Editor’s Note: Eldridge D. Dodson is a member of the Trusts and Estates Practice Group at Ward and Smith, P.A.
Designating the beneficiary of your IRA has more pitfalls than you may think and, due to a recent United States Supreme Court opinion, this decision has become even more complicated. Although the possibilities are endless, this article will explore the consequences of some of the more common beneficiaries such as: (i) your spouse; (ii) other individuals; and (iii) a trust.
Your Spouse Or Another Individual As Beneficiary
The simplest approach is to designate an individual as the beneficiary of your IRA. Typically, married individuals name their spouse as beneficiary, enabling the spouse to roll over the IRA into the spouse’s own IRA. As a result, the surviving spouse can delay taking required minimum distributions (“RMDs”) until age 70½, thus deferring income taxes. If your spouse chooses the rollover, the surviving spouse can name a new beneficiary to receive the IRA at the surviving spouse’s death.
If an individual other than your spouse is named, the individual beneficiary can also elect “stretch treatment” and receive distributions over the beneficiary’s life expectancy. This stretch approach permits the value of the inherited IRA to continue to grow tax‑deferred.
However, due to a recent United States Supreme Court decision, many individuals are reconsidering naming individuals as the beneficiaries of their IRAs. In 2014, the United States Supreme Court held that an inherited IRA was not protected from the claims of creditors. In the Supreme Court case, the beneficiary of an inherited IRA filed for bankruptcy, and the Court held that her bankruptcy estate could not exclude the IRA she inherited from her mother, thus subjecting it to the beneficiary’s creditors. As a result of this decision, if you are concerned about creditors of a beneficiary reaching the inherited IRA, you may want to consider creating a trust for the individual you want to benefit and naming the trust as the beneficiary of the IRA.
A Trust As Beneficiary
Exposure to claims of creditors in bankruptcy is not the only situation that may cause you to consider naming a trust as the beneficiary of your IRA. For example, in a second marriage situation where there are children from the first marriage, instead of naming the second spouse as beneficiary, you might want to consider a trust for the second spouse as the initial beneficiary during the second spouse’s life only to ensure that at the second spouse’s death, your IRA proceeds will pass to your children of the first marriage.
If you have a large IRA that may pass to minor beneficiaries, you should consider naming a trust or custodian under the Uniform Transfers to Minors Act (“UTMA”). Otherwise, a court proceeding may be required to appoint a guardian to manage your IRA for your minor child. However, naming a custodian under the UTMA may not be the best option for larger IRAs since the UTMA provides for management of assets in an UTMA account only until the beneficiary reaches 21. If the assets in your IRA are substantial, you may want to consider naming a trust as the beneficiary as an alternative; by naming a trust as the beneficiary, you can choose the age which the trust’s beneficiary must attain before the trust terminates and ensure that your IRA can continue to be managed for the benefit of that beneficiary after the age of 21. Similarly, if you have a concern that a shortsighted beneficiary might immediately cash out your IRA, a trust may be a better alternative than naming the individual outright.
However, a trust named as the beneficiary of your IRA must be properly drafted to accommodate the minimum RMD rules. In particular, to qualify for stretch treatment of the retirement benefit over the lifetime of the beneficiary of the trust, the trust must include specific provisions. Otherwise the retirement benefit will have to be distributed within five years of your death, and the entire amount distributed will be included in the beneficiary’s taxable income in the year it is distributed. For large IRAs, this compression of distributions typically results in the beneficiary being bumped to a higher income tax bracket and consequently paying higher income taxes than the beneficiary would have paid if the RMDs had been stretched out over the beneficiary’s life expectancy. “Stretch treatment” of IRAs not only minimizes income taxes, but also causes the payment of income taxes to be deferred.
Summary
As is apparent from this discussion, naming the beneficiary of your IRA is complicated. After the Supreme Court’s decision, now, more than ever, there may be benefits to naming a trust as the beneficiary. If you want to explore this option, be sure to seek advice regarding your options and, if you are considering naming a trust as the beneficiary, be sure to see a trusts and estates specialist to ensure that you create a trust that includes appropriate provisions to protect the IRA from creditors, divorcing spouses, and lawsuits, as well as includes provisions that will permit the RMDs to be stretched out over the life expectancy of the beneficiary of the trust.
© 2015 Ward and Smith, P.A.
Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Eldridge D. Dodson practices in the Trusts and Estates Practice Group where she assists clients in the areas of estate planning and estate administration. Comments or questions may be sent to edd@wardandsmith.com.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.
