Exercise Caution When Naming Your IRA Beneficiary

When I meet with new clients for the first time, I discover many have named a living trust as the beneficiary of their IRA. While a trust allows you to retain control over the disposition of assets and affords your beneficiaries enhanced protection from creditors, naming a trust as your IRA beneficiary results in inflexibility and the potential for administrative hassles. In fact, doing so can also eliminate a major benefit for those who wish to leave their IRA to their children. That is, when your IRA is left to a living trust, your heirs may be required to liquidate the account immediately, sacrificing the benefit of longer tax-deferred compounding inside the IRA and much greater potential wealth accumulation.

A better alternative may be naming your children themselves as your IRA beneficiaries. In this case, if you die before beginning the required minimum distributions (RMDs) necessary at age 70½, your heir will be required to withdraw a small amount, based on his or her life expectancy starting the year after your death.  This allows the benefits of tax deferral to accrue over the rest of his or her lifetime. Of course, your heir also has the flexibility to take out more if he or she so chooses.

In a cruel twist of IRS logic, if you die after RMDs have begun, the IRS uses the “expected lifetime of the deceased”—your life expectancy at the age you died—to determine how much your children must withdraw on an annual basis.

With a living trust, it is easy to lose the benefit of “stretching” your IRA that your heirs would enjoy as named beneficiaries. Generally, if the trust qualifies as a “see-through trust,”—so named because anyone can look through the trust to identify the beneficiaries—the IRS requires the use of the oldest beneficiary’s life expectancy for purposes of RMDs. That could result in an erosion of potential growth, especially if many years separate your youngest and oldest beneficiary.  Additionally, there are a number of requirements that your trust must meet to be classified as a “see-through trust” and thereby permits the stretching out of distributions. According to Ed Slott, the nation’s foremost IRA expert, a qualifying trust must meet these four IRS requirements:

  1. It must be valid under state law.
  2. It must be irrevocable or become irrevocable upon the owner’s death.
  3. The trust’s beneficiaries must be identifiable.
  4. The trustee must provide a copy of the trust or a list of the trust beneficiaries and their entitlements to the custodian or plan administrator by Oct. 31 of the year after the owner’s death.

According to Slott, the last requirement causes many trusts to falter and lose their qualifying status. He notes that this administrative duty is the responsibility of the trustee, often a family member without a legal background who remains unaware of the requirement.

Another common mistake that causes your heirs to lose their ability to base their RMDs on their life expectancy is the act of naming an entity that does not have a life expectancy as one of your IRA beneficiaries. Examples include a charity, an estate, or another trust. In this case, the IRS will not allow any of your beneficiaries to stretch out their IRA withdrawals. In fact, if RMDs have not yet begun, the entire account would need to be distributed by the end of the fifth year following the year of the IRA owner’s death. In addition to sacrificing tax-deferred growth potential, withdrawing the entire IRA balance within just a few years can cause a big jump in taxable income, potentially pushing your heirs into a higher tax bracket and costing them far more than if they had been able to spread the tax liability over 30 or 40 years.

Although the basic outline of naming a trust or a series of sub trusts as IRA beneficiaries to ensure that the IRA will not be used up frivolously is legally sound, an important caveat surfaces when you consider that a trust could exist 60 or more years after the death of the IRA owner—and that a trustee will have to oversee it for that length of time. Depending on the value of the IRA and the fees charged by the trustee, there could be situations where the costs could significantly eat away at the average increase in value.

I stress that effective estate planning requires a combination of reflection about your family’s future and the more practical consideration such as the size of your IRA account. And, as in so many areas of life, when focusing on the big picture, it’s equally important to tend to the simplest details. In that regard, please remember that you must name your IRA beneficiary on the IRA beneficiary form, not in your will or other legal documents. Keep your beneficiary forms on file with your personal documents and review them on a regular basis to determine whether you need to make changes.

Of course, if you have questions about your beneficiary designations, you should discuss them and the benefits of a stretch IRA with your attorney or independent wealth manager.