Naming your children as contingent beneficiaries can preserve the ability to avoid a lump sum distribution and qualify for the deferral of income tax. A trust designated to receive retirement distributions after death may also qualify for the stretch out or the deferral of income tax. However, only certain trusts qualify and the rules are complex. Even if the trust qualifies, the length of the stretch out may be shorter and require younger beneficiaries to use the life expectancies of the oldest trust beneficiary. For these reasons, a separate "Standalone Retirement Distribution Trust" may be a valuable tool if the beneficiaries are minors, disabled, have divorce or creditor concerns, or subject to estate tax or if a second marriage is involved. If the funds or assets in the retirement plan equal or exceed $50,000 and the concerns regarding immediate access to the funds, then you should consider a Standalone Retirement Distribution Trust.
An important advantage of a qualified retirement plan or individual retirement account (IRA) is the ability to designate a beneficiary who can defer taxes on the funds until reaching the retirement age. A trust can be named as a beneficiary, but doing so can cause the loss of deferred income tax either as the result of a lump sum distribution or the requirement to use a different measuring life for income tax purposes.
If a lump sum distribution occurs or is required, then the entire proceeds are subject to income tax at the time of the distribution. On the other hand, if the lump sum distribution is avoided, then the funds grow tax free until distributions are withdrawn. As a general rule, the funds must begin to be withdrawn by the age of 70? For example, assume that an IRA with a beginning balance of $1,000,000 accumulates at a tax deferred rate of 10% return for 20 years. That IRA will grow to $6,727,500 without any further contributions. However, if the IRA is taxed at 29% as it grows, then the final value is $4,222,590. Designation of the surviving spouse as a beneficiary can avoid the requirement for a lump sum distribution, allowing the income tax due for the funds received to be taxed over his or her lifetime. This deferral of the payment of income tax is commonly referred to as a "stretch out". This stretch out or deferral of income tax may provide a substantial savings to the beneficiary in part due to the time value of money. Increased value or wealth also arises because the funds grow tax-free within the plan or account prior to distribution.
The types of beneficiaries for whom a trust is advisable include minors, beneficiaries with special medical needs, or with developmental disabilities. Perhaps less obvious is a beneficiary who has a troubled marriage, a beneficiary who is in a high-risk profession, or a beneficiary whose own estate taxes can be reduced by placing all or part of his or her inheritance in a trust. Even a beneficiary with questionable financial judgment may be an appropriate candidate for the Standalone Retirement Distribution Trust.
As to retirement assets in particular, a trust may be advisable to prevent a beneficiary from unwisely deciding to cash in the IRA or qualified plan right after your death so that it becomes immediately and full income-taxable. Even if your beneficiaries wisely opt out to stretch out distributions over their life expectancies, a trust may be needed because the benefits may end up with someone whom you would have chosen as a beneficiary or because your beneficiary may not live a full life expectancy, and he or she gets to designate his or her own death beneficiary for any undistributed amounts.
Whatever the reason, if you're naming a trust as beneficiary of retirement assets, additional rules and strategies apply:
- If your trust has charitable beneficiaries who aren't "cashed out" by September 30 of the year following the year of your death, your trust and its beneficiaries won't be entitled to any stretch out.
- If your trust has a contingent beneficiary who is older than the trust's primary beneficiary, unless your trust has appropriate provisions qualifying the trust as a "conduit trust" for IRS required minimum post-death distributions, or unless each such contingent beneficiary disclaims his or her interest in the trust be September 30 of the year following the year of your death, the oldest contingent beneficiary's life expectancy will determine the stretch out period for your retirement assets.
- If your trust gives your primary beneficiary the power to "appoint" the trust at death among a group which might include older persons or charities, again, unless the trust has appropriate provisions qualifying the trust as "conduit" for IRS required minimum post-death distribution, the retirement assets may have a shortened stretch out or possibly no stretch out at all.
- If upon your death your trust splits into sub trusts for several beneficiaries, unless your IRA or qualified plan beneficiary designation form directly designates the sub trusts as beneficiaries of specified shares of the IRA, the life expectancy of the oldest beneficiary may be used to determine the stretch out on tax deferral.
Note that qualified plan assets, unlike IRA assets, don't automatically qualify for stretch out on income tax deferral by a nonspouse beneficiary. Each plan document must be analyzed to determine the appropriate tax treatment.
If your trust is a mere "conduit" for IRS required minimum post-death distributions, the trust will qualify retirement asset distributions for stretch out or tax deferral over the life expectancy of the trust's (or sub trusts') primary beneficiary, regardless of the identity of the contingent beneficiaries or of any potential appointees under powers of appointment.
Due to the complex rules and strategies in this area, many advisors believe a standalone retirement distribution trust is far preferable to a living trust as beneficiary of retirement assets. The reasons for this include:
- Your trustee and advisors will have an easier time complying with the stretch out rules.
- Your living trust is simpler without adding to the issue and easier to understand.
- Your living trust can name older and/or charitable beneficiaries use normal marriage and adoption provisions contain broad spendthrift, in terrorem, incentive/disincentive, and similar payout- curtailing clauses. Such provisions, prone to being a stretch out defeating minefield, are more easily avoided in a trust dedicated to receiving retirement distributions.
Call our office to learn if an IRA Inheritance Trust© is appropriate for you and your family.