The Trust as a beneficiary
I listened to Ed’s 1-hour webinar where he talked about setting up a trust as a beneficiary for your retirement accounts.
As I understood from the webinar:
1. You should set up a trust as a beneficiary for control purposes, not tax purposes.
2. The distributions from the IRA retirement account will be distributed to the trust.
3. The question is: (1) Does the trustee distribute the distributions to the beneficiaries; or (2) does the trustee keep the distributions and accumulate the distributions within the trust.
4. If the trustee distributes the RMD to the beneficiaries of the trust in the year the RMD is received, this works. The trust won’t owe or pay taxes on these distributions. The beneficiaries will report the distributions from the trust on line 15A of their 1040 and pay the appropriate tax. The net impact–the same as if a trust was not the intermediary between the RMD and the beneficiary.
5. If the trust includes language enabling the trustee to accumulate the RMD, this can be a tax problem. If the trust does not distribute the RMD to the trust beneficaries the year the RMD is received, the trust must report the RMD as income and pay the appropriate taxes. Trust taxes are generally higher than taxes individuals pay, reducing the value of the distribution.
6. A question: If the trustee pays the taxes but accumulates the after-tax RMD, then what happens? If interest is earned on the accumulated after-tax RMD, does the trust report this as income and pay taxes in future years? When the trustee eventually distributes the distribution (and any earnings) to the trust beneficiaries, how do the beneficiaries treat the distribution from the trust? Do they report it as an IRA distribution on line 15a of their 1040 tax return. If not, how does the beneficiary report the distribution from the trust? Is there any credit for the taxes the trust has already paid?
7. Another question: If the account is converted to a Roth, Ed implied the trust tax issue disappear. The trust doesn’t have to report the distributions from the Roth as income because the distributions are tax-free. ??? What happens if the Roth RMD is accumulated in the trust? Does the trust report and pay taxes on interest earned. When the trust eventually distributes the RMD and earnings– are the trust distributions reported on line 15a of the beneficiary 1040 tax return? If not, how does a beneficiary of the trust receive the Roth distribution tax-free when a trust is named as the beneficiary.
thanks
kathy
Thanks.
Permalink Submitted by Bruce Steiner on Mon, 2010-08-16 03:41
1. Partially correct. A trust as beneficiary may save taxes as well. If you leave your IRA to a child in trust rather than outright, the trust will not be included in the child’s estate. Also, since each state has its own rules on when it taxes a trust, it is often possible to set up a trust so that it will not be subject to state income tax in any state.
2. Correct.
3. Except in the case of a marital (QTIP) trust where the spouse receives all of the income of the trust, the trustees can (and in almost all cases should) have discretion to distribute the income and principal, or to accumulate the income. In that way, the trustees can do what they think best from year to year, taking into account all of the facts and circumstances, including income taxes.
4. Correct. If the trustees distribute the income (including, for this purpose, the distributions from the IRA, even though some of it may be considered principal), then the income will be taxable to the beneficiaries rather than to the trust.
5. Somewhat correct. Except in a marital (QTIP) trust where the spouse receives all of the income (though not necessarily the portion of the IRA distributions treated as principal), it’s almost always preferable to give the trustees discretion to distribute the income and principal, or to accumulate the income. If, after considering all of the facts and circumstances, including income taxes, the trustees think it best to distribute the income (including, for this purpose, the distributions from the IRA), they can do so, in which case the tax will be payable by the beneficiaries. But if some other factor outweighs the income tax rates (such as creditor protection or keeping the assets out of the beneficiaries’ estates), the trustees will have the flexibility to accumulate some or all of the IRA distributions or other income (and pay the tax at the trust level, though often at higher rates).
6. If the trust accumulates some or all of the distributions from the IRA, and earns investment income, then in future years the trust can either distribute the investment income (in which case it will be taxed to the beneficiaries) or accumulate it (in which case it will be taxed to the trust). This is done on a year-by-year basis.
7. One of the benefits of the Roth conversion is that (with rare exceptions) distributions from the Roth IRA are not subject to income tax. The Roth conversion is particularly attractive to IRA owners who want to provide for their children in trust rather than outright. If the trust accumulates distributions from the Roth IRA and earns investment income, then each year the investment income is taxed to the beneficiaries if distributed, or to the trust if not distributed. Accumulated distributions from the Roth keep their tax-free character. The first first money distributed is the taxable money.
For more on trusts as beneficiaries of retirement benefits, see my article on this subject in the March 2004 issue of BNA Tax Management’s Estates, Gifts & Trusts Journal: http://www.kkwc.com/docs/AR20041209132954.pdf.
Finally, if this involves planning for a particular case, you should consult with the lawyer who handles your estate planning, or other competent tax/estates counsel, who can give you specific advice based on your particular situation and your objectives.
Permalink Submitted by kathleen Lane on Mon, 2010-08-16 04:03
When the trust distributes the assets in the trust to the trust beneficiaries–is this distribution reported as an IRA distribution on line 15a of the beneficiary 1040 tax return?
If not….how does a trust provide tax fee income to the beneficiary of a Roth IRA?
If not…does this mean regular IRA distributions are not reported on line 15a….which means the distributions from a retirement account are now included as part of their AGI/MAGI?
I read your answer…but still am not clear how having a trust in the middle impacts how the RMD gets taxed/treated on the ultimate beneficiary income tax form when a trust receives and distributes the RMD
?
thanks
kathy
Permalink Submitted by Bruce Steiner on Mon, 2010-08-16 15:03
If the trust distributes what it receives, it may not make any difference. But the trust might accumulate some of the money it receives from the IRA (if keeping it out of the child’s estate or protecting it against potential creditors, including spouses, if the trustees think it’s worth the additional income tax cost). Or, if it’s a trust for a child, the trust might make distributions to the child’s children.
Permalink Submitted by kathleen Lane on Mon, 2010-08-16 16:06
My question is:
Step 1. the trust receives the RMD.
Step 2. at some point, the trust distributes the RMD to the trust beneficiaries
???How do the beneficiaries report the distribution from the trust on their tax return?
???Does the beneficiary report the trust distribution on line 15a of their 1040 tax return..i.e., they report the trust distribution as an IRA distribution.
>>>Or, is the trust distribution reported someplace else on the 1040.
??? Is the reporting of the distribution by the trust beneficiary different if the RMD received by the trust is from a Roth IRA?
Is the reporting of the distribution by the trust beneficiary different if the trust immediately distributes the RMD….or accumulates and then distributes?
thanks
kathy
Permalink Submitted by Bruce Steiner on Mon, 2010-08-16 16:15
With some exceptions not relevant here, distributions from a Roth IRA are not taxable.
Income taxation of estates and trusts can be complicated, so if this is an actual case you or your tax preparer should consult with competent tax/estates counsel. But the following, though simplified, may be helpful.
Distributions from a trust carry out ordinary income to the extent of the trust’s income in that year. For example, if a trust earns $1,000 a year and distributes $500 in year 1 and $2,000 in year 2, in year 1 the beneficiary is taxable on $500 and the trust is taxable on $500, and in year 2 the beneficiary is taxable on $1,000 and the trust is taxable on nothing. Capital gains are generally taxable to the trust but can sometimes be passed through to the beneficiaries.
Permalink Submitted by mk foss on Mon, 2010-08-16 16:58
I think Kathy is looking for actual form numbers etc to see this trust scenario through.
Let’s say our trust receives the RMD in August 2010. There may be some 2010 expenses, tax preparation fees, trustee fees etc. Assume the net income is distributed to the beneficiary. The distribution is reported on Schedule K-1 to the beneficiary as ordinary income. When the beneficiary prepares his/her income tax return, the distribution will be reported on page 2 schedule E as ordinary income from a trust or estate. That amount will transfer to page 1 of Form 1040. No one looking at the Form 1040 would know if the distribution was from an IRA or not.
Now let’s assume that in year one not all of the RMD was distributed and the amount retained was invested. In year two the trust will have another RMD and also some interest income. If everything is distributed to the beneficiary, he/she gets a Schedule K-1. The interest income is reported on one line, the RMD on another – both figures will be net of trust expenses. On Form 1040, the beneficary will have income reported on Schedule B and on Schedule E, page 2.
Permalink Submitted by kathleen Lane on Mon, 2010-08-16 17:57
Thanks for the last answer.
So..this is how it would work:
Step 1. The trust is the beneficiary of a Roth IRA.
Step 2. The RMD the trust receives is not reported as income—making it a tax-free distribution to the trust.
step 3. The trust distributes the RMD to the beneficiary–and reports the distribution on the K-1.
step 4. The trust beneficiary reports the K-1 on his tax return….the beneficiary pays whatever taxes are due.
The benefits of the tax-free income from a Roth retirement goes to the trust…not to the beneficiary of the trust.
If this is true…..is there any way to set up an IRA trust so the tax-free income from a Roth retirement account can be realized by the beneficiary of the trust….not the trust.
thanks Kathy
Permalink Submitted by mk foss on Mon, 2010-08-16 21:11
When a trust is the beneficiary of a Roth IRA – RMDs are still due but are nontaxable. The trust would report them as income but subtract the tax-free portion (all of it). If the trust requires that income be distributed to beneficiaries, the tax – free income is also distributed. It would be shown on the Schedule K-1 but the beneficiary would not need to enter it on their personal return. They would just enjoy the tax-free income. If the trust does not provide for distributions to the beneficiary – it would accumulate the Roth RMDs – reinvest them and report the income from the reinvestments. What happens to that income again depends on the trust agreement.
Permalink Submitted by kathleen Lane on Mon, 2010-08-16 22:21
When the trust is the beneficiary of a traditional IRA….does the trust beneficiary report the K-1 income on line 15A of his or tax return and report the distribution from the trust it as an IRA distributions?
thanks
Permalink Submitted by mk foss on Mon, 2010-08-16 23:06
The trust beneficiary does not use line 15a. The reporting to the beneficiary on Schedule K-1 does not distinguish between IRA distributions and other kinds of ordinary income – like a state tax refund for example. Trust income is reported on Sch B, Sch D or Sch E depending on how it is coded on Schedule K-1.