When someone dies and leaves an IRA to an individual, distributions can stretch out over the beneficiary’s lifetime, allowing the funds to grow tax-deferred over many years. But when the IRA is left in a trust for the beneficiary, and it’s not set up strategically, the money will have to be withdrawn much sooner – depriving the recipient of the intended tax benefits.
There are many situations in which it makes sense to leave an IRA to a trust rather than directly to an individual.
“The obvious example is in the case of a minor,” said John Gordon, an associate with a trust and estate law practice at Vishnick McGovern Milizo in Lake Success.
In addition, account-holders may not want to give unfettered access to large amounts of money to adult heirs who are spendthrifts, substance abusers, in a bad marriage or disabled. In the latter case, leaving IRAs and other inherited funds in a trust will protect the individual’s ability to receive government benefits.
However, when left to a trust, the general rule is that distributions from the IRA must be withdrawn based on the original account-holder’s life expectancy or within five
years of his death, if it occurs before age 70½, Gordon said. Minimum percentages must be withdrawn – and taxes paid on them – each year, and they quickly become larger and larger until the account dwindles to nothing.
“When people put money in an IRA, the reason they’re doing it is they want to defer the tax,” Gordon said. “The idea that the tax can be triggered and must be paid quicklyafter their death is counter to what they were trying to accomplish by setting up the IRA in the first place.”
Fortunately, under current law, there are ways to set up the trust so that the IRA’s benefits can be stretched over a much longer period of time.
“Say I’m 70 years old, and I leave my IRA in trust to my children or grandchildren, and they’re able to draw it down over their lifetime,” said Scott Ditman, a partner in accounting firm Berdon, which has offices in Jericho. “Allowing tax-deferred growth over 30, 40 or 50 years can be a huge economic benefit to a family.”
To ensure the trust is able to provide this strategic advantage for the next generation, Ditman said, certain technical requirements must be met.
“If you set it up as a ‘look-through’ or ‘see-through’ trust, the government allows you to pierce through the trust and base the distributions on the individual beneficiary’s life expectancy, even though the IRA is legally owned by the trust,” Ditman said.
The trust must meet four IRS requirements, he said. It must be valid under state law; it must be or become irrevocable upon the account-holder’s death; the beneficiary or beneficiaries must be identifiable; and, by Oct. 31 in the year after the account-holder’s death, the trustee must provide a copy of the trust document to the plan administrator.
In some cases, an IRA may be left in trust to multiple people, such as if the account-holder leaves it to his four children. “In this case, the distributions will be based on the life expectancy of the oldest child,” said Evan Branfman, a financial adviser with Kuttin-Metis Wealth Management in Melville.
Especially in cases where there are significant age differences among the beneficiaries, it makes strategic sense to set up separate trusts for the individuals, Branfman added. There are other scenarios where separate trusts are especially important, such as if one child has special needs, he said.
Because the rules are so technical and the financial implications are weighty, it’s important to work with a team of planners with experience creating IRA trusts and who are mindful of the issues, Gordon said.
“An estate planning attorney, accountant and investment adviser all have a role to play,” he said. “The choices you make can have a significant economic effect on the ultimate beneficiary.”
As Ditman noted, “Mistakes are common and the IRS is unforgiving.”