Control or Taxation? The Prospective Risks of Using a Trust as an IRA Beneficiary

The primary reason for establishing a trust is not necessarily to defer or avoid taxation, as that is not one of the benefits of the common “Living Trust” that so many Americans have created to receive and manage their estates after death. In many instances, a trust is designed to avoid the taxation on a decedents estate, however, since the threshold for that requirement exceeds 5 million dollars for an individual, and ten million dollars for a married couple, using a trust for such a purpose is not in the offing for the vast majority of Americans. More often than not the reason for a trust is simple. Post mortem CONTROL of the assets in a manner the decedent saw fit during their life. The problem created by utilizing a trust as the beneficiary for an IRA is that the rules for distribution of qualified assets, such as 401k’s, 403b’s, IRA’s and other tax deferred, and therefore tax infested assets, are so greatly different from the distribution of other assets in an estate. For the sake of simplicity, we will refer to all qualified plans from this point on as IRA’s. IRA’s do not pass by trust, will or any other external method of distribution. They are subject in their entirety to their BENEFICIARY ARRANGEMENT. The specifics of transfer that are inclusive in the beneficiary arrangement are subject to the conditions stipulated by the PLAN CUSTODIAN. So many times, IRA owners have placed these assets in wills, trusts and other legal documents designed to distribute them at death, to no avail. This commentary is in regard to using a trust as a beneficiary.

One of the modern miracles attributed to IRA distributions to beneficiaries is found under Section 401(a)(9) of the Internal Revenue Code as stipulated in IRS Publication 590-B. Up until the last day of 2001, anyone except a spouse that inherited an IRA was required to distribute the assets either as a lump sum or over a 5 year period, otherwise known as the 5 year rule. That meant if you inherited an IRA as anyone other than a spouse, the tax shelter wrapped around the asset was removed immediately, the proceeds distributed within the prescribed period, and the infestation of taxes within could readily cost the inheritor as much as 50% of the total value. Only a spouse could continue the tax deferral, subject to the tax law then in effect. Then, on January 1st, 2002, things changed. After that time, the concept of the Multi-Generational IRA was in play for many more inheritors, not just spouses. What that means to this day is any DESIGNATED BENEFICIARY of an IRA has the ability to stretch the IRA over their entire lifetime, and if they predecease their life expectancy as seen in Publication 590-B, their inheritors have the capacity to maintain the tax deferral for the balance of the life expectancy of the original inheritor. Therefore, now a child born a week prior to the IRA originators death and properly designated as a beneficiary, can stretch the tax deferral of the IRA, subject to the rules regarding Required Minimum Distributions, for as long as 82.4 years. The key is that this is applicable only to DESIGNATED BENEFICIARIES, and not just BENEFICIARIES. Anything or anyone may be a BENEFICIARY. That means you can leave the IRA to a school, Friends of Cats, or your old fraternity. They are BENEFICIARIES and can accept the gift, and in some cases avoid taxation on it based on their own treatment under the tax code. However, to ensure the tax deferral is maintained for the entire life of your DESIGNATED BENEFICIARY, you must have one. A DESIGNATED BENEFICIARY is a living person, of United States Citizenship, with a date of birth and a Social Security Number. They must have a life expectancy as noted in the distribution tables within IRS Publication 590-B. Why is this so important? And what does it have to do with trusts? Simple, trusts have no life expectancy. To ensure treatment of the IRA for purposes of being Multi Generational , the beneficiaries must have a life expectancy, and trusts lack that attribute. That means if you leave the asset in trust for control of it post mortem, you generally blow up the tax shelter of the IRA immediately, and cause heavy, immediate and UNNECESSARY taxation that could otherwise be avoided. There are some rules that WILL allow a trust to be used under the concept of the separate account, but that is a topic for a different day. Overall, using a trust generally destroys the IRA as a tax sheltered asset.

Here is how it works. Taxes under our tax code are progressive and by that virtue, confiscatory at higher levels of income. While an individual reaches the highest progressive tax bracket at a taxable income of $413,200, a trust reaches that level of taxation with a taxable income of $12,250. Keeping control of the asset, for whatever purposes you see fit, causes it to be destroyed by taxation if the beneficiary is a trust. Trusts have no life expectancy. They cannot meet the distributions rules of IRS Publication 590-B. They cause heavy, immediate and unnecessary taxation that is fully avoidable with proper planning and advice. Now, sometimes there are reasons for that control. A special needs child or spouse. A desire for control that exceeds ones dislike of taxation. But, overall, if you would rather risk a spendthrift attitude on the part of the inheritor and find it less of a risk to your financial legacy than the confiscatory tendencies of taxation, you should consider never having a trust as your IRA beneficiary without a truly pressing need. Besides, a little education goes a long way with inheritances. Teach your children and your other designated beneficiaries the value of keeping the IRA intact when they receive it. For every dollar they receive within the IRA wrapper of tax deferral, they may receive over 5 times that amount over their life expectancy based on taking Required Minimum Distributions only. This process allows the miracle of Tax Deferred Compound Interest to remain in effect. At an age of 35, an RMD may be only 2.062% of the total asset. However, what if the return was over 7% that year? The asset may continue to grow, tax deferred, for decades more. Leaving it to a living, breathing Designated Beneficiary, allows a legacy that may live on for as long as 82.4 years more than leaving it to a trust. Which of these options would you choose?

Source: IRS Publication 590-B for 2015 Tax Returns/IRS Tax Tables for 2015 Tax Year
Please note that this information is based on current tax laws.

Jason R. Lund
CA Insurance License 0808110
35713 Pecan Tree Lane
Murrieta, CA 92562

Mobile: 619.200.7141
Office: 951.461.3638
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Advisory Services Offered Through Client One Securities, LLC an Investment Advisor. Lund Financial and Client One Securities, LLC are not affiliated.