Many people want to leave the substantial wealth they have accumulated in retirement accounts in trust for their beneficiaries, rather than having the retirement accounts pass outright to them.  However, the IRS has established extremely complicated rules governing when retirement plan, IRA and Section 403(b) annuity contracts payable to a trust can be distributed over the life expectancy of one of the trust beneficiaries, rather than under the general five year distribution time limit.

If you have a substantial amount in your retirement account, paying it out over five years under the general five year rule can dramatically accelerate the income taxes paid by your beneficiaries, and reduce the tax-free compounding inside the retirement account after your death. As a result, the IRS rules regarding trusts as beneficiaries must be carefully followed, or the retirement plan benefit will have to be paid out over the maximum period of five years after the retirement plan account owner’s death.

One of the safest and clearest methods to comply with the IRS’s rules regarding retirement plan distributions to trusts is to make the trust a “see-through” or “conduit” trust as to one beneficiary.  In order to do so, the trust terms must require that all distributions from the retirement plan account be distributed to that beneficiary.

The trust terms in this case covered by the IRS ruling were mixed in this regard.  One favorable provision obligated the trustee to withdraw the minimum required distribution from any retirement account for which the trust is named as beneficiary, and distribute those amounts, net of any expenses, to the beneficiary daughter outright.  Beyond that, the Trustee was given discretion to distribute the Trust income and principal for the daughter’s health, maintenance, support and education.  Significant to the outcome, the Trust also expressed the Decedent’s intent that the Trust qualify as a conduit trust, and that all provisions were to be construed in accordance with this “primary intent.”  If the daughter died before the full distribution of her trust and before age 30, the trust terms permitted the daughter to appoint the trust assets to any person or entity she wanted, which is known as a “general power of appointment.”  If the daughter failed to exercise this power, then the trust assets passed to her descendants.  Helpfully, the trust terms also prohibited distributions of any retirement plan account benefit to any non-individual beneficiary.

The IRS ruled that the language requiring the trustee to withdraw and distribute all the minimum required distributions in the retirement account helped to meet the IRS regulation granting conduit trust treatment.  Further, based on a court ruling, the various distribution provisions in the Trust were construed to require the Trustee to pay any and all funds withdrawn from the retirement accounts to the daughter.  The overall intent of this language prohibited any accumulation of retirement account distributions in the trust for the benefit of any beneficiary other than the daughter, according to the IRS ruling.  Despite the fact that there were remainder provisions for the benefit of the daughter’s issue or her appointees, the IRS concluded that the trust was for the daughter as the single, identifiable beneficiary during her lifetime, which also helped meet the conduit trust test.  The IRS ruled that the retirement account could be paid out over the daughter’s life expectancy.

Under the technical conduit trust rules established by the IRS, this ruling must be viewed as a favorable one for the daughter.  The trustee was not obligated by the express trust terms to give all retirement account distributions to the daughter, just the required minimum distributions.  Therefore, in theory, the trustee could have withdrawn more than the required minimum distributions in a given year, and not distributed those to the daughter.  The fact that the trust expressed the “primary intent” to qualify as a conduit trust was very helpful, as was the daughter’s power to appoint the trust to her own estate upon her death before age 30.

When designating a trust as the beneficiary of a retirement plan, the moral of the story is to plan and draft the trust very carefully.  To create a proper conduit trust, be sure to state in the trust that all retirement account benefit amounts withdrawn by the trustee must be paid in full to the beneficiary, whether the distribution happens to be a minimum required distribution or some amount in excess of that.  Otherwise, you could end up with a long wrangle with the IRS over the permissible payout period, or with the need to pursue both a state court construction action and an IRS private letter ruling like this family, at considerable time and expense.  Financial institutions have grown increasingly gun shy about trust compliance with the distribution rules, and they may force the issue even if the IRS does not.  Also, if the minimum required distributions under the applicable payout period are not fully met, i.e. because you erroneously select an impermissibly long payout period based on the trust beneficiary’s life expectancy, the IRS can apply a 50% penalty to the resulting underpayment amounts.

Have a question? Contact Mark Sommer. 

Your comments are always welcome!