Avoiding Pitfalls for Minor Beneficiaries of IRAs and Other Qualified Retirement Benefits, 1017 COBJ, Vol. 46, No. 9 Pg. 46

• Author: EMILY L. BOWMAN AND DAVID W. KIRCH, J.

Avoiding Pitfalls for Minor Beneficiaries of IRAs and Other Qualified Retirement Benefits

Vol. 46, No. 9 [Page 46]

The Colorado Lawyer

October, 2017

TRUST AND ESTATE LAW

EMILY L. BOWMAN AND DAVID W. KIRCH, J.

This article discusses pitfalls to avoid when naming a minor as the beneficiary of a retirement account. Specifically, it addresses using "see-through" trusts as a vehicle for managing the retirement account proceeds for the minor.

Individual retirement accounts (IRAs) and other qualified retirement plans are increasingly common assets in a client's estate. Thus, determining how to properly transfer and distribute such assets is critical to proper estate planning. A client wishing to transfer such an asset to an adult child on the client's death will have different estate planning considerations than a client wishing to give such an asset to a minor grandchild as a primary or contingent beneficiary.

This article focuses on the distribution of an IRA or other qualified retirement plan (also referred to as retirement account or retirement benefits) to a minor beneficiary at the plan participant's death. Such distributions present unique considerations and demand careful and customized estate plan drafting.¹

Considerations for Retirement Accounts Payable to Minors

Designating retirement benefits payable to a minor can help ensure that the minor has access to funds throughout his lifetime while minimizing or deferring the minor's income taxation on those benefits. Once the retirement account participant passes away, the minor beneficiary's life expectancy can be used to calculate the applicable distribution period (ADP) and required minimum distributions (RMDs) that must be made each year.² Because a minor's life expectancy is longer than that of an adult beneficiary, the RMDs are smaller and spread out over a longer period of time for a minor. This "stretch" not only ensures a longer stream of income throughout the minor's lifetime, it also allows for the longest tax deferral on the total income received from the retirement account.

IRAs and other qualified retirement accounts have been the target of potential legislative change, including proposals to limit the amount of income available for the stretch for non-spouse beneficiaries.³ Such changes would reduce the need for special planning regarding minors. But under current law, there are potential pitfalls to naming a minor as the beneficiary of a retirement account. How will the participant ensure that the funds are managed prudently by the minor, or that the minor does not take all the proceeds in one lump sum, increasing and accelerating income taxation and squandering the retirement benefits? In the absence of customized estate planning, a custodian may be needed to manage the minor's retirement account proceeds until the minor reaches age 21. The minor, however, is not prevented from withdrawing and squandering the retirement account proceeds upon reaching adulthood. What if the proceeds are needed to provide financial support and security for the minor's entire lifetime? What if the client wants more control of when and how the retirement account proceeds are distributed to the minor, even after the minor turns 21?

In these situations, rather than simply designating the minor as a beneficiary, the client should consider using a trust as a vehicle for managing the retirement account proceeds for the minor. For the trust to use the benefits of the minor's life expectancy in calculating the RMDs and ADPs, extra care must be taken to ensure that the trust qualifies as a "designated beneficiary"⁴ for tax purposes. If the trust fails to so qualify, the retirement account proceeds must be distributed to the beneficiaries in full either (1) within approximately five years of the participant's date of death, if the participant died before the beginning of the required beginning date of distributions,⁵ or (2) "over the remainder of what would have been the participant's life expectancy," if the participant died after the start of the required beginning date for distributions.⁶ This outcome results in larger and earlier distributions to minors, loss of control of the retirement account's management and distributions, and significant tax ramifications to the recipient, which can be particularly disadvantageous for larger retirement accounts, especially if the participant had not yet reached the "required beginning date" for distributions at the time of death. (Typically, the required beginning date is April 1 of the calendar year following the calendar year that the participant reaches age 70 ½ ⁷ )

The following discussion focuses on how to ensure that a trust holding retirement benefits for FEATURE TRUST AND ESTATE LAW minors is able to use the longer life expectancies of the minor beneficiaries to calculate RMDs while still allowing for significant control by the participant and/or third parties over how the account is managed and distributed.⁸

The Trust as Designated Beneficiary

To use a beneficiary's life expectancy for purposes of calculating RMDs, the beneficiary must qualify as a designated beneficiary.⁹ This is not problematic when individuals are specifically named as beneficiaries under the retirement account's beneficiary designation, but it becomes more complicated when a trust is named as the retirement account's beneficiary.

While the IRS typically does not consider a trust to be a true designated beneficiary,¹⁰ an exception is allowed when the trust qualifies as a "see-through" trust. The logic behind this exception is that when trusts are structured such that the IRS can essentially "see through" the trust to all of its individual beneficiaries, the beneficiaries of the trust, and not the trust itself, are considered the retirement account's true designated beneficiaries.

Ensuring "See-Through" Trust Status

There are four IRS rules with which a trust must comply to qualify as a see-through trust and allow the trust's beneficiaries to be treated as the designated beneficiaries of the retirement account.¹¹ Three of these rules are relatively straightforward: (1) the trust must be valid under state law; (2) the trust must be irrevocable as of the participant's date of death; and (3) the trustee must provide certain documents to the plan's administrator by October 31 of the year following the participant's date of death. The remaining rule requires more attention and careful drafting: (4) trust beneficiaries must be "identifiable" from the trust instrument.¹²

Beneficiaries Must Be Identifiable

The IRS regulations require that" [a] designated beneficiary need not be specified by name in the plan or by the employee to the plan in order to be a designated beneficiary so long as the individual who is to be the beneficiary is 'identifiable' under the plan. The members of a class of beneficiaries capable of expansion or contraction will be treated as being identifiable if it is possible to identify the class member with the shortest life expectancy."¹³

While this rule appears simple, it holds traps for the unwary that could cause a trust to inadvertently run afoul of this rule. Depending on the type and terms of the trust, in addition to the named beneficiaries under the beneficiary designation, certain remote or contingent beneficiaries may all need to be "identifiable." If some such beneficiaries are not identifiable, they will cause the stretch to be lost for all beneficiaries. Whether and to what extent these more remote beneficiaries need to be considered depends on the type of trust at issue—that is, whether it is an accumulation trust or a conduit trust, as discussed below.

Beneficiaries Must Be Individuals

Once the trust qualifies as see-through by complying with the above four rules, the trust's beneficiaries are considered the true designated beneficiaries of the retirement account rather than the trust itself. Implicit in the designations is a fifth rule for a trust to be able to use the life expectancies of its beneficiaries in calculating RMDs: all of the trust's beneficiaries themselves must be considered "individuals" as of the "beneficiary finalization date." [14]

Beneficiaries that do not qualify as "individuals" within the meaning of the Internal Revenue Code include charities, business entities, and estates.¹⁵ Special care should therefore be taken to ensure that no part of the distribution goes to the participant's estate, as this could cause the stretch to be lost (depending on the age of the participant). For example, having retirement account proceeds pass as directed under a will, either by failing to name specific beneficiaries under the retirement account's beneficiary designation, or by specifically directing under the beneficiary designation that proceeds be paid according to the client's will, will likely disqualify the recipients as designated beneficiaries.¹⁶ It is therefore necessary to specifically name the intended beneficiaries in the beneficiary designation instrument. As an added precaution, do not include any provisions in the client's estate plan documents allowing for such things as a decedent's debts, expenses, or final taxes to be paid from the retirement account proceeds.[^17]

Note, however, that if otherwise disqualifying designated beneficiaries of a deceased participant's retirement benefits (such as charitable or business entities) receive their share of outright distributions before September 30 of the year following the participant's death, they will not disqualify the remaining individual beneficiaries of the retirement benefits from the stretch.¹⁸

Structuring the Trust

Once the drafting attorney ensures that the qualifications for a see-through trust are met, there are...