IRS Allows More Trust Options

Estate Planner May-Jun 1998
Regulations on Trusts as IRA Beneficiaries Are Loosened

An individual retirement account (IRA) or other retirement plan is often an individual’s largest and most difficult-to-handle asset. Decisions regarding when and how to take distributions, distribution amounts, and choice of beneficiaries all affect both income and estate taxes. While changes in the Taxpayer Relief Act of 1997 have eased the tax bite on IRAs, the rules remain complicated. The Internal Revenue Service (IRS) has, however, simplified the requirements for treating trusts as designated beneficiaries for distribution rule purposes.

The Regulations

In 1987, the IRS issued proposed regulations to explain the then recent amendments to the Internal Revenue Code (IRC) relating to required distributions from qualified plans and IRAs. The regulations stated that:

Distributions to a plan participant (or IRA owner) cannot generally begin without penalty before the participant reaches age 591/2.

  • Distributions must begin by April 1st of the year following the participant reaching age 701/2, the date known as the required beginning date.
  • Distributions must be made at least annually and/or based on the life expectancy of the participant and, if applicable, the designated beneficiary named by the participant.
  • Post-death distributions must be completed at least as rapidly as lifetime distributions. If no designated beneficiary has been named as of the required beginning date, then the participant is treated as having no designated beneficiary when determining the minimum required distributions. In that situation, distributions are based on the participant’s life expectancy.
  • If the participant dies before the required beginning date, distributions must begin within one year of the participant’s death and must be made over the life or life expectancy of the designated beneficiary. If there is no designated beneficiary, distributions must be completed within five years of the participant’s death.

A Question of Trusts

The IRC defines”designated beneficiary” as an individual designated as a beneficiary by the participant. The term “individual” generally rules out the possibility of naming a trust, the participant’s estate or a charity as a designated beneficiary. Under the 1987 regulations, however, a trust can be a designated beneficiary for minimum distribution purposes if it meets the following requirements:

1. The trust is valid under state law.
2. The trust is irrevocable.
3. The individual beneficiaries are identifiable from the trust instrument.
4. A copy of the trust instrument is provided to the plan administrator.

As a result of these requirements, naming a revocable trust did not appear to be an option. While naming the revocable trust was arguably a viable option if a plan participant died prior to the required beginning date (since, on the death of the participant, the trust would become irrevocable), this would not be possible for a participant who is approaching or has reached age 701/2.

Revocable Trusts Allowed

After more than 10 years, the IRS has determined that allowing a revocable trust to be a designated beneficiary makes sense and adopted revised requirements in December, 1997. Under the modified proposed regulations, a trust can either be irrevocable or become irrevocable, by its terms, on the death of the participant. In addition, the rule saying a copy of the trust instrument must be provided to the plan administrator has also been revised to allow alternate methods for satisfying the documentation requirement.

The preamble to the proposed regulations indicates that taxpayers may rely on the revised proposed regulations pending the issuance of final regulations. Also, note that the IRS did not indicate that the revised regulations should apply prospectively only. It would, therefore, appear that these proposed changes apply retroactively to the effective date of the existing proposed regulations.

Careful Planning Is Key

We have only touched on the issues regarding distributions from IRAs and other qualified plans. The importance of proper IRA distribution planning cannot be over emphasized. We would be pleased to discuss these issues with you in greater detail.

Rules For Spousal Beneficiaries

The rules relating to a spouse as a designated beneficiary are somewhat different than the general rules. Specifically, if a participant’s spouse is named as a beneficiary of the IRA, the spouse has several options. One is to transfer and rollover the IRA benefits into his or her own IRA, allowing the spouse to defer taking distributions until he or she reaches age 701/2, if desired. This also allows the spouse to designate a new IRA beneficiary, potentially allowing further deferral until after that beneficiary’s death. If the spouse is older, he or she can also elect to retain the participant’s IRA and defer taxable distributions until the participant would have reached age 701/2.

Another benefit: Naming a spouse as beneficiary not only means possible tax advantages, but also allows you to use the marital deduction for estate tax purposes. However, if you do not want your spouse to have full control over your IRA benefits on death, you should consider other alternatives.

Penalties Loosened

Under the prior rules, not only are issues regarding the timing of distributions and the designated beneficiary complex, but severe penalties were imposed when a participant took out too much from the plan in any given year (excess distributions) or died with too much in the plan (excess accumulations). Changes made by Taxpayer Relief Act of 1997 repealed the excise tax on both excess retirement distributions and excess retirement accumulations for distributions after 1996 and for taxpayers dying after 1996. Other penalties and excise taxes still apply however:

1. With limited exception, a 10% additional income tax is imposed on distributions made prior to the time when the participant reaches age 591/2.
2. A 50% penalty tax continues to be imposed on the amount of a required distribution that is not actually distributed.

An Example

Dan Jones, who will reach age 701/2 in 1998, named as his IRA beneficiary a revocable trust for the benefit of his sister, Melissa. The terms of the trust provide that it becomes irrevocable at Dan’s death. Dan has provided a copy of the trust agreement to the plan administrator. Under the proposed regulations as modified in December, 1997, Melissa will be treated as Dan’s designated beneficiary, so distributions can be made over their joint lives or life expectancies. Under the prior proposed regulations, Melissa would not have been treated as Dan’s designated beneficiary unless Dan amended the trust to make it irrevocable by his required beginning date.