Debunking IRA Urban Legends

Investors in IRAs often need a reality check when it comes to these common misconceptions.

by Natalie Choate

It's time to drive a stake through the heart of some widely held but very mistaken beliefs about planning for retirement benefits.

The Myth: By leaving your IRA to a perpetual or "dynasty" trust that also qualifies as a "see-through trust" under the Internal Revenue Service's minimum distribution trust rules, you can obtain a perpetual stretch-out for your IRA, or (even better) a perpetual tax-free family investment pool with a Roth IRA.

The Reality: It's true that certain states now permit clients to establish perpetual or 1,000-year trusts. But leaving your IRA or Roth IRA to such a trust in no way lengthens the maximum payout period permitted under the Tax Code's minimum distribution rules--even if the trust does manage to qualify as a "see-through trust" under the IRS' "minimum distribution trust rules." The minimum distribution rules require that all benefits be distributed, beginning the year after the participant's death, in annual installments over the life expectancy of the designated beneficiary. The longest payout period possible under that rule is about 81 years (the life expectancy of a one-year-old beneficiary). So if the perpetual trust qualifies as a see-through, and the oldest beneficiary of the trust is a newborn baby, the payout period for the benefits will be about 81 years. The trust can last forever, but the IRA (or Roth IRA) payable to that trust cannot last beyond the life expectancy of the oldest trust beneficiary.

The Myth: We can get a perpetual stretch-out of our IRA death benefits by leaving them to an individual (say the participant's child), who at his later death leaves the account to a next-generation beneficiary (say the participant's grandchild), who at his later death leaves the account to the next younger generation (the participant's great-grandchild), and so on.

The Reality: Well, it's true that the original beneficiary can name a successor beneficiary for the account, and thus pass it on to, say, the original beneficiary's own child. And it's even true that each successor beneficiary can leave what's left of the account on such beneficiary's death to still another successor beneficiary. But no matter how many successor beneficiaries there are, the account will still have to be distributed over the life expectancy of the FIRST beneficiary--he is the original "designated beneficiary," and his life expectancy is the payout period for the inherited IRA regardless of whether he survives for that entire life expectancy or dies prematurely and passes the account on to a successor beneficiary. So you can see it is unlikely that the account will even exist past the life expectancy of the first beneficiary (because he will probably survive to his life expectancy and therefore he will withdraw 100% of the account). It is extremely unlikely that the account will exist for multiple generations--that would require that each successive generation of beneficiaries dies within the life expectancy of the original beneficiary.

The Myth: The client can leave his retirement accounts to a "conduit see-through" trust for the benefit of his surviving spouse. During the surviving spouse's overlife, the applicable distribution period will be the surviving spouse's life expectancy. When the spouse ultimately later dies, the remaining benefits can be paid to the children over the life expectancy of the oldest child.

The Reality: No they can't. When retirement benefits are paid to a trust, if the trust qualifies as a see-through trust, the applicable distribution period is the life expectancy of the oldest trust beneficiary (the surviving spouse in this example). Even if the trust is the special type of see-through trust known as a "conduit" trust, there is no way for the trust to "flip" over to using the children's life expectancies as the applicable distribution period for benefits remaining in the plan at the surviving spouse's later death. By the way, it's very unlikely there will even be anything left in the retirement plan at that point--that would happen only if the spouse did not survive for her entire life expectancy.

If you want the payout period to "flip" to the children's life expectancy at the death of the surviving spouse, there's only one way to get that result: Leave the retirement benefits outright to the surviving spouse, and she rolls them over to her own IRA. By doing that you eliminate the requirement of distributing the benefits over the spouse's life expectancy (instead, she can defer all distributions until she reaches age 70 1/2, then withdraw using the Uniform Lifetime Table, which is much more favorable than a payout over her single life expectancy). At her death, she can leave the remaining balance of the rollover IRA to the children as her designated beneficiaries. As designated beneficiaries, they will qualify for a payout over their life expectancies.

All of these myths arise out of forgetting the basic bedrock principle of the minimum distribution rules: The retirement plan account cannot stay in existence longer than the life expectancy of the original owner (the participant) and his or her designated beneficiary. The money doesn't all have to be spent; the participant and beneficiary can save and invest the distributions they receive (after paying taxes on them, of course, in the case of non-Roth accounts). But at the end of that Code-mandated payout period, all of the money must be out of the plan.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The views expressed in this article are the author's.