IRA Beneficiary

Designating Your Spouse versus a Trust for your Spouse as Beneficiary of your IRA

A common estate planning principle communicated by spouses who have children from prior marriages and relationships is, “If I predecease my spouse, I want my assets to be available for my surviving spouse’s needs, but when my surviving spouse dies, I want my assets to revert back to MY children.”

This can get complicated when the estate consists of Traditional IRAs, as many estates do. Let’s take the example of a Husband and Wife who each have two children. When H dies, his IRA is worth $1,000,000. In the year after Husband dies, Wife is 80 years old.  

When it comes to income tax planning and IRAs, most recommend to keep the IRA balance as large as possible, allowing an IRA owner to earn investment income on deferred income taxes. 

In this post we will discuss two strategies: (1) Naming the surviving spouse as the designated beneficiary of Husband’s IRA; and (2) Naming a trust (for the benefit of the spouse) as the beneficiary of Husband’s IRA. 

When a surviving spouse is the designated beneficiary of an IRA, the surviving spouse’s ability to roll over inherited benefits to her own IRA gives her a powerful tax-deferring option, not available to any other IRA beneficiaries. If the surviving spouse holds the IRA as an owner, her Required Minimum Distributions (RMDs) are determined using the Uniform Lifetime Table under which her Applicable Distribution Period (ADP) is the joint life expectancy of the surviving spouse and a hypothetical 10-years-younger beneficiary. If she withdraws only the RMDs under the Uniform Lifetime Table, the IRA is guaranteed to outlive the surviving spouse. And it’s likely that the IRA will be worth more in the surviving spouse’s late 80’s than it was when she inherited it at age 80. 

Let’s look at some numbers. Since Wife can use the Uniform Lifetime Table, her first required distribution the year after Husband dies (assuming a $1,000,000 IRA value) is $53,500 (5.35% of the IRA value). The next year her RMD is 5.59%. And the next year, 5.85%. If the investment performance of the IRA exceeds these distribution percentages, and she only takes the RMDs, the IRA will grow.  

The downside, however, is that since Wife is treated as the owner of the IRA, Wife can name whoever she wants as the beneficiary of beneficiaries of her IRA. She could exclude Husband’s children by naming Wife’s children, or perhaps even Wife’s new spouse that she married after Husband died! 

So instead of naming Wife as the designated beneficiary of Husband’s IRA, Husband considers naming a trust for Wife as beneficiary. The trust instrument might provide that RMDs go to Wife for her lifetime, but when Wife subsequently dies, trust assets revert back to Husband’s children. But since a trust was named as the beneficiary of Husband’s IRA, even if the trust qualifies as a “see-through” trust, RMDs after Husband dies will be based on the single life expectancy of the surviving spouse (Wife) which results in substantially less income tax deferral than would be available if the surviving spouse were named as the outright beneficiary and rolled over the benefits into her own IRA. 

Let’s look back at the numbers. If a trust for Wife is named as beneficiary of Husband’s IRA, the first RMD when Wife is 80 (based on the same $1,000,000 IRA) will be $98,000 (9.8% of the IRA value). At age 81, the RMD will exceed 10% of the account value. And each year, the percentage will increase. If Wife lives long enough after Husband dies, the RMDs based on the required single life expectancy table will cause most of the benefits to be distributed to Wife outright which will defeat the purpose of trying to protect those IRA assets for Husband’s children. 

So keep in mind that there are tradeoffs when it comes to naming beneficiaries of IRAs.

Should You Name a Trust as a Beneficiary of an IRA?

Had some discussions today with a Baton Rouge family today who that was trying to make the most of their father's IRA. The family wanted to make sure that after the father died, the IRA would benefit one of the children, and then after that child died, the family wanted the IRA to be shared among the other children.

The family kept asking: "Should we name the child as the beneficiary, or should we name a trust (for the benefit of the child) as the beneficiary.

One of the children was married to an accountant. His suggestion (whether it has merit or not is debatable) was, "Don't name a trust as the beneficiary of an IRA because I hate trusts."

One of the children stated, "Dad wants it left to a trust for the benefit of a child so that Dad has assurance that when the child dies, the remaining IRA would go to the child's siblings."

What should they do?

We talked about some of the advantages of naming the child as the beneficiary of the IRA. Those reasons include:

  • Naming a child as a beneficiary, instead of a trust, is simple;
  • There are tax deferral advantages to naming an individual as a beneficiary. Not every trust qualifies for "see-through" treatment, thus expediting required distributions;
  • As long as the beneficiary does not squander the money, the beneficiary can then name beneficiaries to inherit the "inherited IRA" when the first beneficiary dies.
  • Many attorneys, CPAs, financial advisors, trustees, and beneficiaries don't understand the complexities of naming a trust as a beneficiary - thus complicating the estate settlement of the IRA owner.
  • If a spouse is a beneficiary of the trust, the spouse will not be able to defer tax as long as if the spouse was named as the individual beneficiary.

Some of the reasons to name a trust as a beneficiary of an IRA include:

  • The IRA owner is ensured that when the first trust beneficiary dies, the remainder of the IRA will pass for the benefit of the people that the IRA owner hopes to get the IRA;
  • A trust prevents the first beneficiary from squandering the IRA, because another party will serve as the trustee;
  • If the trust is established properly, the trustee can use the age of the beneficiary for purposes of required minimum distributions.

The decision regarding whether to name individuals versus a trust as the beneficiary of an IRA can be a complex, but important decision. The wrong decision can have adverse income tax effects, or it can cause the IRA to be squandered by the wrong people for the wrong reasons.