Skip to content

The IRS Gets Its Swagger on When It Comes to IRA Beneficiary Trusts

By: Kevin Murphy

Vast amounts of wealth are held in individual retirement accounts, 401(k) plans and other retirement plans. The importance of proper estate planning for such retirement benefits was recently illustrated in private letter ruling 201021038. In this ruling, the Internal Revenue Service rejected a post-mortem reformation of a trust and concluded that the designated beneficiary of an IRA must be identifiable on the IRA owner’s date of death.

There are many reasons that it may be advisable to fund trusts with retirement assets. For example, a trust can be used to optimize a decedent’s exemption from federal and New Jersey estate taxes. Under current law, beginning on January 1, 2011, the exemption from federal estate tax will be $1,000,000 and the exemption from New Jersey estate tax will be $675,000. A trust could be designated as the beneficiary of retirement benefits to use such exemptions. In addition, trusts can be helpful in protecting children or grandchildren who may have spendthrift tendencies.

Paramount to planning with retirement benefits is “stretching” the mandatory distributions so that the income tax triggered by such distributions is deferred to the maximum extent. The key here is to qualify the trust as a “designated beneficiary” under the Internal Revenue Code.

In PLR 201021038, mother and father created a revocable trust that provided for the establishment of a testamentary trust upon the death of the first spouse. Some estate planners refer to this form of trust as a bypass trust. Upon the death of the first spouse, the bypass trust captures the deceased spouse’s exemption from federal and state estate taxes. Mother died first. After her death, father designated the bypass trust as the beneficiary of his IRA. When father died all of the various testamentary trusts created by mother, including the bypass trust, were collapsed. The assets from the collapsed trusts were distributed to what the ruling referred to as “protective” trusts for each of their daughters. 

The trusts for the daughters were what are generally referred to as “accumulation” trusts. The trustee of the respective protective trust had the discretion to distribute appropriate amounts of income and principal for the health care, maintenance, support and education of the respective daughter. There was no requirement for mandatory distributions to the respective daughter.

Also under the protective trusts, the daughters each had a broad power of appointment over the assets of her protective trust, which power extended to descendents of the daughters or to charities.

As a general rule, only individuals can meet the definition of a designated beneficiary under the code. If a person other than an individual is designated as a beneficiary, the IRA owner will be treated as having no designated beneficiary and accelerated income taxation shall result because the distributions cannot be paid out over the lifetime of the beneficiary. For example, if an estate is designated as an IRA beneficiary, accelerated distributions are mandated.