The benefits of IRAs and qualified plans have reached almost mythical proportions. Justifiably so. Deferring income tax liability until distribution of the assets provides the opportunity for tax-free growth of an IRA and, thus, enormous income tax savings.
To maximize the tax savings, the employee generally defers distributions from the IRA as long as possible. After the employee’s death, the beneficiary of the IRA should similarly seek to defer payout of the IRA. Of course, the opportunity for deferral is limited by the Internal Revenue Code’s required minimum distribution (RMD) rules.
During the account owner’s (a/k/a the “employee’s”) lifetime, the RMD is calculated to pay out the IRA over the lifetime of the employee and a beneficiary. IRC § 401(a)(9)(A). After the employee’s death, the RMD is calculated to pay out the remaining balance of the IRA over the “designated beneficiary’s” lifetime. IRC § 401(a)(9)(B). Thus, it is advantageous to appoint the youngest possible beneficiary, to the extent consistent with the estate plan. Practical considerations, however, require additional safeguards when appointing a young individual as beneficiary of any substantial asset—including an IRA.
Suppose, for example, that the employee wishes to appoint her grandchild as the IRA beneficiary. Appointing such a young beneficiary may be wise in terms of taxation. But, if the beneficiary is a minor at the employee’s death, the beneficiary’s incapacity creates practical problems when the beneficiary becomes owner of the IRA. Moreover, if the beneficiary is a young (or immature or disabled) adult, the employee will be anxious to assure that the IRA is not squandered.
One solution to these problems is to leave the IRA to the beneficiary in trust. This creates two issues, however. First, consider the easy issue: how does one designate a trust as a beneficiary of an IRA without running afoul of the RMD rules? These rules require distribution of the IRA within five years of the employee’s death if the IRA has a non-individual designated beneficiary. IRC § 401(a)(9)(B)(ii).
Second, consider the more subtle issue: In structuring the trust, how does the estate planner assure distribution over the lengthy life expectancy of the young intended beneficiary rather than the shorter life expectancy of some older contingent beneficiary?
Only individuals may be designated beneficiaries of an IRA. Otherwise, the IRA must be paid out within five years of the employee’s death. Treas. Reg. § 1.401(a)(9)-4, Q&A 3. It is important to meet four relatively simple requirements so that the individual beneficiary (or beneficiaries) of the trust are treated as the designated beneficiaries of the IRA. Treas. Reg. § 1.401(a)(9)-4, Q&A 4.
First, the trust must be either valid under state law or valid if there were a corpus. Second, the trust either must be irrevocable or must become irrevocable at the death of the employee. These requirements allow the use of a revocable trust even if it is unfunded or nominally funded. Third, the individual beneficiaries who will be treated as the designated beneficiaries must be identifiable. Fourth and finally, certain documentation (generally a copy of the trust instrument or a list of the beneficiaries) must be provided to the plan administrator. Treas. Reg. § 1.401(a)(9)-4, Q&A 6(a).
It is important to note that these requirements must be met when identification of the beneficiaries is necessary for determination of the RMD. Treas. Reg. § 1.401(a)(9)-4, Q&A 5(b). Unless the individual designated beneficiary is a 10-year-younger spouse, this does not occur until the employee’s death. Specifically, the IRA beneficiary will be the designated beneficiary if she was a beneficiary at the employee’s death and remains a beneficiary as of September 30 of the calendar year following the calendar year of the employee’s death. Treas. Reg. § 1.401(a)(9)-4, Q&A 4.
The delay between the employee’s death and the date the designated beneficiary is determined allows for a variety of planning opportunities. One is the strategic use of disclaimers. An older beneficiary can disclaim his interest so the balance of the IRA can be paid out more slowly. Treas. Reg. § 1.401(a)(9)-4, Q&A 4. A second planning opportunity is to take advantage of the time between the employee’s death and September 30 of the following calendar year, which can be used to divide the IRA into separate shares for each beneficiary to provide the slowest payout possible. Treas. Reg. § 1.401(a)(9)-4, Q&A 4(a). A third is to make use of the fact that the trust does not need to be irrevocable when it is named as a beneficiary, which means that the trust may be testamentary. See, e.g., Treas. Reg. § 1.401(a)(9)-5, Q&A 7(c), ex. 1.
If the beneficiary is the trustee of a trust, then the designated beneficiaries of the IRA will be the beneficiaries of the trust as of September 30 of the calendar year following the calendar year of the employee’s death. Treas. Reg. § 1.401(a)(9)-4, Q&A 5. The greatest tax deferral results from the youngest possible designated beneficiary. The goal, therefore, is to structure the trust so that the youngest possible individual is treated as the designated beneficiary. Unfortunately, this is easier said than done.
Designated Beneficiaries When a Trust Is the Beneficiary of an IRA
Only individuals may be designated beneficiaries. IRC § 401(a)(9)(E). When there is more than one designated beneficiary, the proceeds of the IRA are paid out over the oldest beneficiary’s life. Treas. Reg. § 1.401(a)(9)-5, Q&A 7(a). In a trust, this means that the IRA proceeds must be paid out over the lifetime of the oldest beneficiary of the trust. Thus, the goal in structuring the trust is to assure that only the youngest possible individuals are treated as the beneficiaries of the trust.
For example, suppose that an employee wishes to designate a minor grandchild as the IRA beneficiary. The employee’s child is 35 years old and her grandchild is five. Of course, designating the grandchild as the beneficiary of the IRA accomplishes the result of maximizing deferral because the balance will be paid out over the grandchild’s lifetime. But the grandchild’s minority, and concomitant legal incapacity, makes this simple designation unwise.
Similarly, for myriad reasons, it may be unwise to designate the grandchild as beneficiary even if she is an adult. For example, the grandchild may be immature, incapacitated, or a spendthrift. In any of these cases, leaving the IRA to the grandchild in trust, as opposed to outright, would better protect the grandchild and the assets. The trust must be carefully structured, however, so that the grandchild’s life expectancy is used to calculate the required minimum distributions after the employee’s death.
Suppose that a typical trust during minority is used. The assets are held in trust until the grandchild attains age 35 or the grandchild’s earlier death. At that time, the grandchild receives all trust assets outright, if living, or, if not, the assets are paid to the employee’s then living issue. The problem is that these very typical trust terms will cause the required minimum distributions to be calculated based on the 35-year-old child’s life expectancy rather than the five-year-old grandchild’s. Treas. Reg. § 1.401(a)(9)-5, Q&A 7.
This unfortunate result obtains because contingent beneficiaries of a trust are deemed designated beneficiaries of an IRA held by the trust. Treas. Reg. § 1.401(a)(9)-5, Q&A 7(b). Thus, the age of the oldest beneficiary, whether vested or contingent, determines the required minimum distributions. But contingent beneficiaries who are merely “successor beneficiaries” are not considered designated beneficiaries. Treas. Reg. § 1.401(a)(9)-5, Q&A 7(c). A contingent beneficiary is a disregarded successor beneficiary if her interest is solely that “the person could become the successor to the interest of one of the employee’s beneficiaries after that beneficiary’s death.” Id. Arguably, this language could be read to include the 35-year-old child in the above example as a “successor beneficiary.” The very next sentence makes clear, however, that such a contingent beneficiary is not disregarded as merely a successor beneficiary.
The import of the regulations can be demonstrated best by an example. In the hypothetical above, suppose that the contingent beneficiaries of the trust are the employee’s 35-year-old daughter, but, if she is not living, then the employee’s 70-year-old brother. Even though the five-year-old grandchild is the primary beneficiary, and, practically, distributions to the daughter or sibling are unlikely, both the grandchild and child will be considered designated beneficiaries. The sibling, however, is merely a successor beneficiary (successor in interest to the employee’s daughter) and, thus, is not considered a designated beneficiary.
Of course, the greatest tax deferral results if the grandchild (or the grandchild and additional younger beneficiaries) is the sole designated beneficiary. The problem is: how to structure the trust to accomplish this result in a way that is consistent with the employee’s goals. The trust will likely continue until the grandchild reaches a specified age, say age 30. At that age, trust assets (the IRA) will be paid outright to the grandchild. In reality, the grandchild likely will live until the specified age. Nonetheless, the identity of the contingent beneficiary is pivotal. IRC § 401(a)(9)(B)(ii).
Typically, the trust will specify a contingent beneficiary in case of the grandchild’s death before trust termination—for example, the grandchild’s then living issue, if any, or, if none, the employee’s then living issue. As discussed above, however, this common provision will, in the above example, make the employee’s child one of the designated beneficiaries of the trust. This is because the child is a contingent beneficiary, but not merely a successor beneficiary. Treas. Reg. § 1.401(a)(9)-5, Q&A 7.
It is tempting to try to avoid this result by excluding any beneficiary other than the grandchild. For example, the trust could require that trust assets be distributed to the grandchild’s estate in the event of her untimely death. Under state law, this would make the grandchild the sole beneficiary of the trust. Unif. Trust Code § 103(3), (8). But, because the IRA could be distributed to the grandchild’s estate, the IRS would likely view the grandchild’s estate as a contingent beneficiary of the trust and, thus, a designated beneficiary of the IRA. Because the estate is not an individual, if it is a designated beneficiary of the IRA, all IRA assets would need to be paid out within five years of the employee’s death. IRC § 401(a)(9)(B)(ii).
Similarly, suppose the trust document does not specify a beneficiary in the event of the grandchild’s death before trust termination. Under state law, the settlor (presumably the employee) would have a reversionary interest in the trust. Of course, after the employee’s death this means that the holder of the reversion—typically the employee’s estate—would hold the reversion. Thus, the employee’s estate would receive the IRA on the grandchild’s death. Once again, the IRS would likely argue that a non-individual is one of the designated beneficiaries and that IRA assets would need to be paid out over five years. IRC § 401(a)(9)(B)(ii).
In this situation, the taxpayer may try to argue that the regulations specifically state that the designated beneficiaries are the beneficiaries of the trust. Treas. Reg. 1.401(a)(9)-4, Q&A 5(a). Even though the employee/settlor retained a reversion under state law, that reversion does not make the employee, or his estate, a beneficiary of the trust. Unif. Trust Code § 103(3), (8). In many trusts the settlor retains some incidental, and often insignificant, reversionary interest. Nonetheless, the settlor is not treated as a beneficiary on account of this reversion. Thus, the IRS’s supposed argument is inconsistent with state law regarding the identity of the trust beneficiaries.
That argument has merit and is supported by state law. The fact remains, however, that the IRA would pass to the holder of the reversion on the grandchild’s death before trust termination. Thus, that entity is effectively the contingent beneficiary of the IRA, even if not a contingent beneficiary of the trust.
If the employee tries this technique, it may be wise to transfer the reversion to some younger individual, for example, the employee’s child. In that case, if the IRS’s above-described argument were to prevail, the child (age 35, in our hypothetical) and not the employee’s estate would be the additional designated beneficiary. This would require payout of the IRA over the child’s, rather than the grandchild’s, life expectancy. But this would likely be a slower payout than the five-year payout required in case the estate is deemed a designated beneficiary. Thus, this may be an acceptable fallback position.
If the employee has several grandchildren, then the other grandchildren can be the contingent beneficiaries. That is, if the primary grandchild beneficiary dies before termination of the trust, the IRA would be distributed outright to the other grandchildren. In this case all of the grandchildren would be designated beneficiaries of the IRA. This would require payout of the IRA over the life expectancy of the oldest grandchild, which may be an acceptable result. On the downside, though, if the primary-beneficiary-grandchild dies before termination of the trust, the IRA would potentially be distributed to a cousin from a different branch of the family. This would skew the distribution of shares within the family. Further, the distribution to the contingent beneficiary grandchildren must be outright. Otherwise, the contingent beneficiaries of that continuing trust would also be designated beneficiaries. Of course, if the contingent beneficiaries are minors (or immature or incapacitated) at the time of the distribution, this outright distribution would be problematic.
Perhaps the simplest alternative is a so-called conduit trust. A conduit trust requires that any funds paid from the IRA to the trustee must be paid directly to the designated beneficiary. Treas. Reg. § 1.401(a)(9)-5 Q&A 7, ex. 2. In such a case, the regulations provide that only that beneficiary will be considered a designated beneficiary. Id. This, of course, accomplishes our goal. If the trust is structured so that it qualifies as a conduit to the grandchild, then only that grandchild will be a designated beneficiary of the IRA held by the trust. Thus, the longest possible income tax deferral is secured.
The planning drawback of a conduit trust is the requirement that the IRA distributions be “paid directly” to the beneficiary, even if that beneficiary is then a minor. Id. Once again, the minor’s legal incapacity makes this payment to the beneficiary problematic.
Any estate planner familiar with Crummey or other withdrawal powers, would likely consider giving the grandchild-beneficiary a lapsing power to withdraw the funds, rather than requiring outright payment. Unfortunately, the regulations specifically state that a withdrawal power is insufficient. Treas. Reg. § 1.401(a)(9)-5 Q&A 7, ex. 1(ii). If the beneficiary merely has a withdrawal power, then IRA distributions may be accumulated for the contingent beneficiaries, and, thus, the contingent beneficiaries will also be designated beneficiaries. Id.
Although not addressed in the regulations, it seems that a requirement in the trust document that IRA distributions be paid to, or used for the benefit of, the beneficiary should be sufficient. From an income tax perspective, using the IRA funds for the benefit of the beneficiary is no different from paying them to the beneficiary. Further, to the extent the concern, as reflected in the regulations, is that IRA assets might be accumulated for the contingent beneficiaries, this is not possible if the IRA distributions are used for the benefit of the beneficiary.
Nonetheless, the disadvantages of a requirement that the IRA distributions be paid to, or used for the benefit of, the grandchild-beneficiary are significant. This requirement may make it more difficult to protect the distributions from the beneficiary’s minority or folly. Moreover, if the beneficiary is incapacitated, this requirement may make the assets available for the purpose of the relevant government benefits.
As detailed above, there are, broadly speaking, two alternatives regarding how to structure a trust to protect an IRA while simultaneously assuring the longest possible income tax deferral. The first alternative is to simply accept that the contingent—but not the “successor”—beneficiaries will be designated beneficiaries of the IRA. This allows for the greatest flexibility in structuring the trust and, thus, the greatest possible protection of the assets. For example, the trust could be fully discretionary, thereby providing the maximum protection from creditors and Medicaid.
The extent to which this reduces the income tax deferral will depend on the difference in age between the primary and contingent beneficiaries. For example, if the employee’s family situation requires that the contingent beneficiary be the primary beneficiary’s parent, then the lost opportunity for income tax deferral may be significant because of the difference in life expectancy between the primary beneficiary and his parent. In contrast, if the contingent beneficiaries can be other individuals the same age as or younger than the primary beneficiary (such as siblings and cousins), then the deferral lost from using the life expectancy of the eldest designated beneficiary may be nominal.
In essence, this option allows for the most flexibility in creating the trust, but that flexibility comes with the likely necessity of sacrificing some income tax deferral. The amount of increased taxes will depend on the tax brackets, ages of primary and contingent beneficiaries, and so on.
A conduit trust assures that the life expectancy of the primary beneficiary will be used to determine the required minimum distributions. As long as the trust document requires that distributions from the IRA be “paid directly” to the primary beneficiary during her lifetime, the contingent beneficiaries will not be considered designated beneficiaries. Moreover, as discussed above, it should be possible to allow the trustee to use the IRA distribution for the beneficiary’s benefit, instead of mechanically delivering a check to her.
Further, because a separate conduit trust can be created for each beneficiary, each beneficiary’s share of the IRA will be paid out over his or her individual life expectancy. Thus, the greatest aggregate deferral is assured.
The greater deferral possible through use of a conduit trust comes at the cost of flexibility in the trust’s terms. It is not permissible for IRA distributions to be accumulated in the trust. This may compromise some of the asset protection benefits that are likely the reason for using a trust in the first place.
The answer “it depends” is never particularly satisfying. That is, however, the answer to the question of how to structure a trust that is intended to hold an IRA. The estate planner must weigh the value of additional tax deferral against the value of flexibility in the trust’s terms in light of the employee’s family situation, goals, other assets, and income. Only through careful balancing of these factors will the estate planner be able to recommend the best course of action for the client.