Retirement Plans and Trusts

People frequently use trusts as part of their financial and estate planning. A beneficiary typically may designate a trust to receive an interest in a qualified defined contribution plan (qualified plan) or IRA on his or her death. The problem is that the trust may not be able to stretch out the distributions from the qualified defined contribution plan or IRA. Stretching out the distributions from a qualified plan or IRA can increase the after-tax amount that the beneficiary’s heirs may receive.

An individual who inherits an interest in a qualified plan or IRA usually may take distributions from the plan over his or her estimated lifetime. (The lifetime is estimated based on IRS actuarial tables.) The amount that must be distributed each year is called the Required Minimum Distribution (RMD). The individual receives this favorable treatment because he or she is what is called a Designated Beneficiary.

Usually a Designated Beneficiary must be an individual. A trust may, however, qualify as a Designated Beneficiary in certain cases. In those situations, the Required Minimum Distribution is based on the life of the oldest trust beneficiary or, in some cases, may be calculated separately as to each trust beneficiary.

Even if the trust qualifies as a Designated Beneficiary, there are drawbacks to using a trust. A trust must pay income tax on qualified plan or IRA distributions unless the trust itself distributes an equal amount to the trust beneficiaries. Trusts reach the top income tax rate of 39.6% once they have taxable income of over $12,300. In contrast, a married couple does not reach the top income tax rate of 39.6% until they have taxable income of $464,850. Thus, the trust must (1) pay the distribution to the individual beneficiaries or (2) pay tax on the income at a higher rate than individuals would have to pay.

A couple of examples illustrate how these rules work.

  1. Trust for Minor Children

John and Joan are married and have three minor children. John names Joan as the recipient of his IRA if she survives him. John wants to name a trust for his three minor children as the recipient of his IRA account if Joan does not survive him.

If John passes away, Joan is a Designated Beneficiary who can stretch out the distributions from the IRA. Also, she is a surviving spouse who has additional options for withdrawing funds from the IRA.

If Joan predeceases John, the retirement benefits will go to the trust. A trust generally must withdraw the retirement funds in five or six years. However, if the trust qualifies as a Designated Beneficiary and makes the proper filing with the plan administrator, the trust may be able to stretch the payout over the trust beneficiary’s life expectancy.

Someone needs to draft the trust so that it qualifies and make the proper filings with the retirement plan administrator so that the trust is a Designated Beneficiary. If the trust qualifies, the trustee must pay an amount equal to the retirement plan or IRA from the trust for the benefit of the beneficiary or pay tax at a relatively high rate.

  1. Trust for Spouse

Bob and Mary are married. It is the second marriage for each of them and both have children from prior marriages. Bob is seven years older than Mary. Bob has a $2 million IRA. Bob wants funds from the IRA to be available to Mary for her life, but he also wants for the remaining property to go to his children on her death. He names a trust as the recipient of the IRA upon his death. The trust provides for income to Mary for her life with any property remaining on Mary’s death going to Bob’s children.

As a surviving spouse, there are options available to Mary that are not available to other beneficiaries. For example, Mary could rollover the IRA to any IRA for herself. She then could take distributions based on her life expectancy, which is longer than Bob’s since she is seven years younger.

If there are other assets that Bob could use to provide for his children, he could name Mary as the outright beneficiary of the IRA. Mary then could take advantage of the options available to a surviving spouse.

If naming Mary as the outright beneficiary is not a workable solution, the trust can be the recipient of Bob’s IRA. If properly structured, Mary can be the Designated Beneficiary and the Required Minimum Distributions can be based on Mary’s life.

An additional consideration in this case is estate tax. A person can leave an unlimited amount of property to his or her spouse and not pay estate tax. However, this exclusion from estate tax would only apply in the case of a trust for a surviving spouse if the surviving spouse can require that the trust pay out its income annually. For the trust to qualify for the estate tax exclusion, the surviving spouse must have the right to the trust income each year. In the current example, Mary could receive most of the IRA during her lifetime if she lives long enough. There might not be much left for Bob’s children.

The point is that a trust may be a beneficiary of a retirement plan. The trust also can be designed and managed so that distributions may be stretched out to increase after-tax income from the qualified plan or IRA. However, designing the trust to obtain the stretched out payments may conflict with other estate planning goals. The beneficiary of a qualified plan or IRA must carefully evaluate the alternatives.

 


This post discusses general rules and is not specific legal or tax advice for you to rely on. Please consult a qualified advisor to discuss your specific situation.