Mind on Money: New IRS Rules More Functional

I’ve had a number of conversations recently regarding the use of living trusts, or a more specific type of trust called an IRA beneficiary trust, as the beneficiary of IRA accounts.

IRAs, of course, hold much of the liquid net worth of middle-class American families. According to a 2019 study by the Boston Federal Reserve, American households hold about 50% of their liquid net worth in IRAs and related retirement accounts, so it makes sense that many families are concerned about how these assets will be handled when they pass.

There seems to be some confusion regarding a rule change that went into effect this year that alters the way IRAs and other retirement plans must be handled upon the death of the account owner.

Prior to this year, upon the death of an IRA owner, for non-spouse beneficiaries, IRS rules required the IRA account to be distributed, and therefore taxed, using one of two options. The IRA account could be entirely distributed by the end of the fifth year following the year of death, or it could be distributed using an IRS life expectancy table to determine annual Required Minimum Distributions, sometimes called the “stretch IRA,” over the life of the beneficiary. The method of distribution selected had to be determined by the end of the year following the year of IRA owner’s death.

Some estate planning attorneys used the “stretch IRA” rules to draft specific types of trusts, which required beneficiaries to use the lifetime payment option to distribute the IRA after the owner’s death. These trusts, which I call “IRA beneficiary trusts,” also enable other stipulations such as creditor protection or spend thrift provisions as well, essentially allowing an IRA owner to somewhat control the way the IRA was used after their death.

The IRA beneficiary distribution rules that went into effect this year changed the five-year distribution rule to 10 years, and removed the stretch option all together. The new rules have left investors who adopted an IRA beneficiary trust or have even named a typical family living trust as their IRA beneficiary wondering if they need to change gears are made new beneficiary designations.

Before I weigh in on this conversation, let me first state I am not an attorney and before any changes are made to an estate plan proper legal advice should be considered. With this out of the way, from a planner’s perspective I think the new IRS rules are actually a bit more functional (how often do you hear me say that), and with a little contemplation may not necessarily negate the usefulness of designating either a living trust or an IRA beneficiary trust as an IRA beneficiary.

Prior to the rule change, the primary downside of naming a living trust as an IRA beneficiary is non-natural beneficiaries, aka trusts, were not able to use the stretch option as a distribution method. The logic was, if a trust was therefore used the beneficiaries would be denied an important tax planning tool, and would, as a result, lose some level of control over the taxes they incurred.

Now, with the stretch option off the table all together this potential downside is negated and some IRA owners may find the control structures penned into their living trust as attractive tools to manage the disposition of their IRA assets. The trust can now use the 10-year rule to take distributions, which will fund the trust and subject the assets to provisions such as re-marry protections, creditor protections or spend thrift protections that may be written into the trust document. Kind of a win-win in my opinion.

As far as IRA beneficiary trust goes, it is true the new rules do negate the original purpose of the trust which was to compel the use of the stretch option. This doesn’t mean, however, just like with the living trust structure, the other trust provisions are no longer useful. So rather than tossing these documents out, I would suggest reviewing them to see how they may be utilized or amended to reflect the new rules.

This is probably a situation where some professional advice can go a long way to assuage concerns, so why not take the opportunity to review the ole estate plan, making sure it reflects the current intentions as well.

This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor. Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at marc.ruiz@oakpartners.com. Securities offered through LPL Financial, member FINRA/SIPC.