Designating a Trust as Retirement Beneficiary

It is very common for IRA owners to designate a trust as the beneficiary of the account. A trust is a popular designation because it generally gives the IRA owner some degree of control over how the assets are distributed after he or she is deceased. However, while a trust is an effective estate-planning tool for many, an IRA owner must take some steps to ensure that the outcome is consistent with his or her needs.

Almost anyone or anything can be the beneficiary of an IRA. However, if the beneficiary is a non-person, the IRA owner is treated as having no beneficiary when it comes to determining the beneficiary's life expectancy for required minimum distribution (RMD) amounts. This means that if the IRA owner dies before the required beginning date (RBD), the beneficiary is not eligible to use the life-expectancy method to calculate post-death distributions. The beneficiary must therefore distribute the assets within five years. If the IRA owner dies on or after the RBD, the distribution period may not be stretched beyond the remaining life expectancy of the deceased.

This rule for non-person beneficiaries also applies to trust beneficiaries, unless an exception applies, in which case the oldest underlying beneficiary of the trust is treated as the beneficiary of the IRA – for purposes of determining the distributions options. In general, the exception applies if the following requirements are met:

1. The trust is valid under state law.
2. The trust is irrevocable or will, by its terms, become irrevocable upon the death of the IRA owner.
3. The beneficiaries of the trust are identifiable.
4. A copy of the trust documents are provided to the IRA custodian by Oct. 31 of the year immediately following the year in which the IRA owner died.

In most cases, an IRA owner designates a trust as the beneficiary of the IRA in order to have control over the disposition of the assets after he or she dies. The following are some reasons why an IRA owner may designate a trust as beneficiary:

• Spendthrift beneficiary protection. An IRA owner may be aware that a beneficiary may squander the inheritance. As such, the IRA owner may want the assets to be disbursed according to a certain schedule instead of in a lump-sum payment. The IRA owner may also want some of the assets to be used for specific purposes, such as financing the beneficiary's education. The IRA owner can ensure these conditions are met by designating a trust that includes the desired payment options. The trustee of the trust would then be responsible for complying with the trust provisions.
• Providing for children from a previous marriage. An IRA owner may want to ensure that both a current spouse receives income from the assets and children from any previous marriages receive their share of the assets. This can be accomplished by designating a trust that meets certain requirements, such as a qualified terminable interest property (QTIP) trust.

Designating a trust as the beneficiary of an IRA should be a solution to the IRA owner's financial planning needs. However, steps must be taken to guarantee that the designation does not create problems for the parties who will inherit the assets. An IRA owner should check with the IRA custodian to ensure that the provisions of the trust are acceptable to the IRA custodian and that they meet regulatory requirements.

In addition, the IRA owner should consult with a competent attorney or estate planning professional for assistance in designing the trust. Here are some examples of circumstances that cause the trust to fail to satisfy the needs of the IRA owner:

• A copy of the trust is not provided to the IRA custodian by Oct. 31 of the year following the year the IRA owner died, preventing the underlying beneficiary of an otherwise valid trust from using the life expectancy of the oldest identifiable beneficiary in calculating RMD amounts.
• The trust is eligible to disclaim the assets. If this happens, the other primary or contingent beneficiary usually inherits the assets, and the provisions of the trust no longer apply. This can be avoided by including a 'disclaimer provision' in the trust. In general, this provision may require that in the event the trust disclaims the assets, the disclaimed assets, instead of going to an individual, must be disposed according to certain provisions of the trust.
• The IRA custodian does not find the provisions of the trust acceptable, or the provisions of the trust conflict with the provisions of the IRA plan document. When designating a trust as the beneficiary of his or her IRA, the IRA owner should check with the IRA custodian in advance.

Designating a trust as the beneficiary of an IRA can be an effective estate-planning tool. However, it is effective only if all the parties involved – especially the IRA owner, the IRA custodian, the trustee of the trust and any attorneys representing the beneficiary – agree on the interpretation of the provisions of the trust and applicable laws. Conflicting interpretations could result in a delay of disposition of the assets and can be quite frustrating for those involved. Designing a trust is a complex process. The IRA owner should seek the assistance of a competent attorney and tax professional to determine if and when a trust is appropriate, the type of trust that suits the IRA owner's needs and to ensure that estate planning needs are met and maximized.

For related reading, see "Mistakes in Designating a Retirement Beneficiary."