September 1998 Issue

IRA Planning


By Edward A. Slott

On December 30, 1997, the IRS made a major change in its position on IRA trusts when it issued an amendment to proposed regulations section 1­401(a)(9). It allows a trust to qualify as a designated beneficiary if it becomes irrevocable upon the death of the IRA owner (who named the trust as beneficiary). Since most trusts set up for IRA purposes become irrevocable at death, virtually all of them will qualify as designated beneficiaries due to this ruling. As a result, the life expectancy of the trust's beneficiaries is to be used in determining required annual IRA distributions after the death of the IRA owner.

Before this ruling, only trusts that were irrevocable on the required beginning date (RBD)--April 1st after the calendar year in which the owner turned 70 ½ years old and met certain other conditions--qualified as designated beneficiaries. This meant that most revocable living trusts and credit shelter trusts created under wills did not qualify.

For IRA distribution purposes, a designated beneficiary has a life expectancy and a beneficiary does not. To have a life expectancy, an entity must be able to celebrate a birthday. That is why generally only natural persons have been considered designated beneficiaries. The amendment now says certain trusts meet this definition. An estate or a charity, for example, does not qualify as a designated beneficiary and cannot be used to extend the life of an IRA after death.

The problem was that many in the legal profession were not aware of the IRA trust rules and were inadvertently creating IRA trusts that would not work. This new ruling effectively corrects most of those defective trusts and helps the many IRA owners and beneficiaries that planned to stretch out their IRA distributions through the use of a trust.

The downside is that this new IRS ruling may create a cottage industry of people offering IRA trusts to many IRA owners who simply do not need them. They are cumbersome and costly to set up, and are often worded incorrectly. The IRA distribution rules are generally not taken into account within the trust wording.

When You Need an IRA Trust

There are situations where a trust is warranted. Here are four of them.

Minor as Beneficiary. Because of the highly technical and sophisticated planning and tax decisions that are often required for IRA accounts, a trust is the best way to go if the IRA beneficiary is a minor. If the minor were named a direct beneficiary of a sizable IRA account, the surrogate's (probate) court might require the appointment of a guardian for the minor. A custodian could be named as beneficiary on behalf of the minor under the Uniform Gifts to Minors Act or the Uniform Transfers to Minors Act; but the custodian in most states cannot make IRA distribution elections and does not have the same powers that would be granted to a trustee of a trust.

Second Marriages. In a typical second marriage situation (or even with some first marriages), the IRA account owner may want to leave his or her spouse the annual IRA income. But, upon the spouse's death, the account owner may want the IRA balance to go to children of a prior marriage or perhaps not to children from the spouse's first marriage. Another common desire on the part of account holders is to make sure that, if his or her spouse remarries after his or her death, the IRA goes to the account holder's children upon the spouse's death and not to a new spouse.

A QTIP (Qualified Terminable Interest Property) trust would be the form to use. This special trust qualifies for the marital deduction and also gives the IRA owner and trust creator control over the trust principal (the IRA) after his or her death and after the spouse's death.

Management and Creditor Protection. A trust may be advisable where the IRA beneficiary is not capable of managing the IRA funds and seeing that the required distributions are made. It is also a way to protect a beneficiary from unscrupulous people who might seek to take advantage of the beneficiary's naivete. The trust could also protect the beneficiary from creditor problems.

Estate Taxes. A trust can be used to hold money for estate taxes if there is a risk that the IRA beneficiary will take the money and run without paying the appropriate share of estate taxes. When an individual is named as the direct beneficiary of an IRA, the entire IRA is transferred upon death. There is usually a clause in the will called the tax apportionment clause which spells out who is responsible for the estate tax, both on items that pass through the will and on property that passes outside the will, such as an IRA or life insurance proceeds. But even if the will's tax clause states that the IRA beneficiary must pay his or her share of the estate tax from the IRA proceeds, it may be too late if the beneficiary has already skipped town with the newly inherited IRA. A trust could be used to escrow a portion of the IRA for payment of estate taxes.

How IRA Trusts Work

When an IRA is left to a trust, the trust must abide by the IRA distribution rules just like any other IRA beneficiary. If the trust is irrevocable upon the death of the IRA owner and meets certain other new certification requirements (including details that must be provided to the IRA custodian about the trust's beneficiaries), the trust will qualify as a designated beneficiary. This means that required annual IRA distributions after the death of the IRA owner can be stretched over the life of the trust's beneficiaries. It is important to keep in mind that there could be substantial IRS penalties if the IRA tax rules are not complied with. Contrary instructions within the trust will not excuse beneficiaries from penalties.

If the trust states that only the income is to be paid to the trust beneficiary, but the required distribution is greater than the income, a 50% excise tax could result on the amount of the required distribution that should have been made but was not. For instance, if the trust income was $8,000 but the required distribution was $20,000, there would be a $6,000 penalty on the $12,000 that should have been withdrawn but was not (50% of the $12,000=$6,000 penalty). There could also be a tax problem if the correct required distribution of $20,000 (in this example), was made from the IRA to the trust, but only $8,000 was actually distributed to the trust's beneficiary. In this case, the 50% excise tax would not apply because the correct required distribution was made from the IRA to the trust. But, the trust would be taxed on the taxable IRA distribution (the $12,000) that was not passed through to the beneficiary. Because trusts pay the highest income taxes (for 1997, a trust's rate hits the 39.6% bracket after only $8,100 of income, compared with $271,050 for individuals), such mistakes should be avoided.

Another problem with a trust is that, after the IRA owner dies, trust tax returns will have to be filed each year for the life of the IRA. This can get expensive, and it creates even more paperwork and potential problems if the IRS decides to audit the trust tax returns.

IRA Trusts Mean Calling in The Experts

The drafting of trust agreements to be used in connection with IRA distributions should be performed by an attorney who specializes in this relatively new field. It is not enough that the attorney be an estate or trust attorney, he or she must also be familiar with the IRA distribution rules and know how to integrate them within the trust language.

IRA trusts are not for everyone. And errors in drafting the language associated with the trusts can result in the liquidation of the IRA at the owner's death, leaving little for beneficiaries. *

Edward A. Slott, CPA, E. Slott & Company, is the editor of Ed Slott's IRA Advisor, from which this article was adapted.

Edward A. Slott, CPA
E. Slott & Company

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