It usually is not a good idea to name a trust as beneficiary of an IRA, because heirs often are penalized with higher taxes.
There are a few exceptions to the general rule. An IRS ruling gives an example, but the ruling also reveals potential pitfalls in the strategy.
The general rule is that when an IRA beneficiary is an entity instead of an individual, the IRA must be distributed fully within five years after the original owner dies. Entities that trigger the five-year rule include trusts, estates, and all types of business entities.
One exception is when a trust qualifies as a “look-through” or “see-through” trust under IRS regulations. The rules for such a trust are technical, so estate planner draft this trust to make sure it avoids the five-year rule. Even then, in most cases the IRA must be distributed to the trust within 10 years.
Another exception discussed, in an IRS ruling, reveals how making your spouse’s revocable living trust the IRA beneficiary can avoid the tax penalty.
The ruling involved a married couple. One spouse, I’ll say it was the husband, owned a traditional IRA and had begun receiving required minimum distributions (RMDs).
The husband passed away. He designated a trust as sole beneficiary of the IRA.
The trust was a classic revocable living trust in which his wife was the grantor, sole beneficiary and sole trustee. The wife had the right to amend or revoke the trust and could distribute all income and principal of the trust for her benefit.
After the husband passed away, the wife, now widow, wanted to exercise the option available only to spouses who inherit IRAs. She wanted to roll over the inherited IRA to an IRA in her name.
This would give her a fresh start, allowing her to manage the IRA without reference to her late husband’s IRA. She could start RMDs based on her required beginning date and life expectancy. The widow also could name new beneficiaries. She would not be required to distribute the entire IRA within 10 years.
The widow asked the IRS to rule that, though the trust was named the beneficiary, she could act as though she as an individual was named the sole beneficiary. That would allow her to roll over the IRA tax free into an IRA in her name.
The IRS ruled in the widow’s favor. It pointed out that the widow was the trustee and sole beneficiary of the trust. She was entitled to all the trust’s income and principal and could revoke or amend the trust. Under the tax code, the trust was not treated as a separate entity. The widow was taxed on all income of the trust.
Also, she was the surviving spouse of the deceased IRA owner, and the trust was the sole beneficiary of the IRA.
In these circumstances, the widow was the only person for whose benefit the IRA was maintained. She was allowed to take a distribution from the inherited IRA and roll it over to an IRA in her own name without having to include any amount in gross income, provided the rollover was accomplished within 60 days of the distribution.
In other rulings, the IRS has allowed a similar result when an IRA was payable to an estate and the surviving spouse was the sole primary beneficiary of the estate.
In each case, the surviving spouse effectively was the sole individual intended to benefit from the IRA.
While the widow had a happy result, it still is not a good idea to name a living trust or estate as the beneficiary of an IRA, even under similar circumstances.
The widow had to apply to the IRS for a private ruling, which is an expensive and time-consuming process, to be sure of the tax results.
Also, the widow had to take a distribution of the entire IRA balance and roll it over to an IRA in her name within 60 days. If she failed to complete the rollover within 60 days, she would be fully taxable on the IRA balance.
The widow did not request approval of the simpler transfer from one IRA custodian to another. It is likely the IRA custodian was unwilling to transfer the inherited IRA to any IRA other than one with the exact same legal title. The general rule is an inherited IRA can be rolled over to another IRA tax free only if the two IRAs have identical names or titles.
The custodian probably also saw that the named beneficiary was a trust. It was unwilling to risk the legal liability of transferring the IRA balance to an entity or person other than the trust or trigger taxes for the widow.
These complications are why it is best to review your IRA beneficiary designations every year or two. Don’t leave extra work or stress for your family.
Be sure only individuals (and perhaps charities) are named as beneficiaries of your IRA and that they are the ones you currently want to inherit the IRA. Do not name entities, such as trusts or estates, or fail to name one or more individual beneficiaries.
(IRS Letter Ruling 202040003)
