The primary purpose of IRAs is to provide for the retirement needs of the original owner. However, IRAs have also become a useful tool in estate planning, and many IRA owners look for ways to protect their assets for future generations. Naming an irrevocable trust as a beneficiary of an IRA can provide that protection, but if you don't structure the trust correctly, it can come at a high cost.

IRAs and see-through trust status
How the trust will get taxed as an IRA beneficiary is the prime consideration in setting up the arrangement. Ordinarily, trusts would not be eligible to take advantage of so-called stretch-IRA provisions that allow some beneficiaries to take small distributions throughout their lifetimes. Instead, the trusts would have to take out all IRA money within the first five years, accelerating taxation and potentially creating a larger tax bill.

However, there is a way to get preferential tax treatment for an IRA beneficiary trust. If the trust qualifies for see-through status, then the rules governing inherited IRA distributions will disregard the trust as a separate entity and instead use the life expectancy of the trust's beneficiary to calculate minimum required distributions. Therefore, there's a huge tax incentive to structure the trust in a way that will qualify for see-through treatment.

Requirements for a see-through IRA beneficiary trust
In order to be treated as a see-through trust, a trust must be irrevocable as of the date of death of the owner of the IRA. The trust must also be validly formed under appropriate state law.

However, the toughest provision involves identifying the trust's beneficiaries. According to the tax laws and regulations, the IRS must be able to figure out exactly who the beneficiaries of the trust are. Once it does so, it can then assess whether those individuals are able to be what the IRS calls designated beneficiaries who can qualify for preferential tax status. It only takes one beneficiary who can't be ascertained as a designated beneficiary to disqualify the entire trust, so it's important in drafting the trust not to make mistakes about beneficiaries. If there are multiple beneficiaries, the oldest one's life expectancy will be used to determine required minimum distributions.

Finally, the financial institution that is acting as custodian of the inherited IRA must receive a copy of appropriate documentation of the trust arrangement and the designated beneficiaries. This must be done by Oct. 31 of the year following the year of the original IRA owner's death.

Using a trust as an IRA beneficiary adds a layer of complexity to estate planning, but it also builds in some extra protection. Just make sure you follow the rules in order to avoid what could be an unintended bad tax result. For more on the ins and outs of investing in IRAs, the Fool's IRA Center will help you figure out everything you need to know.

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