Financial Planning Focus – Beware the Pitfalls of Designating Your Trust as a Beneficiary for your IRA or 401(k)

December 22, 2014

Many of our clients have created a trust as part of their estate planning, or have experience with a family member’s trust. A trust is a financial tool that can assist with the handling of your legal and financial affairs, both during life and after death. One possible use is to designate your trust as the beneficiary of your retirement account, such as a 401(k) or IRA. However doing so can potentially defeat the “stretch” benefits of an inherited retirement account over the life of the beneficiary.

Typically spouses should be the first choice to name as retirement account beneficiary, in order to maintain his or her control over the assets and to provide flexibility in account withdrawals. However in some situations, and for the second to- die spouse, other beneficiary options are often utilized. One of the most prevalent strategies is to designate a young beneficiary or beneficiaries, seeking to “stretch” a retirement account’s tax-deferral period and potentially allow for decades of compounded growth.

An alternative to naming a young beneficiary would be to designate your trust as beneficiary, with the goal of exerting control over your retirement funds after your death. Your concerns could include protecting your children from overspending, or guarding against the loss of legacy assets to divorce. You may also wish to leave assets in trust to care for a minor or a person with special needs.

When a trust meets certain requirements, the IRS will “look through” the trust and treat its beneficiary as if he/she were directly named the retirement account’s beneficiary, thus preserving the opportunity to stretch required withdrawals over the life of the ultimate beneficiary. One pitfall to this strategy can occur if the trust has multiple beneficiaries. In this case the oldest beneficiary – including contingent beneficiaries – will be used to determine the RMD calculations for all trust beneficiaries, thereby shortening the stretch for younger beneficiaries.

Another pitfall is failing to meet the requirements to qualify as a look-through trust. This could force the trust to withdraw the retirement account funds in as little as five years, potentially causing an income spike for the beneficiary and perhaps a huge tax bill. The most problematic look-through requirement is the stipulation that each of the trust’s beneficiaries must also be identifiable as eligible beneficiaries of the retirement account itself. The IRS does not want to leave the door open for beneficiaries to be swapped-out over time for younger beneficiaries, allowing the stretch period to be extended over multiple life spans. Therefore, the trustee of the trust should not be given a power of appointment that includes the ability to change the trust’s beneficiaries. Additionally, the trust beneficiaries must all be human beings, as they have life spans on which to calculate RMDs. Therefore, unless specifically crafted to preserve the stretch option, a trust should not include a charity or other organization as beneficiary, even as a last option after all other beneficiaries have died.

The specificity of requirements involved with the look-through trust can present a further pitfall if a trustee is not adequately informed. For instance, the trust documents must be provided to the retirement account’s custodian by October 31st of the year following the account owner’s death. Even before that, however, the trustee should confirm that the current custodian’s policies permit making withdrawal payments to a trust.

If you are concerned your trust may not qualify as a look-through, you should consult your attorney before designating it as your retirement account beneficiary. If you have already made such a designation and would like to reverse that decision, the solution is fortunately very simple. While modifying a trust can be an involved process, changing your IRA beneficiaries can be accomplished in just a few minutes, including removing or adding a trust as beneficiary.

 

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This report has been prepared by West Financial Services, Inc. from original sources and data we believe to be reliable. This report is for informational purposes only and should not be construed as investment, legal or tax advice. Analysis of past market conditions may not predict future market activity.