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Probate, Trusts, and Estate Law Blog

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Should a Trust Be the Beneficiary of Your Retirement Plan?

  
  
  
  
  

California trust taxSpeed of distribution may make a big difference

Under the minimum distribution rules, after your death, assets in a qualified retirement plan, such as a 401(k), generally may be distributed over the life expectancy of your plan’s designated beneficiary. Without a designated beneficiary, your plan will have to be distributed more quickly, losing the benefits of extended tax-deferred growth. Although the general rule is that a designated beneficiary must be an individual, a trust may be the beneficiary and its beneficiary may be considered the designated beneficiary for purposes of the minimum distribution rules.

Naming a trust as beneficiary

Many people ask me "should I name my trust as beneficiary of my retirement plan?"

Should you name a trust as your retirement plan’s beneficiary? Perhaps. First, you may want your spouse to benefit from your plan but not be able to control who’ll receive the balance of such benefits on his or her subsequent death.

When a spouse is the beneficiary

Generally, if you name your spouse as beneficiary, he or she will roll over your retirement benefits to an IRA and then be free to designate the IRA’s beneficiaries on his or her death. This is particularly important if your spouse remarries after your death. Second, if you want your children to benefit from your retirement plan’s benefits, you may create a trust and name your children as beneficiaries if they’re young or not capable of managing money.

5 rules

Your trust beneficiaries will be treated as your retirement plan’s designated beneficiaries if you follow these IRS rules:

  1. The trust must be valid under state law.
  2. The trust must be irrevocable or must, by its terms, become irrevocable on your death.
  3. The trust’s beneficiaries must be identifiable from the trust instrument.
  4. You must provide trust documentation to the retirement plan administrator.
  5. All trust beneficiaries must be individuals.

Rules three and five are where problems can easily occur, so let’s take a closer look at them.

Identifying beneficiaries

This rule is more flexible than you might think. If you name more than one trust beneficiary, for example, the members of the beneficiary class will be treated as being identifiable as long as the trust labels the oldest class member. Why? Because that’s whose life expectancy the IRS will use as the measuring period for required distributions after your death.

If the trust beneficiaries are “all your descendants living from time to time,” the members of that class still are considered identifiable, even though the class isn’t closed, because no person with a shorter life expectancy can be added later. The IRS can determine the oldest class member because any descendants who are born after your death are by definition younger than the oldest descendant who is living at your death.

But there are pitfalls. The mere possibility that an older beneficiary could be added to the trust can raise an IRS red flag, regardless of whether any such older beneficiary ever is actually added.

Ensuring beneficiaries are individuals

One common mistake is indirectly naming the estate as one of the trust beneficiaries. An estate isn’t considered an individual for retirement plan designated beneficiary purposes. So, if any part of the trust’s interest in the benefits will pass to your estate, there is no designated beneficiary.

This means your retirement plan assets would have to be distributed within five years after your death. Even indirectly allowing benefits to pass to your estate — as through a trust provision directing the use of trust property to pay your debts or probate expenses — may be treated the same as naming your estate as beneficiary and could result in having no designated beneficiary for retirement plan purposes.

To ensure your trust complies, prohibit its use of the retirement plan assets, or require that no such payments be made from the retirement plan on or after Sept. 30 of the year after the year of your death. (Such payments before that date are permitted.)

Making your choice

You have two choices when designating the beneficiary of your qualified retirement plan: an individual or a trust. When choosing a trust, its beneficiaries are considered the designated beneficiaries for purposes of the minimum distribution rules. Because the IRS regulations are complex, make sure your advisor explains them before you make your choice.

Sidebar: Planning for adopted descendants

If you wish to include a trust beneficiary who is a descendant by virtue of legal adoption on the same basis as a natural descendant and enjoy the advantages extending retirement plan payouts over the life of the designated beneficiary, there is a potential for IRS rule violations. After your death, one of your descendants could adopt someone who was born earlier than the person who was the oldest beneficiary of the trust when you died. It’s unclear whether the IRS would raise this issue, but to avoid the problem, include language in the trust providing that older individuals can’t be added to the class of trust beneficiaries by legal adoption. Instead, implement other estate planning strategies to benefit such individuals.

California trust tax

All the best,
Janet Brewer