How To Avoid The $10,000 Mistake Caused By Naming A Trust As The Beneficiary Of A Roth IRA When Doing So Was Unwarranted

Trusts are an integral part of estate planning. But they are not always suitable beneficiaries for IRAs.

In private letter ruling (PLR) 202136004 released on September 10, 2021, the IRS explained why they allowed the surviving spouse of a Roth IRA owner to roll over a distribution from an inherited Roth IRA when the surviving spouse was not the direct beneficiary of the Roth IRA. The beneficiary of the IRA was a trust, and the surviving spouse was the sole beneficiary of the trust.

Background

The following provisions of the tax code explain the tax impact of distributions from Roth IRAs and show how a spouse beneficiary could avoid having to take distributions from an inherited Roth IRA.

Tax Treatment Of Qualified Distributions 

Earnings grow tax-deferred in a Roth IRA, and distributions are tax-free if they meet certain requirements that make them qualified distributions. An example of a qualified Roth IRA distribution is one that is taken when:

(a) it has been at least five years after the owner funds their first Roth IRA, and

(b) the Roth IRA owner is at least age 59 ½, disabled, or deceased.

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Tax Treatment Of Nonqualified Distributions 

A non-qualified Roth IRA distribution (one that does not meet the requirements to be qualified) is taxable to the extent that the distribution includes earnings. In addition, the earnings and any amount that represents Roth conversions or rollovers from employer plans are subject to a 10% additional tax (early distribution penalty) unless the account owner qualifies for an exception.

Tax Treatment Of Rollovers

Neither the income tax nor the 10% early distribution penalty applies to a distribution that is properly rolled over. One of the requirements that must be met in order for a rollover to be considered proper is that it must be completed within 60 days of receipt. Only eligible amounts are permitted to be rolled over.

Tax Reporting of Distributions and Rollovers Informs The IRS

When a distribution is made from an IRA, the IRA custodian must report the distribution on IRS Form 1099-R. Form 1099-R must be issued to the IRS and the Roth IRA owner (or beneficiary, if the distribution is taken from an inherited Roth IRA). The 1099-R must indicate whether, to the best of the IRA custodian’s knowledge, the distribution is qualified or qualify for a waiver of the 10% early distribution penalty.

A distribution that is rolled over is reported on IRS Form 5498, and the amount rolled over offsets the 1099-R. The IRS uses this information to determine whether or not a distribution that is excluded from income on the recipient’s tax return due to being rolled over was rolled over to an IRA.

Rollover Rules For Distributions From Inherited Roth IRAs

Distributions from inherited Roth IRAs are not eligible for rollover unless the distributee is the surviving spouse of the IRA owner. Where the rollover is permitted to be made for the surviving spouse, the rollover has to be made to the spouse’s own Roth IRA and not a beneficiary Roth IRA. This is because rollover contributions cannot be made to beneficiary Roth IRAs.

Required Minimum Distribution Rules For Roth IRAs

An inherited Roth IRA is subject to required minimum distributions (RMDs). The RMD options are determined by whether the beneficiary is a non-designated beneficiary (a non-person), a designated beneficiary (a person or trust that qualifies to be treated as a person), or an eligible designated beneficiary. An eligible designated beneficiary is a person who falls into at least one of the following categories:

  • Is the surviving spouse of the decedent,
  • Is the minor child of the decedent,
  • Is disabled,
  • Is chronically ill, or
  • Is not more than ten years younger than the Roth IRA owner.

The distribution options for these beneficiaries are:

  • The 5-year rule for a non-designated beneficiary, where distributions are optional until December 31 of the 5th year that follows the year in which the Roth IRA owner died, at which time the entire balance must be distributed.
  • The 10-year rule for a designated beneficiary and an eligible designated beneficiary. Under the 10-year rule, distributions are optional until December 31 of the 10th year that follows the year in which the Roth IRA owner died, at which time the entire balance must be distributed.
  • The life-expectancy option, which is available only to an eligible designated beneficiary.

RMDs do not apply to Roth IRA owners. This includes spouse beneficiaries who roll over or transfer inherited Roth IRAs to their own Roth IRAs.

Under the life- expectancy rule, distributions would be taken over the eligible designated beneficiary’s life expectancy, beginning by December 31 of the year that follows the year in which the Roth IRA owner dies. If the beneficiary is the surviving spouse of the Roth IRA owner, the deadline would be extended to December 31 of the year in which the owner would have reached age 72, if that is a later date.

Facts Of The Case As Explained In PLR 202136004

The Roth IRA owner, let’s call him John, established a trust and appointed himself and his wife, let’s call her Jackie, as trustees. 

Under the terms of the trust, Jackie had complete discretion over when to request distributions from the principal amount and was entitled to all income from the trust. When John died, Jackie became the sole trustee of the trust.

The trust was the sole beneficiary of John’s Roth IRA.

The Rulings That Were Requested In The PLR

Jackie intended to request a distribution of all of the Roth IRA balance to her as the sole beneficiary of the trust and roll over the amount to a Roth IRA in her name. The following rulings were requested on behalf of Jackie by her representative:

  1. That she is eligible to roll over the distribution from the inherited Roth IRA to a Roth IRA in her own name.
  2. That the distribution would be excluded from income due to the fact that it was rolled over
  3. That the Roth IRA would not be subject to RMDs by virtue of not being a beneficiary Roth IRA.

The IRS’s Response

The IRS approved the waiver request on the condition that the rollover was completed within the 60-day deadline, for reasons which include the fact that under the terms of the trust, Jackie, as trustee and sole beneficiary, is entitled to receive all assets held by the trust. And, for purposes of applying the rollover rules, Jackie is effectively the individual for whose benefit the Roth IRA is maintained. 

Appleby’s Commentary

It appears that in this case, naming the trust as beneficiary created avoidable costs and problems for Jackie.

If the trust qualifies to be an eligible designated beneficiary, distributions would be permitted to be made under the 10-year rule or over Jackie’s life expectancy. But, unless Jackie intended to take a full distribution of the Roth IRA balance shortly after John’s death, moving it to her own Roth IRA would be more tax-efficient as that would allow earnings to grow tax-free for as long as she was alive. Naming a trust as the beneficiary of the Roth IRA would have robbed Jackie of this opportunity if she was unable to apply for a PLR and get a favorable ruling. The issue then becomes whether naming the trust as beneficiary was the right thing to do in this case.

A trust can be an integral part of an estate planning strategy. However, careful consideration should be given as to whether a trust should be the beneficiary of an IRA, based on the IRA owner’s objectives. In cases where there would be no restriction on withdrawals and or the purpose for which the funds are used- as in Jackie’s case, it appears that a trust was an unnecessary hoop over which Jackie as the surviving spouse and beneficiary of the trust had to jump.

The IRS charges a fee of $10,000 to review a private letter ruling request. In addition, professionals who are engaged to assist with filing these PLR requests charge fees which can be costly.

The expenses, the time taken to apply for the PLR, and any angst experienced while waiting for the IRS’s ruling, as well as the extra filing that the tax preparer will have to perform, could have been avoided if Jackie had been named as the beneficiary of the Roth IRA.

It Takes A Team

The team members for an IRA should include, at a minimum, a financial advisor, an attorney, and a tax advisor. These professionals should communicate with each other to ensure that the most effective strategies are implemented for their clients’ retirement accounts. In this case, the trust was named as a beneficiary, likely with the best of intentions. Notwithstanding, at least one of the professionals involved should have known that Jackie might not have been allowed to move it to her own Roth IRA without a PLR.

While it cost Jackie over $10,000 to get the inherited Roth IRA to be rolled over to her own Roth IRA, the objective was accomplished and would be worth it if the Roth IRA balance was a significant amount. But not every beneficiary is able to afford these fees, and not every Roth IRA balance warrants the expense. As such, advisors should be cautious about advising clients to name entities as beneficiaries of their retirement accounts when the objective is for identifiable individuals to inherit the IRAs outright.

Clients who are advised to name trusts and estates as the beneficiaries of their retirement accounts must ask why; and whether the objective could be met by naming their ultimate beneficiaries as the direct beneficiaries instead of having them inherit the amounts indirectly through trusts or estates.

Reminder: A PLR is directed only to the taxpayer requesting it and may not be used or cited as precedent. Therefore, individuals who are facing similar challenges will need to get their own PLRs.

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