We frequently get this question from many of our clients, so we thought we’d spend a little time explaining why you need to be careful when naming a trust as the beneficiary of an IRA or Roth.  The primary reason is that a beneficiary normally gets to “stretch” the distributions from an inherited IRA or Roth across the beneficiary’s entire lifetime, and you risk losing that feature if the trust is not very carefully written.

To start, let’s explore why anyone would want to leave an IRA or Roth to a trust in the first place.  After all, it’s easy enough to name individuals as beneficiaries for these kinds of accounts.  You can even name contingent beneficiaries in case the primary beneficiaries predecease you or choose to disclaim the inheritance.  And by naming individuals as beneficiaries, the accounts will pass directly to them without having to go through probate.  So why even bother with a trust?  It turns out there are situations that are best addressed by using a trust rather than by leaving the accounts directly to individuals. Here are some examples:

• The beneficiary is a minor to whom you want to restrict distributions until he or she becomes of age.
• The beneficiary is an adult with special needs requiring a trustee to make his or her financial decisions.
• You want your second wife to get the distributions, but on her death ensure that the children from your first marriage get the remainder.

If you do choose to name a trust as a beneficiary, it’s important to preserve the stretch provision described above. The IRS will allow it if the trust meets the following qualifications:

• It must be a valid trust under state law.
• It must be irrevocable at death.
• The beneficiaries of the trust must be identifiable.
• A copy of the trust document must be provided to the plan administrator by October 31 of the year following the year of the IRA owner’s death.

While these may sound simple, they’re all legal questions that need to be discussed with a qualified estate attorney.  For instance, determining whether the trust has any non-individual beneficiaries can be difficult.  It requires a thorough review of the trust language and an understanding of the law governing primary and contingent beneficiaries.  A mistake in any of these criteria could cause the trust to fail to qualify as an individual beneficiary, requiring the IRA to be paid out under the 5-year rule (if the IRA owner dies before his required beginning date) or over the remaining life expectancy of the deceased IRA owner (if the IRA owner dies after his required beginning date).  In either case that would result in higher taxes and much shorter tax deferred growth than if the beneficiaries had simply been named directly.  Even worse, if the trust document allows the estate to use funds from the IRA or Roth to pay for estate expenses, the IRS could determine that the estate is the beneficiary, requiring the IRA or Roth to be liquidated and taxed within the estate.  Since estate income tax rates are much higher than personal income tax rates, the amount of money ultimately distributed to the heirs would be drastically reduced.

There’s one other big inheritance difference between naming individuals vs. trusts as beneficiaries.  If multiple individuals are named as beneficiaries, when the IRA or Roth is split among the beneficiaries, each beneficiary uses his or her own age to determine the number of years the distributions can be stretched out.  If a trust is named, and the trust includes multiple beneficiaries, the age of the oldest is used for all beneficiaries.  To avoid this you’d need to set up individual trusts and accounts for each beneficiary.

The bottom line: if you are going to name a trust as the beneficiary for your IRA or Roth, make sure to discuss it with your estate attorney to ensure the trust is correctly worded to reflect your intent as well as to preserve the tax benefits of inherited retirement plans.