Probate and IRA’s
Tax Effect of Trust Being Owner
IRA–Take as Lump Sum
Trust as Beneficiary–Life Expectancy Birthday Problem/Look Through Rule
Annuity Owned “Inside” the IRA
Living Trust as Beneficiary of IRA vs. Beneficiary of Annuity
Dear Mr. Miller:
Introduction: I have a Living Trust. Amongst my various assets I have a $750,000 IRA. I want to avoid probate. I called my IRA institution and asked them to put my IRA in the Trust but they said I should not do that.
What’s the right answer?
Perplexed IRA Owner
Probate and IRA’s: IRA’s rarely go through Probate court proceedings. Most IRA’s have a specified beneficiary (and probably a secondary beneficiary if the primary is deceased when the owner dies). The beneficiary designation almost always avoids Probate. Naming the Living Trust as the owner is typically unnecessary to avoid Probate.
Tax Effect of Trust Being Owner: If you make the Living Trust the owner of the IRA it is immediately taxable; in effect, you have taken the assets out of the IRA because a Living Trust cannot really be an owner of an IRA. That being said, you can make the Trust the beneficiary of the IRA. The bigger question is, “Should You?”
IRA–Take as Lump Sum: Making the Trust the beneficiary can create many problems. First, when you die, your beneficiaries will probably want to keep the assets in the IRA to retain the tax deferral. If they take everything out as a lump sum, depending on how many beneficiaries there are and the amount of the IRA at that time, there could be a significant income tax, maybe in the $300,000 range. So, if they are wise, they will probably take it out over their respective life expectancies (according to the IRS table).
Trust as Beneficiary–Life Expectancy Birthday Problem/Look Through Rule: If the Trust is the beneficiary, the problem arises as to how to calculate the life expectancy since a Trust does not have a birthday. In many cases, but not all, the IRS rules allow one to “look through” the Trust to the beneficiaries of the Trust and use their birthdays. The ability to “look through” depends on the distribution scheme of the Trust, for example, does the trust provide for lump sum distributions on your death, life time trusts for your children, payout at various ages for your children, or something else. Each of these approaches could have a different effect on the ability to “look through” the Trust. If one is not allowed to “look through” the trust then, again, that income tax is going to be significantly higher with far less tax deferral.
Annuity Owned “Inside” the IRA: An additional problem may exist in situations where an annuity is owned “inside” the IRA. Annuity contracts often have various payout provisions and guarantees and typically specified a beneficiary when the annuity investment was made. Changing that beneficiary can have significant results–and it may be significantly negative.
Living Trust as Beneficiary of IRA vs. Beneficiary of Annuity: If the beneficiary of the IRA is changed, for example, to the Living Trust, that action could very well conflict with the beneficiary designated for the annuity. The IRA beneficiary designation may well override the annuity designation. Worse, that conflict can eliminate some guarantees in the annuity contract. Often times, the annuity will provide a lifetime payout to the IRA owner’s surviving spouse if she if the sole beneficiary. By naming the Trust as the owner of the IRA, the lifetime payout to the spouse may be destroyed. That could be 100’s of 1000’s of dollars down the sewer.
Recommendation: So before you name the Living Trust as the beneficiary, you should seek the advice of your income tax advisor on the effect of doing so. He may wish (and probably should) consult with your estate planning attorney on the intricacies of the distribution scheme of the Trust in regards to the IRS “Look Through” rules. You should also seek the advice of your financial advisor who handles your IRA, especially if there is an annuity “inside” the IRA.