IRA Beneficiary Designation Planning Opportunities

Designating a beneficiary for an IRA may not be a top priority for most IRA owners, and even those who do give it some thought may not have planned it correctly due to the complex rules surrounding IRA beneficiary designations. However, as investments held in IRAs grow tax-free, it’s important to structure affairs so that the bulk of the funds can remain in the IRA for the longest period of time. This is why an increasing number of clients are seeking planning opportunities for their estate plans, such as naming a trust as the beneficiary of their IRA.

Naming the Trust as the IRA Beneficiary

One of the ways to structure this is to designate a marital trust created under the husband’s will as the IRA beneficiary. If structured properly, the husband’s executor can elect to treat the IRA as qualified terminable interest (“QTIP”) property for estate tax purposes. This allows the IRA to qualify for the 100% estate tax marital deduction upon the husband’s demise. The surviving spouse will be considered the sole beneficiary of the IRA if he or she has the right to the trust income at least annually and/or an equivalent power to demand access to the income, and there are no non-individuals who are beneficiaries of the trust.

However, there can be problems if there are distributions from the IRA to the trust that are not currently distributed to the spouse. In that case, the spouse is not considered the sole beneficiary of the trust. Depending on the terms of the trust, this can cause the IRA payout to have to use the measuring life for purposes of IRA distributions of that of the oldest – i.e., the wife – the beneficiary – even after the wife’s demise. This can significantly reduce the number of years that the IRA can have continued tax-free growth and reduce the amount that will pass to the couple’s children.

Another issue to consider is that taxpayers would still have to examine each individual beneficiary, rather than just the spouse, to ensure that the IRA beneficiaries are all individuals and not trusts or other entities.

Revenue Ruling 2006-26

This brings us to Revenue Ruling 2006-26. The Revenue Ruling addresses what happens if the trustee, under state law, has the power to adjust between principal and income and/or convert the trust to a unitrust. The trustee can in fact make such allocations between principal and income or can convert the trust to a unitrust and these decisions will be respected for tax purposes.

Revenue Ruling 2006-26 added an essential detail to the existing rule that if an IRA or other retirement plan is payable to a marital deduction trust, both the plan and the trust must qualify for the marital deduction. The ruling introduced the definition of what constitutes “income” that the surviving spouse is entitled to with respect to the IRA or plan payable to the marital trust. The income that the surviving spouse is entitled to, with respect to an IRA or other retirement plan payable to a marital trust, is either the IRA’s internal investment income or the “unitrust” percentage of the IRA, if the trust is using an IRS-acceptable “unitrust” accounting method for the IRA.

The Takeaway

Estate and trust attorneys should plan for whether the trustee could or should convert the trust to a unitrust and/or make allocations between income and principal when the trust’s primary or sole asset consists of an IRA. This presents yet another planning opportunity where the attorney – working with the IRA investment advisor and trustee – should be able to structure the trust and IRA so that they achieve one or more of the IRA owner’s goals in a very tax-efficient manner.

Given the complexities of the IRA rules, it is crucial that IRA owners speak to their trusted financial advisors. This is especially true for owners of larger IRAs.