Q: In last Friday's post, you said that when your IRA beneficiary is a trust, the required distribution rules are "less generous" than when the IRA beneficiary is a human being.
What do you mean by "less generous'? Is the trust beneficiary limited to a smaller distribution? If a father wants to use a trust to leave his IRA to his son, for example, can't the terms of the trust permit the son to obtain a larger distribution from the IRA? -- LW via email
What do you mean by "less generous'? Is the trust beneficiary limited to a smaller distribution? If a father wants to use a trust to leave his IRA to his son, for example, can't the terms of the trust permit the son to obtain a larger distribution from the IRA? -- LW via email
A: An IRA beneficiary -- any IRA beneficiary -- can always take out more than the required minimum distribution.
And when you leave an IRA to a properly drafted trust with a human trust beneficiary, the Internal Revenue Service allows the trust to use the rules that apply to human beings. The key words are 'properly drafted'.
But before I explain that, let me clarify what I meant by 'less generous' rules for trusts.
The most generous required minimum IRA distribution is the smallest possible amount.
That may sound counter-intuitive; but remember, each distribution is taxable. The less you're required to withdraw every year, the smaller your annual tax bill and the longer the IRA can keep growing. (You're always free to take out more than the minimum. The government has no objection if you want to empty the entire IRA in a single taxable withdrawal.)
A human IRA beneficiary gets to stretch his IRA distributions over his life expectancy. The younger he is, the smaller his annual required minimum distribution. In other words, he is allowed to postpone paying taxes on most of the inherited IRA for many years, while it keeps growing.
When I said the rules are less generous for trusts I meant that when a trust is the IRA beneficiary, it must empty the account much faster than a human being:
If the IRA owner was under 70 and a half years old when he died, the trust that inherits the IRA must empty it within five years. If the IRA owner was over 70 and a half when he died, the trust must empty the IRA based on his remaining life expectancy as shown on the IRS Single Life actuarial table. (In other words, if the owner died ten years earlier than the IRS actuarial table expected, the trust can stretch the IRA distributions over those ten years.) **
As a general rule, it's a bad idea to name a trust as your IRA beneficiary. But in some cases, it's unavoidable. You need a trust if your heir is a minor or a disabled child, for example.
In that case, you want to make sure the IRS will treat the trust as nothing more than a conduit to your child. If you set it up right, the trust can take required minimum distributions using the child's life expectancy. The trustee will pass each distribution to the child (or to the child's guardian). The distributions will be taxable at the child's income tax rate. And of course the trust document can make it clear the trustee can tap the IRA for more than the required minimum distribution if necessary.
The trust document should also make it clear that the distributions aren't to stay in the trust. Remember, all IRA distributions are taxable as soon as they leave the IRA. If they're passed to your child, they're taxable at his rate. If they stay in the trust, they're taxable at trust rates, which are much higher.
How do you set it up right? To satisfy the IRS that your trust is only a conduit, it must be valid under state law, become irrevocable at your death, and have identifiable beneficiaries; and a copy of the trust document must be presented the IRA custodian by October 31 of the year after your death.
Make sure that your trustee knows about that last requirement!
"I know of one recent case where the trust document wasn't sent to the IRA custodian in time," says Seymour Goldberg, a Melville New York estate lawyer. "Because the deadline was missed, the IRA couldn't use the trust beneficiary's life expectancy. As a result, the trust had to take a $60,000 taxable distribution that otherwise could have been stretched over a 20 year period."
**As originally published, this post incorrectly reversed these rules.
Please send your questions to Lynn@LynnBrennersFamilyFinance.com. I'm sorry I can't respond personally to every email. Questions are only addressed online.
(c) Lynn Brenner, All Rights Reserved
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