Who Inherits an IRA That's Going Into a Trust?

Q: My dad, who has no Internet connection, asked me to ask you this question: Who will get his IRA if he passes? He is 88 years old, and has a living trust set up. I'm his oldest son and he has given me the executor role. He just read your article in the March-April 2010 issue of AARP magazine ('Who'll Get Your IRA?' ) that has given him some concern on how to handle the IRA. -- GL via email

 

A: If the IRA goes into the trust, the trust beneficiaries will get it. But how fast it must be distributed -- and taxed -- depends on how the trust is written.

First, a basic fact that's often misunderstood. The legal document that controls who gets your IRA is your beneficiary designation form. When someone says he is leaving an IRA `to my will', or 'to my living trust', he means either that he didn't fill out the IRA beneficiary form at all, or that he used the form to name his will or his trust as the beneficiary.

In either case, the result is that he has made his estate his IRA beneficiary. His will (or his living trust) directs how his estate is to be distributed.

It sounds as if your father has left his IRA to his living trust. And that creates a potential problem:

When you name a human being as your IRA beneficiary, that person can stretch withdrawals from the account over his or her own life expectancy. If your heir has a long life expectancy, that stretch-out can make a huge difference to the size of his or her inheritance.

Let's say you leave a $400,000 IRA to a 40-year-old, for example. He can stretch his required annual withdrawals from the account over another 43.6 years. (His first required minimum distribution would be $9,174 —$400,000 divided by 43.6.) He'd owe taxes on the withdrawals, but the IRA balance could keep growing untaxed for more than four decades.

Assuming an 8 percent annual return and minimum annual withdrawals, by the time he turned 65, the IRA would be worth almost $1.2 million, says Barry C. Picker , a Brooklyn NY IRA expert -- and in the meantime, he would have received $671,000 in annual distributions!

But it's a different story when you name a non-human beneficiary. Legally speaking, your estate expires when you do. It has no life expectancy, so it can't stretch out its withdrawals from the IRA. Instead, the IRA must be emptied within five years of your death, or on a schedule that's based on your remaining single life expectancy according to the Internal Revenue Service actuarial table -- depending on the age at which you died. (The five year rule applies if you were under 70 and a half when you died. The IRS single life actuarial table applies if you were over 70 and a half when you died.)

Either way, the IRA must be emptied much faster than if your kids were using their own life expectancies.

You can avoid this problem if the trust is worded properly. If it's written right, for tax purposes it becomes only a conduit to the human trust beneficiaries.  In that case, the IRA can be emptied over the life expectancy of the oldest trust beneficiary.

But your father doesn't have to worry about whether his trust is correctly worded.

There's a simple, cost-free way for him to make sure his IRA beneficiaries inherit the account in the most advantageous way. All he needs to do is to name them on his IRA beneficiary form. If he has already named his living trust, he can ask the IRA custodian for a new form and can change his beneficiary designation.

When your heir is a disabled or minor child who'll need help handling his inheritance, it makes sense to leave your IRA to a correctly worded trust (and to name a reliable trustee.) But otherwise, using a trust as your IRA beneficiary doesn't really provide any advantage -- and if it isn't done correctly, it could inadvertently hurt your survivors by making the IRA taxable much faster than necessary.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com. I'm sorry I can't respond personally to every email. Questions are addressed only online.

(c) Lynn Brenner, All Rights Reserved.

 

       

Comments

[darci]

If the IRA is inherited by the trust, and the trust beneficiaries are named properly, does the trustee have the power to distribute to beneficiaries or not, and to decide how large a distribution to make, etc? For example, what if the trustee wants to forgo taking the required minimum distribution for 2009, but one of the beneficiaries wants their portion of the distribution? Who has the power to make this decision?

[lynn brenner]

Lynn responds: The person who sets up the trust has the power to decide how much is distributed to the trust beneficiaries and when -- in other words, you do. The trustee is following your instructions, which are spelled out in the trust document.

But bear in mind that the IRA beneficiary is the trust -- and an IRA beneficiary by law MUST take required minimum distributions from the IRA every year (unless the government specifically waives the RMD for a year.) If the trust doesn't take an RMD from the IRA, the penalty is 50% of whatever amount should have been taken and wasn't.

Of course, just because the trust takes an RMD doesn't mean that the RMD must then be distributed to the trust beneficiaries. It could stay in the trust. But if it stays in the trust, it is taxable at trust rates -- which are much higher than individual income tax rates. Ideally, you don't want any money to stay in this trust. That's why it's called a conduit trust. It exists merely as a conduit between the IRA and the human beneficiaries. Money that's promptly distributed the human trust beneficiaries is taxable at their rates.