The benefits of an Individual Retirement Account (“IRA”) can be enormous. Those who have taken advantage of the tax deductible contributions and tax-free deferral afforded by the IRA laws have been richly rewarded with substantial balances in their IRAs. Because IRAs often represent a significant portion of one’s net worth, estate and tax planning for IRAs has become much more important, and individuals often seek to maximize the long-term benefits of IRAs while preserving the assets for their children and spouses.
For a variety of reasons, people with significant net worth incorporate trusts as part of their estate plan. Trusts have many benefits, including protection of assets from creditors, or spendthrift heirs from their own bad habits, and maximization of available tax benefits. IRA owners can also use trusts to obtain those benefits. However, the complicated rules regarding IRA distributions require very careful planning. While the IRS recently issued final regulations related to IRA distributions, not only are the IRS regulations complicated, but the IRS’s own interpretations of its regulations are often contradictory.
If a person does not have sufficient assets aside from his or her IRA to fund a credit shelter trust and/or marital trust, then IRA assets must be used in order to minimize the effect of estate taxes. In order to qualify an IRA trust for the marital deduction, all income from the marital trust must be payable to the surviving spouse. However, the amount of income received by the marital trust is not necessarily the same – in fact, probably never – as the amount paid to the trust as the required minimum distribution from the IRA. Thus, in order to preserve the marital deduction, care must be taken to provide that all income of the IRA will be distributed to the marital trust so that it can be paid out to the surviving spouse.
To permit the longest payout from an IRA, an individual should establish a separate trust (sometimes referred to as a “conduit” trust or “look-through” trust) for each of his or her intended beneficiaries during his or her lifetime. This trust is separate and apart from any trust the grantor has established in his or her living trust. If the trust fails to identify a beneficiary, the IRA payout cannot be stretched out. Thus, when naming trusts to be the recipient of IRA benefits, it is imperative that the IRA beneficiary designation be clear that the IRA is to be distributed to the separate trust established for each beneficiary. In this way, each beneficiary will be permitted to receive distributions from the IRA over the beneficiary’s lifetime. Failure to create separate trusts will result in the IRA being distributed over the life of the oldest beneficiary.
The alternative to having the entire amount of each year’s IRA distribution paid out to the beneficiary is to have the distributions accumulate within the trust. This prevents the beneficiary from squandering the principal of the trust, but it comes at a cost: the tax brackets for trust income taxes are compressed, so a trust pays the highest tax rate beginning at income of approximately $10,000.
Planning for IRA distributions, particularly when the IRA owner desires to use trusts in order to provide long-term payouts, is complicated and requires careful planning. Please do not hesitate to telephone us if you have any questions regarding estate planning and your IRA.