The Dangers of Naming the Living Trust As IRA Beneficiary

In the last few years we have discovered that the proper handling of IRAs in an estate plan has become increasingly more complex. Although IRAs have been around for some time, they have only recently become a larger percentage of the taxable estate for many of our clients. It's not so much the small $2,000 IRA's that have compounded over the years, it is frequently the larger rollovers from other qualified plans that have created asset rich IRAs. If you do not have a significant IRA now, but are a plan participant in a profit sharing and/or 401-K Plan, in all probability upon retirement you will "rollover" to an IRA. In any event, the rules for other retirement plans are similar to the rules for IRAs.

In the last few years we have also discovered that some individuals are setting up their living trusts, with or without the help of a lawyer, and arranging for the transfer of assets to the trust without proper guidance. This article is an attempt to focus in on the dangers of naming a living trust as primary or secondary beneficiary of an IRA.

In larger estates in particular, we find that our clients are designing plans for the purpose of saving both estate taxes, and reducing income taxes by allowing for a slow withdrawal of IRA assets. This frequently results in the designation of a living trust as a beneficiary. It is possible for a living trust to be an IRA beneficiary and have the withdrawal occur over a number of years based on the income beneficiary's age. However, there is a little known rule that if you use an IRA to fund a "pecuniary" bequest to a trust, there will be immediate taxation of the entire IRA balance. Many of the living trusts used today have a pecuniary clause that kicks in upon the death of the person creating the trust. See Treas. Reg. Sec. 1.661(a)-2(f)(1).

For example, one frequently used clause reads something like this: "Upon my death the trustee is to set aside an amount equal to my exemption to be held in trust with the balance of my estate going to my spouse". If the IRA were to be paid to this trust after death of the owner, in all probability the entire balance would be subject to up front income tax rather than spaced out over the life of the income beneficiary (unless the IRA beneficiary designation is specifically to this post death trust instead of generally to the living trust).

Some, or perhaps, many documents being used today are not up to the task of saving IRA tax dollars. Part of the problem can be traced to older trusts. As previously mentioned, only recently have IRA's grown to a level that they are now an estate planning challenge, and the law was less clear just a few years ago. Unless you periodically check in with your attorney, he or she is not apt to be aware of the inflation of your IRA.

The following hyperlink is technical but might be helpful in your communication with your attorney should you have a concern about your plan

Jack Davidson