12-Apr-18
IRAs Payable to Trusts – Use the Beneficiary Designation Form
Take-Away: As I promised yesterday, what follows is an example of how an IRA Beneficiary Designation should be written if the IRA is payable to the irrevocable Trust on the owner’s death and the goal is for each trust beneficiary to exploit the ‘stretch IRA’ concept where each trust beneficiary is free to use his or her own life expectancy to calculate the required minimum distributions from their portion of the inherited IRA. In order for each trust beneficiary to use his or her life expectancy to calculate the required minimum distributions from their pro rata share of the decedent’s IRA, the IRA needs to be divided in the IRA beneficiary designation, not the trust instrument’s directive to the trustee to divide the trust’s assets.
Example: Father, John Smith, dies a widow, his wife having died year years earlier, and John rolling over her IRA to his own IRA. John is age 73 at the time of his death. John is survived by two adult children: Son, Samuel Smith and Daughter, Diana Smith. Samuel is age 50 years. Diana, a ‘late surprise’ in her parents’ lives, is now age 38 years. John’s IRA at the time of his death is worth $1,800,000. For a variety of reasons John does not wish to name his two children as the beneficiaries of his IRA. Instead, John wants to make his IRA payable to his Trust of which Greenleaf Trust is the Successor Trustee. That Trust, in general terms, directs the division of all of the assets in John’s Trust to be divided into shares of equal value, one share for each child. Each child is entitled to receive all of the income from his/her trust share. Greenleaf Trust is given discretion to distribute trust share principal to a child following a health and support standard. A child is given the right to withdraw their entire trust share when he/she attains age 60 years. John included in his Trust instrument a non-binding statement of his desire for Greenleaf Trust to take the required minimum distribution from the IRA that is made payable to the Trust; John’s intent is for the Trustee to stretch the distributions from the IRA as long as possible, to permit the assets remaining in the IRA not distributed to continue to grow in an income tax-deferred environment (the IRA) as long as possible.
Mistake: Knowing that his Trust requires the division of all trust assets into shares of equal value for his two children on his death, John assumes that the directive given to Greenleaf Trust divide all trust assets, which would include his IRA, into equal shares upon his death will accomplish his objective of fully exploiting the stretch IRA rules. Accordingly, John’s ‘short and sweet’ IRA beneficiary designation provides the following:
Upon my death the custodian shall as soon as practicable distribute this IRA to Greenleaf Trust, as the then acting Successor Trustee of the John Smith Declaration of Trust dated April 20, 2015.
While Greenleaf Trust will create separate trust shares for each of Samuel and Diana using John’s Trust’s assets, and 50% of each distribution from John’s IRA will be transferred to each of those two trust shares, Greenleaf Trust will have to use Samuel’s life expectancy for purpose of determining each year’s required minimum distribution amount to be taken by Greenleaf Trust from John’s inherited IRA. Samuel’s life expectancy on John’s death, at age 50 years, is roughly 29 years. Diana’s life expectancy on John’s death, at age 38 years, is roughly 41 years. [These life expectancy numbers are rounded and taken from the Single Life Table the IRS requires non-spousal beneficiaries to use to calculate required minimum distributions from inherited IRAs.]
So, dividing John’s $1,800,000 IRA at the time of his death results in $900,000 of that IRA being payable to each trust share established for Samuel and Diana. But Samuel’s life expectancy, the oldest trust beneficiary, controls how required minimum distributions will be calculated and paid to each beneficiary from their respective trust share. Thus, the first year after John’s death when required minimum distributions are taken by Greenleaf Trust from John’s IRA, the ‘divisor’ will be Samuel’s life expectancy, or 34 years. $1,800,000 divided by =$52,941. 50% of that distribution will be paid to each of Samuel and Diana’s trust shares, and subsequently distributed by Greenleaf Trust free from the trust share directly to that child. Thus, each of Samuel and Diana will receive a distribution, indirectly from the IRA, of $26,471 for that year.
If Diana’s life expectancy could have been used, not her brother’s, then the ‘divisor’ would have been 46 years. Diana’s required minimum distribution amount for the year would have been $19,565, or $6,906 less, leaving that much more in the IRA to grow in a tax deferred environment.
Correct Beneficiary Designation: Rather than divide the IRA benefits using the Trust instrument’s direction to Greenleaf Trust to divide all trust assets equally (at the trust level), John’s IRA beneficiary designation should divide the IRA (at the beneficiary designation level.) Doing so will enable Diana to use her own, longer, life expectancy to calculate her required minimum distributions from the IRA portion that is allocated to her trust share.
Upon my death the custodian shall as soon as practicable divide the balance of this IRA account determined at the time of my death into two shares of equal value. One 50% share of this IRA shall be distributed to Greenleaf Trust as trustee of the trust share established for my son, Samuel Smith under the John Smith Declaration of Trust dated April 20, 2015. The other 50% share of this IRA shall be distributed to Greenleaf Trust as trustee of the trust share established for my daughter, Diana Smith under the John Smith Declaration of Trust dated April 20, 2015.
If either my son, Samuel Smith, or my daughter, Diana Smith, does not survive me, then their 50% share of this IRA payable to their trust share shall instead be distributed to that deceased child’s descendants, per stirpes, subject to the terms of the John Smith Declaration of Trust, and if that deceased child is not then survived by any descendants the 50% share of this IRA share shall be added to the trust share created for my then living child under the John Smith Declaration of Trust.
With this approach, Greenleaf Trust can then calculate Diana’s required minimum distribution from the portion of the inherited IRA allocated to her separate trust share using her life expectancy of 46 years, and not Samuel’s 34 years.
Clients will not like all the language that is included in the beneficiary designation form, preferring instead the short, succinct, and easy to read beneficiary designation that just names their Trust. But that requires the use of the oldest living trust beneficiary’s life expectancy to calculate the required minimum distributions from the inherited IRA. Imagine if John’s Trust provided for a $100,000 gift to his sister, age 68, with the balance of his Trust being divided into shares of equal value between Samuel and Diana. John’s sister, now the oldest beneficiary of identifiable from the Trust instrument, has a life expectancy of 18.6 years. Using her life expectancy to calculate the required minimum distribution would result in each of Samuel and Diana receiving a distribution from the trust, representing their share of the inherited IRA that is to be paid to them, of $48,387.
Conclusion: If the settlor’s intent is to exploit the stretch IRA rules, the settlor will need to make their IRA payable, as described in the beneficiary designation form, to the trustee of the trust share that is established for each beneficiary under the Trust instrument.