Take-Away: When an IRA or retirement account is made payable to an irrevocable trust, the goal is to assure that the trust satisfies the IRS’ see-through rules so that the oldest individual trust beneficiary’s life expectancy can be used to determine the taxable required minimum distributions that the trustee must take from the retirement account. Problems exist if there is a non-individual beneficiary of the trust, in which case the IRA made payable to the trust must be ‘emptied’ within 5 years of the retirement account owner’s death. When confronted with this problem, sometimes the trust can be ‘fixed’ through some creative and timely planning steps, like disclaimers or ‘cash outs’ to permit the required minimum distributions to be taken by the trustee over the oldest individual beneficiary’s shorter life expectancy.

Background: Normally an individual can inherit an IRA, or another retirement account,  and then begin to take required minimum distributions from that inherited IRA (or account) using their life expectancy. A trust is not an individual, a designated beneficiary [IRC 401(a)(9)E] however, so naming a trust as beneficiary of the retirement account normally will not permit the use of an extended required minimum distribution period to minimize the recognition of taxable income with those distributions. The Regulations make an exception however for what has come to be informally known as a see-through trust which will be treated as a designated beneficiary. The most important condition to qualify as a see-through trust is that the oldest trust beneficiary with the shorted life expectancy must be used to determine the required minimum distribution the trustee must take from the decedent’s retirement account that is payable to the trust. [Reg. 1.401(a)(9)-5.] This then presents another problem when a non-person, with no life expectancy, is also named as a potential beneficiary of the trust. For example, if the trustee is given the discretion to make trust distributions to or among a group of individuals and a charity, the presence of the charity as a potential beneficiary of the trust ‘blows’ the ability to take extended required minimum distributions from the decedent’s retirement account that is made payable to the trust.

The ‘Fix’ is In: Such a problem was the recent topic of a private letter ruling where the IRS approved a ‘fix’ to effectively create a see-through trust when one did not actually exist at the time of the retirement account owner’s death.

  • PLR 20184007, released October 5, 2018.
  • The Facts: The decedent’s 401(k) was made payable to his trust on his death. The trust directed that the trust corpus was to be divided by the trustee among the decedent’s three children. Continuing trusts were to be established for each child who survived their father. Each child was given a testamentary power of appointment over their trust share beginning at age 30 in favor of ‘any person or persons (other than to that child, his/her creditors, and their estate) and to any charity.’ Hence, the problem of the possibility of the 401(k) assets being transferred to a charity through the exercise of the power of appointment,  which normally will cause the decedent’s 401(k) to be emptied into the trust all as taxable income no later 5 years of the decedent-participant’s death.
  • The Fix: One key rule was utilized by the children and the trustee to ultimately permit the trust to be treated by the IRS as a see-through The beneficiaries of an IRA, or in this case the 401(k) account, are determined as of September 30 of the year following the participant-owner’s death. This creates a period during which an IRA beneficiary designation (or 401(k) account) can be ‘cleaned up’ to eliminate problematic named beneficiaries, like a charity. Here the children released/disclaimed a portion of their power of appointment over their trust share by that September 30 drop-dead date, thus narrowing the scope of their power of appointment to only those individual persons (not charities) who were younger than them. The effect of the disclaimers was to remove any charity as a potential beneficiary of the trust, and to prevent any person-appointee who might be older than the oldest child-beneficiary of the trust ultimately receiving any part of the 401(k) account assets distributed to the trust.
  • Result: The result was that the IRS held that the oldest child’s life expectancy would be used to determine the amount of the 401(k) account paid that is to the trust each year as the required minimum distribution from the retirement account- stretching those taxable distributions over a much longer period of time, and ignoring the original broad scope of the power of appointment given to each child over his/her trust share.

Other Observations:

  • Divide at the Beneficiary Designation Level: If the 401(k) beneficiary designation had named the trustee of each trust share to be established for each child as the designated beneficiary of a portion of the decedent’s 401(k) account, then each child’s own life expectancy could have been used to calculate the required minimum distribution for their portion of their late father’s 401(k) account. By simply naming the trustee of the entire trust (prior to the trustee dividing the assets into separate trust shares, one for each surviving child) the trustee was stuck using the shortest life expectancy of the oldest child to determine the required minimum distributions for the younger children.  I’ve harped on this observation too many times in the past to spend any more time on it- divide the IRA (or other retirement account) in the beneficiary designation associated with that account; don’t rely on the division in the trust instrument.
  • Inherited IRA: Yet another IRS finding in the same Private Letter Ruling was that the trustee of the trust could take the inherited 401(k) account and transfer (plan administrator directly to IRA custodian) that account into an inherited IRA. No explanation was given why the trustee wanted to move the retirement funds from the qualified plan and into an inherited IRA. Maybe it wanted more investment options for the retirement funds available through an inherited IRA, or the IRA custodian fees were much lower than the fees associated with the 401(k) account. But the Service authorized the trustee to open an inherited IRA, which may ultimately give more flexibility to the trustee charged with administering retirement assets payable to an irrevocable trust over a long period of time.

Conclusion: Directing retirement assets to a see-through trust is an important part of income tax planning for beneficiaries. Satisfying the designated beneficiary rules is thus critical for a see-through trust. If a trust instrument names non-individuals as a potential beneficiary, it’s a strong possibility that see-through trust treatment will be lost. All of which is why it is important to remember the September 30 of the year following the owner’s death as the end of the period of time in which a non-compliant trust can be ‘fixed’ to satisfy the see-through trust rules.