Last week in Part 1 of this month’s installment of The Monthly 5 and 5, I discussed five advantages of designating a trust as an IRA beneficiary. In Part 2 below, I will discuss five disadvantages. While this post will focus on IRAs, much of it may also apply to designating a trust as a beneficiary of other kinds of retirement assets. As you read in Part 1, designating a trust as an IRA beneficiary may allow you to achieve many of your estate planning goals; but, there are disadvantages that must be considered. Some of these disadvantages are caused by poor trust drafting and are avoidable, while others you are stuck with. Again, it should be noted that the discussion below is very summarized and only covers general rules; an experienced professional should be contacted before designating a trust as a beneficiary of your IRA (or other retirement asset).
Five disadvantages to designating a trust as an IRA beneficiary:
1. Stretch-Out of IRA Balance
Recall in Part 1 that if a trust is properly drafted and designated as in IRA beneficiary, the IRC allows you to “look through” the trust and “stretch out” the IRA balance over the trust beneficiary’s life expectancy. This allows the IRA balance to be protected and grow over a longer period of time; thus, creating more wealth to be transferred to the beneficiary. However, if the trust is not properly drafted, two things could happen: First, if the trust does not qualify under the IRC as a “look through” trust, then the trust will not be considered a qualified beneficiary of the IRA. Depending on the circumstances, this means that the entire IRA balance will have to be withdrawn within five years of the deceased owner’s death or the annual required minimum distributions will have to be taken over the deceased owner’s life expectancy instead of the trust beneficiary’s life expectancy. In most cases, this will result in a loss of any growth the IRA balance may have accrued over the beneficiary’s longer life expectancy and, most importantly, the beneficiary will have unfettered access to the entire IRA balance much sooner than you may have wished.
The second thing that could happen is: even if the trust does qualify under the IRC as a “look through” trust, and thus, considered a qualified beneficiary of the IRA, the trust may still be drafted poorly when considering the trust beneficiaries’ respective life expectancies. When determining which beneficiaries’ life expectancy to use to stretch out the IRA balance and calculate the annual required minimum distributions, the IRC requires you to use the life expectancy of the oldest beneficiary of the trust. Therefore, if the beneficiaries of the trust include both your 15 year old child and your 85 year old brother, the 85 year old brother’s life expectancy is what the annual required minimum distribution is going to be calculated with. This results in a much, much shorter stretch out than you may have wanted; again, causing loss in growth and protection of the IRA balance. If the trust and beneficiary designation had been drafted properly, both of the disadvantages above could have been avoided.
Furthermore, recall from Part 1 the added tax advantages of stretching out the IRA balance over the trust beneficiary’s longer life expectancy. If the trust is drafted improperly like discussed above (i.e., the trust is a nonqualified beneficiary or the trust has an older beneficiary), then the tax advantages of stretching out the IRA balance are quickly lost. If the trust is a nonqualified beneficiary, then the IRA funds will have to be withdrawn within five years of the deceased owner’s death or over his/her shorter life expectancy, not allowing the beneficiary to reap the benefits of longer tax deferral as discussed in Part 1. The same is true if there is an older trust beneficiary that causes the annual required minimum distributions to be withdrawn over a much shorter life expectancy than otherwise could have been achieved.
Additionally, because the entire IRA balance will have to be withdrawn over a much shorter period of time (whether the trust is a nonqualified beneficiary or has an older beneficiary), this will generate more taxable income to the trust and/or trust beneficiary each year. This may result in the trust and/or trust beneficiary jumping into a higher tax bracket and thus, paying more in taxes on the IRA income than they would have had to if it had been stretched out over a longer period of time. Again, with proper drafting the above tax consequences could have been avoided.
Also note that the income tax brackets for a trust are much more condensed than individual income tax brackets; thus, if the annual required minimum distribution from the IRA is held and accumulated in the trust instead of distributed out to the beneficiary each year, this may result in higher income taxes.
3. Complicated & Costly
Designating a trust as an IRA beneficiary is both complicated and costly. It is complicated because the rules governing trusts as IRA beneficiaries are extremely complex and convoluted. There is no easy way about it. Both the trust document and the IRA beneficiary designation form must be completed correctly, considering a mess of rules, to ensure that your wishes are carried out the way you intended. There are many rules and options for the IRA owner to consider and that is why you need to work with a professional to ensure it is done correctly.
Because professional advice and drafting must be sought to designate a trust as an IRA beneficiary, it can be costly upfront. Drafting a trust is not cheap, and most experts would agree that because of all of the complicated rules, a separate trust should be created for your IRA; you should not use your everyday ordinary revocable living trust. And, not only may it be expensive upfront, but once the trust becomes the IRA beneficiary after the deceased owner’s death, there will be ongoing administration costs. The trust will most likely have to be professionally managed by a trustee to ensure it continues to comply with the IRC rules governing IRAs and the trust will have to file its own income tax returns each year. While these added costs may be justifiable in some circumstances, they may not be in others.
4. Spouse Loses Rollover Option
There may be reasons why an IRA owner may want to designate a trust for the benefit of his/her spouse as the IRA beneficiary instead of his/her spouse personally (e.g., in second marriage situations). However, those reasons must be weighed against the disadvantages of that designation. If the spouse is personally named as beneficiary of the IRA, he/she has the option of inheriting the IRA or rolling over the IRA into his/her own name. While there may not seem like much of a difference there, there can be many added advantages to rolling the IRA over into the spouse’s own name instead of the spouse inheriting the IRA (e.g., tax benefits, including greater tax deferral and Roth conversions). If the trust for the benefit of the spouse is instead named as the IRA beneficiary, the spouse can only inherit the IRA, and may not roll it over into his/her own name; thus, losing some of the added benefits to doing so.
5. Heirs Lose Flexibility
Individuals (a/k/a grantors) set up trusts for beneficiaries to restrict and control distributions. A trustee of a trust ensures that the beneficiaries only receive and spend the trust funds according to the deceased grantor’s wishes. A beneficiary does not have unlimited and unfettered access to the funds held in the trust. This is the way the grantor wanted it. However, if the grantor really has no reason to put restrictions on how the IRA funds are used, or is not worried about their heirs being spendthrifts or subject to creditor claims, or has no minor or disabled heirs, then why name a trust as an IRA beneficiary? Just name your heirs as the individual beneficiaries personally. They are afforded much more flexibility in stretching out the IRA balance or cashing it in to pursue other investments. Additionally, it is much less complicated and costly. While a trust as an IRA beneficiary gives the IRA owner the greatest flexibility in controlling those IRA funds beyond the grave, it leaves the beneficiary with the least amount of flexibility in later controlling and using those funds.
As you previously read in Part 1 and above in Part 2, the advantages and disadvantages of designating a trust as an IRA beneficiary can be great. The advantages can really help you accomplish your estate planning goals; but, on the flip side, the disadvantages need to be weighed against those advantages. While some of the disadvantages discussed above are unavoidable, others are caused by poor drafting and are avoidable. Designating a trust as an IRA beneficiary should never be done on the whim; but, with proper professional advice and drafting, and after fully considering the advantages and disadvantages associated with designating a trust as an IRA beneficiary, you can make an informed decision. It certainly is not for everyone, but for some it is certainly necessary.
– Attorney Matthew D. Brehmer
© 2014 Matthew D. Brehmer and Crummey Estate Plan.