Jack E. Stephens Blog

13 AugThe IRA Tax Trap- Designating the Living Trust as the IRA Beneficiary

Remember when you arranged that IRA with the financial institution and received a “bunch of papers”? Yeah, one of those “bunch of papers” was a Beneficiary Designation form- now remember? Okay, I’m going to ask you 3 questions which can have devastating results depending on your answers.

  1. Who did you, for sure, designate as the primary and contingent beneficiary?
  2. Where is the Beneficiary Designation form?
  3. Did you retain a copy of the form and, if so, where is it?

Most people, if they are entirely honest, aren’t sure who they designated as primary/ contingent beneficiaries of their IRAs. If they have a Living Trust, many will answer, “I’m sure it was my Trust.” In response to the location of the Beneficiary Designation form or a copy thereof, most people are unaware.

Hopefully, you are reading this article because you either own an IRA or you are potentially, a beneficiary of an IRA. If so, you will be glad that you took a few minutes out of your life to read and absorb the information presented. Years ago I wrote a book on IRA Tax Traps, and although many of the laws pertaining to IRAs have changed over the years, a number of tax traps still exist, particularly with Trusts.

The first thing I want you to do is to locate a copy of your Beneficiary Designation form. If you can’t find it at home or in your lock box, request it from your financial institution that is the custodian of your IRA.

Once obtained, check to see who is designated as the primary and contingent beneficiaries. If you are married, your spouse, normally, should be designated as your primary beneficiary. If you have children, they may be designated as your contingent beneficiaries in whatever percentages you prefer. If your designation to your children includes the term “per stirpes”, that means a deceased child’s share will go to such child’s children equally.

If you have designated your Living Trust as the beneficiary, you may want to reconsider.

Living Trusts, to be a “designated beneficiary” of an IRA, must be qualified. There is certain provisions that must be included in the Trust to qualify it for that purpose. If properly qualified the IRA may be stretched out over the life expectancy of the Trust beneficiary with the shortest life expectancy. For example, if you designate the Trust as the IRA beneficiary and your spouse and children are Trust beneficiaries, usually, but not always the case in California, the spouse is the oldest Trust beneficiary who has the shortest life expectancy. As a result, the IRA would need to be distributed over the life expectancy of the spouse. This would be a great disadvantage to your children for IRA distribution purposes.

Of even more concern is the Trust providing that the debts and taxes shall be paid by Trust funds. If the IRA is payable to the Trust, the IRA funds become part of the Trust funds and could be utilized to pay the IRA owner’s debts and taxes. If there is no provision in the Trust precluding use of IRA funds to pay such expenses, the IRA owner’s estate is also a beneficiary of the IRA. How many years of life expectancy does an estate have? Yep, you guessed it- zero. Another tax trap. Now, who has the shortest life expectancy? The estate. Since the estate has zero life expectancy, the IRA is taxed in its entirety in the year it is distributed to the Trust and beneficiaries go crazy. Hopefully, you are not one of them.

Can this be corrected with a Trust Amendment? Yes. But better yet, if you have a sizeable IRA, consider an IRA Designated Beneficiary Trust (DBT) which is specifically designed to receive IRA funds with Asset Protection and allowances for maximum stretch provisions over the individual lives of the beneficiaries. Your estate planner must be experienced in order to prudently draft such a Trust as they are full of tax minefields. Please contact our office should you be interested in an IRA DBT or in modifying your Trust to qualify it as a retirement fund beneficiary.