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Using Retirement Trusts to Protect and Transfer IRAs

Logan Baker

Lead, Senior Wealth Strategist

Summary

Here’s a handy primer on why a retirement trust can be the most effective way to transfer IRAs and other retirement plans to beneficiaries.

A senior couple using a laptop and going over paperwork in the garden at home.
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An effective estate plan should cover a client’s entire financial picture, but we frequently work with new clients whose plans don’t consider their individual retirement accounts (IRAs). Many estate-planning practitioners overlook IRAs for two apparent reasons: (1) a trust can’t own an IRA during the account owner’s lifetime, and (2) retirement plans typically pass at death by beneficiary designation rather than by the terms of the account owner’s trust or will. But just because a different set of rules governs these accounts—compared with assets like real estate, cash accounts, and taxable brokerage accounts—doesn’t mean IRAs are any less deserving of the same careful consideration when designing an estate plan. Here we review a comprehensive estate-planning approach for transferring IRA assets to multiple beneficiaries in the most tax-efficient way.

 

Retirement plans as part of an estate plan

One of the most important considerations when designing an estate plan is how the assets, including IRAs, will be transferred to beneficiaries in the future. In that respect, leaving assets to beneficiaries in a trust, rather than outright, can be beneficial for several reasons. The trust can protect the beneficiary against a variety of concerns and allow a designated trustee to manage the trust property on behalf of the beneficiary. Certain types of trusts can also provide asset protection benefits that wouldn’t be applicable if the asset were simply owned in the beneficiary’s name.

Before diving into the different types of trusts, let’s consider this example of an estate that has substantial IRAs and multiple beneficiaries who have unique needs:

H and W are married and have three children: Child 1, Child 2, and Child 3. Child 1 is married, but H and W have concerns about the marriage and about Child 1’s spouse, who has already been through one bankruptcy prior to the marriage and has questionable money management skills. Child 2 has special needs, currently lives independently, and doesn’t receive Medicaid or any other means-tested benefits program, although they may in the future. Child 3 is a minor who lives with H and W.

Their estate includes the following assets:

Primary residence $500,000
Vacation house $500,000
Bank accounts $100,000
Brokerage accounts $600,000
Life insurance $800,000
Business in LLC $1,000,000
H’s SEP IRA $1,500,000
W’s SEP IRA $1,500,000

H and W’s estate plan consists of a revocable living trust and an irrevocable life insurance trust (ILIT). The revocable trust owns their primary residence, vacation house, bank accounts, and taxable brokerage accounts and is the sole member of the limited-liability corporation (LLC). The ILIT owns the life insurance policy. Their estate-planning attorney recommended this structure so that the revocable trust assets could avoid probate at H and W’s deaths and the ILIT assets wouldn’t be subject to estate tax. Both trusts create irrevocable asset-protection trusts for all three children after H and W pass away, including a standby special needs trust for Child 2.

H and W’s estate-planning attorney also advised them to simply name each other as the primary beneficiary of their respective SEP IRA, with the children named as contingent beneficiaries. The attorney explained that these IRAs are not subject to probate because they pass through beneficiary designation, and they’ll be protected from creditors because all IRAs are.

There are several problems with this strategy, all related to how the IRAs will be treated following H and W’s deaths. First, IRAs are not necessarily protected from creditors or from a divorce. A 2014 U.S. Supreme Court case held that, while certain types of retirement accounts are protected during the account owner’s lifetime, those same protections do not extend to beneficiaries who inherit the retirement account after the account holder’s death.1

Second, leaving an IRA directly to the beneficiaries could expose them to several types of liability. For example, Child 1’s share of the IRA may be subject to a claim if a creditor is able to secure a judgment against Child 1, either individually or jointly with their spouse. Third, since Child 3 is a minor, naming them as an outright beneficiary may prove problematic, as the IRA would have to be held in a custodial account until they reach the age of majority. Lastly, should Child 2 need to apply for Medicaid, outright ownership of the IRA will likely jeopardize their eligibility.

Instead of naming them as outright beneficiaries, transferring the IRA assets through a trust can address many issues. For example, a trust could provide an additional layer of asset protection to shield Child 1’s share of the IRA against a creditor claim and solidify separate property treatment in the event of a divorce. A trust could provide that Child 3’s share of the IRA is held until they reach a specified age, rather than being turned over to them upon reaching age 18 (or 21 in some states). A trust could also be used to hold Child 2’s share of the IRA, with provisions for a standby special needs trust (SNT) if they want to qualify for Medicaid or other means-tested programs.

Most importantly, holding IRA assets in trust results in equal treatment compared with nonretirement assets. A common flaw we tend to see among some attorneys is that a comprehensive estate plan is devised for nonretirement assets, but retirement accounts are allowed to pass outright through individual beneficiary designation. By leaving the retirement assets to beneficiaries in trust, we can bring those assets under the same planning umbrella that protects and manages nonretirement assets. The rest of this article will discuss the correct way to make an IRA beneficiary designation to a trust.

 

Naming a trust as an IRA beneficiary

We’re frequently asked: “Can a trust be named as an IRA beneficiary?” Unless prohibited by the IRA plan administrator, the answer is generally yes. However, potential confusion and planning pitfalls lie in the specific terms of the trust as well as in the ways that different types of trusts are treated for tax purposes and when determining the applicable required minimum distribution (RMD) rules.

A trust that satisfies certain IRS requirements will be disregarded as a beneficiary, and the individual trust beneficiaries will instead be treated as the IRA beneficiaries for RMD purposes. However, an IRA beneficiary trust that doesn’t satisfy the requirements will cause the IRA to be treated for RMD purposes as though it had no beneficiary named at all.

RMD obligations and income-tax burdens typically increase when there is no beneficiary named. IRS uses the term “designated beneficiary” to describe those who qualify for an exception to the general rule that an IRA must be fully distributed within five years after the account owner’s death. A designated beneficiary has 10 years to fully distribute their inherited IRA.2 This is the familiar “10-year rule” that was introduced by the SECURE Act. Even though we sometimes think the 10-year rule is a bad thing (and it certainly is, relative to the life expectancy “stretch” rules that existed prior to the SECURE Act), remember that the 10-year rule is actually a beneficial exception to the default five-year rule that would apply if the beneficiary were the account owner’s estate, a charity, or a nonqualifying trust, or if no beneficiary had been named.

In order to name a trust as an IRA beneficiary, and ensure that an individual trust beneficiary enjoys the same tax advantages as an IRA beneficiary, the trust must: (A) qualify as a see-through trust under IRS rules so that individual trust beneficiaries can be treated as IRA beneficiaries for RMD purposes, and (B) be drafted to allow each individual trust beneficiary to determine their own RMD rules under the IRS separate account rules.

 

Qualifying as a see-through trust

To be clear, a trust can never be the designated beneficiary of an IRA for RMD purposes. Treasury regulations clearly state that “only individuals may be designated beneficiaries for purposes of section 401(a)(9).”3 However, as explained below, a properly drafted trust can still be named as the IRA beneficiary, and the individual beneficiaries of that trust will be treated for RMD purposes as the “designated beneficiaries” of the IRA under IRS rules. Caution must be exercised in naming a trust as an IRA beneficiary. If the named beneficiary trust does not satisfy certain IRS requirements, then the IRA will be treated for RMD purposes as if no beneficiary had been named.4

This raises the question: If only individuals qualify as designated beneficiaries who are subject to favorable RMD rules, how could it ever be beneficial to name a trust as an IRA beneficiary? Fortunately, the regulations provide a special rule for what the IRS calls a “see-through” trust. If a trust qualifies accordingly, then it will be ignored for RMD purposes, and RMDs will be determined with reference to the individual trust beneficiaries.5

A trust qualifies as a see-through if it satisfies four requirements:

  • The trust is valid under state law, or would be but for the fact that there is no corpus.
  • The trust is irrevocable or will, by its terms, become irrevocable upon the death of the account owner.
  • The beneficiaries of the trust are identifiable from the trust instrument.
  • The trust documentation has been provided to the plan administrator within specified time limits.6

The first requirement isn’t generally a concern. A trust could conceivably be invalid due to improper execution, lack of legal capacity on the part of the grantor, having an unlawful purpose, procuring the trust agreement through undue influence on the grantor, or some other reason. In practice, however, such situations would be exceedingly rare, and we seldom encounter trust documents that aren’t valid.

Similarly, the fourth requirement is generally not a concern. This has less to do with the content of the trust itself and is more of an administrative requirement. That’s not to say the requirement isn’t important. Failure to provide the trust documentation to the plan administrator will disqualify the trust just as certainly as will failure to satisfy any of the other three requirements.

Regarding the content of the trust itself, the second and third requirements generally cause any problem. The second one requires that the trust be irrevocable or (as is more common) must become irrevocable upon the death of the IRA account owner. Consider a revocable trust created by Z, which names Z’s two children as the beneficiaries. The trust states that Z, during their lifetime, may revoke or amend the trust, but upon Z’s death the trust becomes irrevocable. This common provision would satisfy the second requirement.

The third requirement—that the beneficiaries of the trust be identifiable—is probably the most commonly unmet of the four. It requires not only that the beneficiaries’ identities be known but also that their life expectancies be ascertainable. If the trust beneficiary, or even one trust beneficiary among several, is not a natural person, then the trust will fail this requirement.

A similar concern exists with common “boilerplate” language found in many revocable trusts that directs the trustee to pay all of the grantor’s final expenses, such as funeral and burial, administrative costs, and preparation and filing of tax returns. The problem with this language is that many, if not all, of these expenses will be of the grantor’s estate. Paying the estate’s expenses is tantamount to naming it as a trust beneficiary. This would also violate requirement three, since the estate is an artificial legal entity without a determinable life expectancy, thus causing the entire trust to fail as a designated beneficiary.

Can you think of any other common trust beneficiaries that don’t have a life expectancy? What about a charity? Like any other artificial legal entity, it doesn’t have a life expectancy. This means that the simple and common act of naming a charity as a trust beneficiary, even when other beneficiaries are natural persons, would disqualify the trust as a see-through trust. And even if a revocable trust doesn’t currently name a charity as beneficiary, it’s always possible that a charity may be added in the future.

Adding a charity to a trust is a major potential trap for unwary clients and their advisors. If a client consults with an estate-planning attorney who isn’t well versed in these rules (as many are not) and asks to amend their trust to include a charity, most attorneys wouldn’t think twice about making the change. They could unknowingly disqualify the trust as a see-through trust.

A trust that satisfies all four of these requirements will be treated as a see-through trust. This means the trust will be disregarded for the purpose of determining applicable RMD rules, and the trust beneficiaries will be treated as IRA beneficiaries. However, it doesn’t necessarily mean they’ll have all of the tax and RMD benefits of being named individually as IRA beneficiaries. As explained below, the structure of the trust and the beneficiary designation form must allow the beneficiaries to use what the IRS calls “separate account rules.” Without these, beneficiaries won’t be able to independently determine the applicable RMD rules.

 

Maintaining separate account treatment

Separate account rules state that if an IRA is divided into accounts that have different beneficiaries, then RMD rules apply to each account separately, allowing the beneficiary to apply their own unique age factor in determining the RMD.7 In the case of an IRA with multiple beneficiaries, separate account treatment essentially allows each beneficiary to treat their inherited IRA as if it were a different account from what the other beneficiaries inherited. Contrast this with an IRA that has multiple beneficiaries who have been denied separate account treatment, in which case they’d have to determine the RMD as if they’d all inherited the same IRA.

Separate account treatment is what would normally result with an IRA that names multiple individual beneficiaries. If, for example, an IRA names Child 1, Child 2, and Child 3 as equal primary beneficiaries, then separate account rules allow the creation of three inherited IRAs, and each beneficiary can determine their own RMD and applicable distribution period without regard to the other beneficiaries.

Similarly, separate account rules provide a workaround of the general rule that naming a combination of designated and non-designated beneficiaries will cause an IRA to be treated for RMD purposes as if no beneficiary had been named. For example, if the account has three individual beneficiaries and one charitable beneficiary, separate account rules allow the charity to cash out its share immediately while the individual beneficiaries set up their own inherited IRAs.

How do separate account rules apply to a trust? We’ve already established that, with a see-through trust, beneficiaries will be treated as IRA beneficiaries for the purpose of determining applicable RMD rules. But does that mean the individual trust beneficiaries will also be able to avail themselves of the separate account rules? Not necessarily. In addition to improperly drafted trusts that don’t qualify as a see-through trust, this is a major planning pitfall.

For the individual beneficiaries of a see-through trust to qualify for separate account treatment, two things must happen. First, the trust must create, or allow for the creation of, separate trust shares for each beneficiary. Second, the IRA beneficiary designation form must actually name these separate trust shares as beneficiaries.

1. Creating separate shares within the trust

Some trusts are drafted as a “common pot trust.” This is a single trust for multiple beneficiaries and may be appropriate in limited circumstances, such as holding a pool of money for minors who live with their parents and have relatively similar needs. Or it might be suitable for a trust that’s dedicated to a limited purpose, such as funding the education of its multiple beneficiaries. For adult beneficiaries, however, we almost always draft trusts that have separate shares for each beneficiary. This helps to minimize conflict when someone has unique needs or depletes their funds faster than the other beneficiaries. Separate shares are always included in our retirement trusts, for reasons that will become apparent here. Separate shares also allow for separate account treatment once the retirement trusts are funded after the account owner’s death.

2. Making the correct beneficiary designation

If a trust has multiple beneficiaries, regulations state that the oldest beneficiary’s life expectancy must be used when determining the applicable RMD rules for the inherited IRA in the aggregate.8 But don’t the separate account rules save us here? We saw above that if a combination of designated and non-designated beneficiaries is named, the separate account rules will save the designated beneficiaries and allow them to independently determine their applicable RMD rules. Unfortunately, the same rule doesn’t apply when determining the applicable life expectancy among multiple designated beneficiaries of a trust.9 To be clear, this doesn’t mean that separate inherited IRAs can’t be created for them. We’d still create one for each beneficiary, but they wouldn’t be able to determine the RMD rules separately under the separate account rules.

To preserve separate account treatment, the IRA beneficiary designation form should name the separate trust shares (not the primary trust itself) as the IRA beneficiaries. For example, consider the following alternative IRA beneficiary designations of the H&W Revocable Trust for the benefit of H and W’s three children. The H&W Revocable Trust creates a separate trust share for each child:

Correct IRA Beneficiary Designation:
1/3 to the Child 1 Separate Trust, as created under the H&W Revocable Trust
1/3 to the Child 2 Separate Trust, as created under the H&W Revocable Trust
1/3 to the Child 3 Separate Trust, as created under the H&W Revocable Trust

Incorrect IRA Beneficiary Designation:
100% to the H&W Revocable Trust

The difference between these two beneficiary designations might seem minor, but it’s actually critical. The correct designation will allow the beneficiaries to separately determine the applicable RMD rules and distribution periods, while the incorrect designation will deny them separate share treatment and require them to determine these rules in the aggregate, usually with reference to the oldest beneficiary’s life expectancy. This would force younger beneficiaries to take larger RMDs and, thereby, pay more in income tax. It also means that a see-through trust that isn’t properly drafted to create separate shares and/or has an improper beneficiary designation can cause a worse tax result for the beneficiaries than if they’d simply been named individually.

 

Practical considerations

Any trust named as an IRA beneficiary should be specifically designed for that purpose. A general-purpose revocable trust is ill-suited as an IRA beneficiary for several reasons. It frequently names a charitable beneficiary, which will disqualify it as a see-through trust. A revocable trust is also frequently drafted as a common pot trust for beneficiaries, especially minors, which precludes the use of separate account rules. Even if a revocable trust is drafted initially to qualify as a see-through trust with separate trust shares, it could be amended throughout the grantor’s lifetime in a way that would disqualify it, such as by adding a charitable beneficiary or instructing the trustee to pay estate expenses.

An attorney who isn’t well versed in these rules might amend a trust in a way that disqualifies it from favorable tax treatment under IRS rules. Even a revocable trust that satisfies all of the relevant requirements might contain distribution provisions that contradict the RMD rules applicable to an IRA within the trust. For example, a revocable trust might contain a provision stating that the trustee is only permitted to distribute a fixed sum per month to a beneficiary. However, if the trust holds an inherited IRA, and if the RMDs from that IRA are more than the allowable distribution, the trustee may have to decant the trust, or petition a court to amend it, to comply with the RMD rules.

All of these concerns lead to the conclusion that one of the most effective ways to transfer IRAs and other retirement accounts to beneficiaries in trust is to utilize a retirement trust that’s drafted specifically for that purpose. A retirement trust qualifies as a see-through, names only individual beneficiaries, creates separate shares for each beneficiary, has distribution rules that always allow RMDs to be satisfied, and is clearly drafted for the sole purpose of holding and managing IRAs and other retirement accounts. This puts future practitioners on notice that any amendment to the trust must adhere to these important provisions.

Our Family Wealth Solutions group is here to assist clients and advisors in determining whether a retirement trust could be beneficial in a given situation. These trusts are relatively inexpensive to set up and maintain, and many of our clients have determined that the many advantages of a retirement trust vastly outweigh the minimal costs. Advantages include creditor protection, divorce protection, control over distributions, financial oversight, and tax management. If your estate plan includes a trust that sets rules for your beneficiaries, but your IRA, 401(k), and other retirement assets aren’t included in this plan, we encourage you to question why. Our advisors can assist, and we’re happy to discuss the options for including retirement accounts in your estate plan.

1Clark v. Rameker, 573 U.S. 122 (2014) (“In ordinary usage, to speak of a person’s ‘retirement funds’ implies that the funds are currently in an account set aside for retirement, not that they were set aside for that purpose at some prior date by an entirely different person.”)

2IRC § 401(a)(9)(B)(iii)

3Treas. Reg. § 1.401(a)(9)-4, Q&A-3

4Id. (“A person that is not an individual, such as the employee’s estate, may not be a designated beneficiary. If a person other than an individual is designated as a beneficiary of an employee’s benefit, the employee will be treated as having no designated beneficiary for purposes of section 401(a)(9) … .”). Note that this doesn’t mean a beneficiary designation will be disregarded for the purpose of determining legal ownership. For example, a charity would also not be considered a designated beneficiary, but this doesn’t mean that naming a charity as IRA beneficiary would invalidate the beneficiary designation entirely and cause the IRA to revert to the account owner’s estate. The charity would still receive the IRA as beneficiary, but because it’s not a designated beneficiary, it would be subject to the five-year rule. Of course, the charity would be indifferent since it wouldn’t owe any income on the distributions regardless of the applicable RMD rules.

5Treas. Reg. § 1.401(a)(9)-4, Q&A-5(a)

6Treas. Reg. § 1.401(a)(9)-4, Q&A-5(a)

7Treas. Reg. § 1.401(a)(9)-8, Q&A-2. Note that separate accounts must be established no later than the last day of the year following the calendar year of the account owner’s death in order for the applicable distribution period to be determined independently for each account.

8Treas. Reg. § 1.401(a)(9)-4, Q&A-5(c); Treas. Reg. § 1.401(a)(9)-4, Q&A-7(a) (“… if more than one individual is designated as a beneficiary with respect to an employee as of the applicable date for determining the designated beneficiary under A-4 of § 1.401(a)(9)-4, the designated beneficiary with the shortest life expectancy will be the designated beneficiary for purposes of determining the applicable distribution period.”)

9Treas. Reg. § 1.401(a)(9)-4, Q&A-5(c) (“However, the separate account rules under A-2 of § 1.401(a)(9)-8 are not available to beneficiaries of a trust with respect to the trust’s interest in the employee’s benefit.”)

Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services. Mercer Global Advisors Inc. (“Mercer Advisors”) is registered as an investment advisor with the SEC. The firm only transacts business in states where it is properly registered or is excluded or exempted from registration requirements.

All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Some of the research and ratings shown in this presentation come from third parties that are not affiliated with Mercer Advisors. The information is believed to be accurate but is not guaranteed or warranted by Mercer Advisors. Content, research, tools and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. The hypothetical example is for illustration purposes only. Actual results will vary. For financial planning advice specific to your circumstances, talk to a qualified professional at Mercer Advisors.