Because IRAs are frequently a large part of a client's total assets, estate planners are often required to include part or all of the IRA in the client's estate plan. The client may also request that the estate plan provide that assets be given by will or living trust to beneficiaries at the client's death, particularly when the client believes there should be management of the IRA asset and supervision over the payout of the bequest. Thus the estate plan frequently provides that IRA benefits be payable at death to a trust.
Typically, when a trust is drafted, the instrument will call for one's spouse to be the primary beneficiary and one's children to be the secondary beneficiaries. However, if the surviving spouse has sufficient separate assets, the trust may provide that the surviving spouse and one's children are equal beneficiaries under separate sub-trusts. If the asset bequeathed is an IRA, then an extra step must be taken, this being to name each trust beneficiary in the IRA beneficiary designation form. If this technique of separate sub-trusts is used, then the estate plan can take advantage of income tax savings that will result from creating separate trusts for one's surviving spouse and each child.
All IRA owners and their designated beneficiaries must begin taking distributions on a certain date called the required beginning date. The amount that must be distributed starting on the required beginning date is called the required minimum distribution. The annual distribution is usually based on the life expectancy of the owner. If, however, the owner names a trust with sub-trusts for the surviving spouse and each child, then the annual distributions are based on the life expectancy of each beneficiary. The tax advantage of this technique is that the life expectancies of each trust beneficiary will be used to compute the annual minimum distribution and the payout will be "stretched out" over a substantially longer time period.
Setting up a trust and sub-trusts and separate beneficiary designations sounds complicated, but the following example may help explain how simple but proper use of the separate accounts exception can work to your family's advantage.
Mr. X provides in his will that his IRA is left to a trust which will then be divided into four sub-trusts, one for his spouse, age 65, and one for each of his three children, who are ages 40, 35, and 30. Additionally and most importantly, Mr. X also completes and files with the financial institution that manages his IRA account four beneficiary designation forms, one for his spouse's sub-trust, and one each for his three children's sub-trusts.
Upon Mr. X's death, the IRS will look to the beneficiary designation form and not the trust instrument to determine whether there are, in fact, four sub-trusts. If the beneficiary designation is in order, then the IRS will apply the life expectancy of each of the four beneficiaries in determining the annual required minimum distribution for each sub-trust. The 35-year-old, for instance, will receive his distributions over a 43.7-year period, while the annual distributions to Mr. X's spouse will be over a 23-year period.
The use of the sub-trusts described in the above example results in a substantial income tax deferral for each of the three children. The use of a standard trust with the spouse as primary beneficiary, and the children as secondary beneficiaries, in most cases will result in the life expectancy of the spouse being used to determine the minimum distribution for the spouse and the children, which in the example would result in distribution of all the trust assets over 23 years, and would "bump up" each beneficiary's tax bracket.
Although completing multiple beneficiary designation forms for the same IRA would not appear to be that difficult a task, with the continued merger and consolidation of financial institutions, it would appear that in some cases beneficiary designation forms have been lost or never included in the customer's file. Recently, the Wall Street Journal reported a number of cases where the institution managing IRAs failed to create the sub-accounts that were requested by the IRA owner, and the family of the deceased only discovered the error after the IRA owner's death, and thus the resulting tax savings described in the above example could not be achieved. If the required sub-accounts of the IRA are not set up at all, or not set up properly, then the required minimum distribution to establish the life expectancy will be on the life expectancy of the oldest beneficiary, and the possible tax savings will be lost.
So, a word to the wise: you can not be too careful in making sure that the institution handling your IRA has on file the correct beneficiary designations. As always, experienced professional advice and IRA administration is a small price to pay to ensure that everything is in order.
Attorney Anthony Vaida of Steamboat Springs has 32 years experience with estate planning.