Take-Away: Naming a trust as an IRA beneficiary is complicated. It can also be very expensive when you consider that an irrevocable trust is at the highest marginal federal income tax bracket of 37% when the trust’s income, which includes IRA distributions to the trust, exceeds roughly $13,300 during the year.

Background: As we know by now, the SECURE Act significantly changed the rules with regard to required minimum distributions (RMDs.) Those new distribution rules, coupled with the IRS’s complex see-through-trust rules, cause a trust that is drafted to receive the deceased settlor’s IRA a drafting and administrative challenge. Consider the follow trusts that are often created for a surviving spouse.

Spousal Withdrawal Trust: Under this trust arrangement, the surviving spouse possesses the unlimited right to withdraw the trust’s assets. Treasury Regulations allow the surviving spouse the same options as if the surviving spouse had been named directly as the deceased spouse’s designated beneficiary. Importantly, this type of trust provides control to the surviving spouse to delay distributions until the deceased IRA owner would have reached aged 72 and/or allows for a rollover of the IRA into the surviving spouse’s own IRA.

QTIP Trust: This more restrictive trust produces a different result than the spousal withdrawal trust, which also qualified for the unlimited federal estate tax marital deduction. Treasury Regulations require two conditions for the QTIP trust to qualify for the marital deduction:

-(i) All Income: The trust must specify that the surviving spouse is entitled to the income of the IRA as well as the income of the trust, i.e. the trust’s other assets. Making things complicated, the IRS regards the trust and the IRA account payable to the trust as two separate items of QTIP property. Restated, the IRA is not an asset of the trust like commercial real property or an investment portfolio, but treated as a separate entity. 

-(ii) Define Income:  The IRS requires the definition of the income of the IRA (either in the trust instrument or under state law.) For federal estate tax marital deduction purposes, the IRS will accept either the internal income of the IRA payable to the trust (e.g. interest and dividends earned inside the IRA) or a unitrust provision between 3% and 5% distributed annually. [Revenue Ruling 2006-26.]

QTIP Trust Distributions: For IRA distribution purposes, the QTIP trust can require the trustee to distribute to human beneficiaries, i.e. the surviving spouse, not just the income but all distributions received by the trustee from the IRA during the survivor’s lifetime. This will qualify the trust as a conduit see-through trust, which means that the trust is entitled to take distributions using the survivor’s life expectancy recalculated annually, an to defer distributions until the deceased spouse would have reached age 72.

Caveat: However, the surviving spouse cannot do a spousal rollover. In this situation, because the IRA remains an inherited IRA, and not the survivor’s own IRA, the QTIP trust is required to use the Single Life Table to determine the survivor’s life expectancy, and he/she is not eligible to use the longer distribution periods provided by the Uniform Table which a surviving spouse would use for an IRA that is rolled over into the survivor’s own IRA.

Accumulation QTIP Trust: Note that a QTIP trust does not have to be a conduit trust. If the QTIP trust instrument allows the trustee to accumulate and retain in trust the IRA distributions in excess of the income that must be distributed to the surviving spouse, the QTIP trust becomes an accumulation trust and the IRA distributions will be taxed differently, as explained below.

Bypass Accumulation Trust:  If a bypass trust (or credit shelter trust) is named as beneficiary of the IRA, it does not make sense to allow the surviving spouse to take the larger of the income or RMD, or all distributions received from the IRA, because that would potentially defeat the purpose of the bypass trust. The entire IRA would be distributed  to the survivor (through RMDs passed through the bypass trust to the surviving spouse) over the survivor’s life expectancy, and nothing would be left for the next generation if the survivor survives to his/her normal life expectancy. No dollars would bypass the survivor’s estate unless the survivor dies prematurely.

Consequently, a bypass trust should, instead, generally allow the accumulation of income and/or RMDs. Unfortunately, such an accumulation trust would generally eliminate all the special, i.e. flexible,  RMD provisions that are available to a surviving spouse, leaving the bypass trust subject to the SECURE Act’s 10-year distribution rule, even if the trust otherwise qualifies for the unlimited federal estate tax marital deduction. Moreover, the accumulation of the IRA distributions will mean that the IRA distributions so accumulated will be taxed at the trust’s income tax rates and not at the (in most cases) lower income tax rate applicable to individual trust beneficiaries.

Disabled and Chronically Ill Trust Beneficiary: As noted, since the arrival of the SECURE Act, naming an accumulation trust, like a bypass trust, as the IRA beneficiary generally will require the full distribution of the IRA to the trust within 10 years after the IRA owner’s death. Yet, there is one situation under the new rules where the life expectancy option is still available for an accumulation trust. An accumulation trust for a disabled or chronically ill individual allows the IRA owner to name a special needs trust that meets various requirements, (including that IRA distributions may not be paid to anyone other than the disabled or chronically ill trust beneficiary during their lifetime) will be treated as an eligible designated beneficiary, and therefore qualify for the life expectancy payout even though it is not a conduit trust. This allows the IRA distributions to be deferrred potentially over deceased which significallly enhances after-tax returns.

Conclusion: These IRA distributions rules were complicated even before the SECURE Act. They are now even more of a challenge to decipher. Add to that the confusion with the IRS’s Proposed SECURE Act Regulations, and it is almost impossible to fully assure individuals how their IRA will be taxed if it is made payable to an irrevocable trust. Hopefully the Final Regulations will bring some clarity to the situation.