Estate Planning Pitfall A trust is the beneficiary of an IRA or retirement plan – Insight on Estate Planning April/May 2012

If you own an IRA or participate in a qualified retirement plan such as a 401(k), it’s possible to have the assets distributed to a trust when you die. As illustrated in a recent IRS private letter ruling (PLR), however, to preserve your retirement account’s tax-deferral benefits, it’s critical to properly designate a trust beneficiary.

If certain requirements are met, the trust beneficiary will be considered the retirement account’s designated beneficiary, and required minimum distributions (RMDs) from the account can be stretched over the trust beneficiary’s life expectancy — or, in the case of multiple beneficiaries, over the oldest beneficiary’s life expectancy. If the requirements aren’t met, the entire account balance will have to be distributed in a relatively short time.

IRS regulations state that a trust beneficiary qualifies as a designated beneficiary of an IRA or qualified plan if:

• The trust is a valid trust under state law (or will be after it’s funded),
• The trust is irrevocable (or will become irrevocable at death),
• The beneficiaries with respect to the trust’s interest in the retirement account are identifiable from the trust instrument, and
• Appropriate documentation has been provided to the plan administrator.

The PLR involved a married couple whose estate plan included several trusts, one of which was named beneficiary of the husband’s IRA. Unfortunately, at the time of his death, the trust — and, therefore, the IRA — didn’t have a designated beneficiary. The couple’s children, as trustees, obtained a state court order allowing them to modify, or “reform,” the trust to designate a beneficiary.

But the IRS refused to apply the terms of the reformed trust retroactively for federal tax purposes. Although the IRS will respect such state court orders when reformation is specifically authorized by the Internal Revenue Code, that was not the case here. The result: The husband’s IRA was treated as having no designated beneficiary, accelerating distribution of the IRA balance.