the IRA balances pass to the children beneficiaries, thus utilizing part or all of the owner s applicable exemption and shielding the assets from inclusion in the surviving spouse s estate. A similar result might have been achieved if, instead of the children as contingent beneficiaries, a credit shelter trust was named as contingent beneficiary. Final Thoughts There is an old adage that says, If you don t know where you are going, you will wind up somewhere else. This is certainly true when it comes to making choices about IRA beneficiaries. Making the wrong choice or no choice at all will take you somewhere that you never intended to go. The where may be unfavorable income (in terms of tax treatment), estate taxation or just not having the benefits pass as you intended. Knowing where you are going requires that you know how to get there, and the best way to do this is to be educated about your decisions. The discussion provided by this article is intended to provide information concerning the choices the account owner can make and the consequences of those choices. Unfortunately, the decisions that need to be made hinge on a complex interplay of tax rules and personal objectives. Therefore, the overarching advice here is to always seek legal, financial and professional tax advice when selecting IRA beneficiaries. Selecting IRA Beneficiaries 13

IRA Checklist 1. Always be sure to name a primary and a contingent beneficiary of your IRA. 2. consider naming your spouse as primary beneficiary with one or more of your children as contingent beneficiaries. This designation potentially permits the longest income tax deferral by requiring the lowest RMDs over an extended period. 3. If you name a trust as beneficiary of your IRA, make sure you understand the RMD rules that apply to that type of trust and, if necessary, change the terms of the trust to make it work more effectively for you, as described in the Trusts as Beneficiary section. 4. consider converting a traditional IRA to a Roth IRA. Many of the challenges presented by naming a trust as beneficiary of an IRA are removed with a Roth IRA, since there is no income tax on distributions. However federal and state income tax will be due upon conversion. 5. Coordinate charitable gifts in your estate plan with the beneficiary designations on your IRA. In some instances, doing so can greatly increase through tax savings the net amount your beneficiaries receive. 6. Don t forget disclaimers and the role they play in helping change beneficiary choices after death. 7. Review the choices you make on your IRA on a regular basis and particularly when your family situation changes, your estate plan is completed or revised and when other changes to the law might impact the choices that you have made. 14 Selecting IRA Beneficiaries

Tax laws are complex and subject to change. This information is based on current federal tax laws in effect at the time this was written. Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Smith Barney s Financial Advisors do not provide tax or legal advice. This material was not intended nor written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are urged to consult their personal tax or legal advisors to understand the tax and related consequences of any actions or investments described herein. Individuals are also urged to consult their legal advisors for matters involving trust and estate planning and other legal matters. Selecting IRA Beneficiaries 15

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