Qualifying a Trust as a Beneficiary of a Retirement Plan

In Part 1, I discussed the staggering monetary potential a beneficiary of certain inherited retirement plans is capable of achieving if the beneficiary stretches that plan over their lifetime. Most beneficiaries, however, just don’t do it. It doesn’t happen for a variety of reasons, some of which involve a beneficiary who is:

1. a minor who upon turning 18 steps into a good bit of money and mishandles it;

2. an adult who is irresponsible; or

3. someone who is simply not aware of the concept.

I then discussed the reasons why naming a Trust as a beneficiary of your retirement plan addresses these situations, better ensuring that the stretch actually happens.

But just naming any Trust as the beneficiary is not enough to allow the stretch – the Trust must meet several requirements or otherwise the beneficiary will have to withdraw RMDs at a much faster rate, thus costing some beneficiaries what potentially could be millions of dollars!

Again, if an individual is named as the beneficiary of certain plans, RMDs must be paid to that person soon after the beneficiary inherits it, determined by the beneficiary’s own life expectancy rather than that of the original plan participant. And, as stated before, the younger the beneficiary is the better because:

• Younger people = longer life expectancy

• Longer life expectancy = lower RMDs

• Lower RMDs = More years of compounded tax-deferred (or possibly tax-free) growth

But what is the life expectancy of a Trust? Technically, there’s not one, but Congress tells us that we find the answer by “looking through” or “seeing through” the Trust to identify its beneficiaries, all of whom must be actual people. Additionally, we must consider all the beneficiaries of the Trust, as well as the contingents when determining whose life expectancy will be used, with the shortest life expectancy to control how long the plan can be stretched.

THE PROBLEM

Here are just two examples where things can go south:

1. A Trust names a 25 year old as the beneficiary but if he dies before age 30, then to an 80 year old person.

* even though the 80 year old is only a contingent beneficiary, the 25 year old can only stretch it using the 80 year old’s life expectancy instead of his own much longer one

2. A Trust names a 25 year old as the beneficiary for her life and at her death, the remainder to the Red Cross.

* the Red Cross is a charity and thus has no life expectancy – the “5 year rule” applies meaning the 25 year old has to withdraw the entire plan within 5 years OR possibly over what would be the remaining life expectancy of the deceased

There are many other ways things can go wrong in addition to the above examples, but in reviewing clients’ existing plans, it’s more of the second example that I’ve come across a number of times. One involved a single woman in her late 70’s who planned to leave her Roth IRA to her three grandchildren in Trust, primarily because they were all minors. Each grandchild stands to benefit from roughly $150k of the Roth. The language in her documents said nothing about retirement plans and the Humane Society was the contingent beneficiary, meaning the Roth would have to be paid in full to the very young grandchildren over a much shorter period of time, rather than their own long life expectancies. Bottom line is that had the woman died without changes made to those documents, her grandkids would be out of what could be large amounts of money!

THE SOLUTION

The easiest way to ensure the Trust qualifies for the stretch is to include what are called “conduit” Trust provisions. Basically these provisions say that the RMD and any another other distributions to the Trustee must be paid out to the beneficiary each year. If the RMD and other distributions have to be paid from the Trustee to the beneficiary each year, you don’t have to bother considering who the contingent beneficiaries are or possibly could be, in determining whose life expectancy applies or even if there is one – the primary beneficiary’s life expectancy will be used to determine the stretch, even if the contingents are charities or people older than the primary beneficiary.

But throwing in conduit provisions and thinking all is good does not make sense for just any and every situation. Including these provisions is the most conservative approach to ensuring the plan can be stretched, but depending on the client’s situation and concerns, conduit provisions may actually do more harm than good. Situations where this can occur, as well as a common problem in filling out the plan’s beneficiary form to allow the stretch, will be discussed in future parts of this series.

Contact Hamrick Law in Greenville, SC for estate planning and business planning!

* Disclaimer – There are other requirements for a Trust to qualify to allow the stretch. Furthermore, the intersection of Trusts and retirement plans is incredibly complicated and only so much can be addressed in 1.5 pages. This is not intended as legal advice. As always, you should not act upon any such information without first seeking qualified professional counsel on the specific matter.