Trusts as Death Beneficiaries of Retirement Plans

A trust cannot own a retirement account (e.g., an Individual Retirement Plan (“IRA”) or 401(k)) but it can be named as a death beneficiary. Until 2020, individuals receiving distributions from a retirement plan as a death beneficiary, either directly or as a beneficiary of a trust could expect to take annual taxable income distributions stretched out over their own lifetime; the stretch-out provided both tax deferred growth and income tax savings.

In 2020 the so-called, ”Setting Every Community Up for Retirement Enhancement” (“SECURE”) Act of 2019 greatly reduced who was eligible for such benefits. A limited pool of death beneficiaries, i.e., so-called, “Eligible Designated Death Beneficiaries” (EDB”s), now continue to receive the so-called “stretch out” lifetime death “Required Minimum Distribution” (“RMD”) payments (i.e., over the beneficiary’s lifetime). EDB’s include a surviving spouse, a disabled or chronically ill person, a minor child of the retirement plan participant, and a person who is not more than ten years younger than the plan participant (owner).

All other individual death beneficiaries who are not EDB’s are called Designated Beneficiaries (“DB”). A DB must receive his RMD distributions over a ten year period by which time everything must be fully distributed. In 2022, the Internal Revenue Service (“IRS”) issued new proposed regulations that now also require annual RMD distributions for DB’s within the ten year period.

Designating a trust as beneficiary should only occur after careful estate planning regarding current “RMD” rules: Will the trust will qualify as a DB for maximum tax deferred RMD distributions under the IRS rules, and, if so, what annual RMD’s and what final distribution year rules might apply. If the trust itself does qualify as a DB then the RMD rules depend on whether the individual trust beneficiaries are DB’s and/or EDB’s. Otherwise, if the trust is not a DB, such as because it has a beneficiary who is not an individual (e.g., a charity), then either more or usually less favorable RMD rules apply.

Thus, what is at stake is preserving either the EDB’s lifetime stretch out or the DB’s ten year distribution period, as relevant.

Generally, it is best to name individuals as death beneficiaries to retirement plans. This avoids unintended income tax consequences associated with having a trust as beneficiary. A trust should only be named as a death beneficiary to a retirement account when there is a good reason, such as, (1) the beneficiary is a disabled or incapacitated person receiving needs based government benefits; (2) the beneficiary is a minor; (3) the beneficiary has creditor problems; and (4) the trust has a complex distribution scheme.

Whether a trust qualifies as a DB is determined at the retirement plan participant (owner)’s date of death. First, does the trust satisfy the four (4) so-called “see through” rules to allow the trust to qualify as a designated death beneficiary? This is rarely an issue (except infrequently when all trust beneficiaries are not identifiable).

Second, the trust itself must, for RMD purposes, be categorized as either a, “Conduit Trust” or as an, “Accumulation Trust”. A “Conduit Trust’ is one that requires that, “all receipts of income from a retirement plan received by the Trustee must be distributed in the same tax year either to or for benefit of the beneficiary.” Any other trust is an “Accumulation Trust” which may accumulate retirement account distributions.

Third, all individual trust beneficiaries must be identified and listed, each beneficiary then be categorized as either a countable or a disregarded beneficiary when applying RMD rules. All persons who either must or may receive benefits following the death of a participant are countable. Any alternative (back-up) beneficiaries who only stand to inherit if some other beneficiary dies, are secondary and may sometimes be disregarded for applying RMD rules.

Every listed beneficiary who either must or who may receive a benefit from the trust counts when applying RMD rules. Secondary (alternative) death trust beneficiaries, i.e., who might receive benefits if a primary intended beneficiary were to die, are sometimes disregarded. With a Conduit Trust any secondary (alternative) death beneficiary is disregarded.

Fourth, if a trust is named a beneficiary and the trust is not an ongoing Conduit Trust or an ongoing Accumulation Trust but distributes assets outright to trust death beneficiaries at the settlor’s death, then unless one or more disabled or chronically ill trust beneficiaries are involved, each countable individual trust beneficiary is considered when determining a single annual RMD rule for all trust beneficiaries. However, if a disabled or incapacitated trust beneficiary is involved, the new 2022 regulations provide that each trust beneficiary is considered separately as if each beneficiary had been named individually instead of naming the trust. The annual RMD rules are then applied separately to each beneficiary’s share so long as one or more disabled or chronically ill trust beneficiary are involved.

Thus, for example, if one trust beneficiary is a disabled or chronically ill EDB they can inherit their share of the decedent’s IRA subject to their EDB lifetime stretch-out annual and final year distribution RMD rules and any other beneficiary who is an ordinary DB will inherit subject both to the DB’s ten year final distribution and annual RMD rules.

The foregoing is a simplified discussion of a very complex subject. It is neither financial nor legal advice. Consult a qualified financial advisor or attorney for guidance. Dennis A. Fordham, Attorney, is a State Bar-Certified Specialist in estate planning, probate and trust law. His office is at 870 S. Main St., Lakeport, Calif. He can be reached at Dennis@DennisFordhamLaw.com and 707-263-3235.