It is probably safe to say that most IRA owners really don’t put much thought into who they designate as their IRA beneficiary, but even IRA owners who do may very well have not done their planning correctly. This is especially true in that the IRA beneficiary designation rules are so complex.
With traditional IRAs (not Roth IRAs) one must generally start taking minimum required distributions when the beneficiary reaches age 70.5. Because investments held in IRAs grow tax-free, many taxpayers try to structure their affairs so that the bulk of the funds can remain in the IRA for the longest period of time.
The number of clients who ask about these planning opportunities seems to be on the rise. The facts are typically something like this: The husband owns the majority of the couple’s assets, which includes a couple of million dollars held in the husband’s IRA. Both the husband and the wife own their house jointly and it is now valued between $1 or $2 million. The husband and wife are younger than 70, so they haven’t begun taking minimum distributions from the IRA.
The husband wants to prepare his estate plan. His primary concern is how to leave the IRA funds to a trust so that his wife can benefit from the funds and not have any obligation to manage the funds and upon the wife’s demise the funds will pass to the couple’s children.
After running through the options with the husband and encouraging the husband to merely name his spouse or his children or a charity as the IRA beneficiaries, the husband almost always wants to name a trust as the beneficiary (see Trust As IRA Beneficiary post for more info).
One of the ways to structure this, the one that is outlined in the IRS’ recent Revenue Ruling (Rev. Rul. 2006-26), is to designate a marital trust created under the husband’s will as the IRA beneficiary.
If structured properly, if the husband predeceases the wife 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, which allows the IRA assets to avoid estate taxes upon the husband’s demise (the rest of the husband’s estate passes to a spousal trust created under the husband’s will, to use up the husband’s estate tax unified credit or applicable exclusion amount – thereby making that portion free of estate tax).
As outlined in the Revenue Ruling, 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. This is a pretty common arrangement.
The problem lies in situations where 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 – 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.
In addition, 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.
The interesting tax issues that the Revenue Ruling addresses is 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 (for the non-tax folks, this allows the trustee to decide how much income to distribute to the wife during her lifetime, essentially regardless of what the trust provides).
The Revenue Ruling concludes that 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.
While most estate and trust attorneys are very familiar with the trust principles, I don’t think many have planned for whether the trustee could or should convert the trust to a unitrust and/or make allocations between income and principal when the trusts primary or sole asset consists of an IRA.
This seemingly 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.
Of course, given the complexities of the IRA rules it is imperative that IRA owners speak to their trusted financial advisors. This is especially true for owners of larger IRAs.