Here’s a question I get at least once a week: “I’m dealing with a trust that holds an inherited IRA. Can the trustee transfer that IRA out to the individual beneficiary(ies) of the trust?” The unspoken part of the question is, “....without triggering an income tax?”
The simple answer is yes, in most cases a trustee can transfer an inherited IRA out of the trust to the trust beneficiary or beneficiaries without any negative tax consequences. Of course (surprise!) there are many qualifications, limitations, ifs, ands, and buts around that simple answer.
Here is the long path to the short answer.
1. Does the trustee have the authority to make this transfer? Before we get into the tax considerations and mechanics involved in transferring an IRA, we first have to be sure the trustee has the right to transfer any assets to the beneficiary.
For example, if the trust says “When my child reaches age 30, the trustee shall terminate the trust and distribute all assets to such child,” and the child has reached age 30, the trustee clearly is required to transfer the remaining trust assets, including the IRA, to the child. In my experience, this is how the question usually comes up--it's time to terminate the trust (or a particular beneficiary’s subtrust) and the trustee needs to get the trust assets over to the beneficiary.
In contrast, if the trust says “Pay all income of the trust to my spouse, and pay to my spouse principal if needed for my spouse’s health and support,” it is unlikely that transferring the IRA to the spouse can be justified as distribution of income or principal needed for the spouse’s health or support. If those are the trustee’s only authorizations to make distributions to the spouse, then the transfer is not allowed.
The trustee cannot transfer an IRA out of the trust just because the trustee thinks such a transfer would be a good tax idea, or would make the trust administration easier, if the trust instrument does not authorize distributions for those reasons.
Finally, the trust or applicable state law must authorize distributions of assets to beneficiaries “in kind,” meaning the trustee is authorized to transfer the asset itself to the beneficiary; some trusts and/or state laws require all distributions to beneficiaries to be in cash.
2. Is the transfer in fulfilment of a "pecuniary" or a "residuary" bequest? A "pecuniary" gift or bequest is one of a specific sum of money either stated as such in the trust instrument ("Pay $100,000 to my niece") or determined by a formula in the instrument ("Pay my spouse the smallest dollar amount required as a marital deduction to eliminate federal estate tax on my estate"). In contrast, a residuary (or percentage or fractional--same meaning) bequest is not a specific dollar amount--it is a percentage or fraction of what's left in the trust after paying out the pecuniary gifts. For example, with "Pay $100 to my nephew and everything else to my uncle," the $100 is a pecuniary bequest and the "everything else" is residuary. With "Pay 20% of the trust to my spouse and the rest in equal shares to my surviving children," all the gifts to the spouse and children are residuary.
The IRS’ position is that transferring an IRA in fulfillment of a pecuniary bequest is treated as a sale of the IRA.
Result: The IRA ceases to be an IRA and is 100% income taxable to the trust that is making the transfer (deemed sale). Transferring an IRA in fulfilment of a residuary bequest does not have this effect: It results in no increase or decrease in the trust’s income and does not constitute taxable income to the beneficiary. Obviously you want to avoid transferring an IRA in fulfilment of a pecuniary bequest if possible.
3. How do you effect this transfer? Assuming the trustee has determined that it is possible, and desirable, to make a transfer, here is how to do it.
The beneficiary to whom the account is being transferred opens an “inherited IRA” with the same or a different IRA provider. The new account is titled “[Beneficiary’s Name], as beneficiary of [Decedent’s Name]” or “[Decedent’s Name], for benefit of (fbo) [Beneficiary’s Name].” The trustee then directs the IRA provider where the account is currently held to transfer the IRA’s assets, via IRA-to-IRA transfer (also called “plan-to-plan transfer” or “trustee-to-trustee transfer”), directly into the newly opened “inherited IRA” created by the beneficiary. In requesting the IRA provider to make this transfer, the trustee should remind the applicable IRA providers that (per instructions for IRS Forms 1099-R and 5498) this transfer is not a “distribution” from the transferor account, is not a contribution to the transferee account, and is not a reportable transaction at all for tax purposes.
4. If this is permitted, why does the IRA provider say we can't do it? Confusing matters further, major IRA providers have come to widely different conclusions regarding the permissibility of these transfers. Legal authority for such transfers is found in the statute and a Revenue Ruling (partly by the absence of contrary authority there). There have been several dozen private letter rulings, or PLRs, blessing these transfers. Accordingly, some IRA providers permit the transfers routinely, based on their reading of the law, and even help walk the fiduciary through all the necessary steps.
But since the statute and Revenue Ruling do not specifically deal with exactly this type of transfer, and since PLRs cannot be cited as "legal authority," some IRA providers have concluded that there is no authority for the transfers. These "nonbeliever" IRA providers cite the innumerable PLRs blessing such transfers, not as evidence that these transfers are permissible, but rather as evidence that you need to get your own PLR to do such a transfer!
These providers apparently believe (incorrectly) that the purpose of a PLR is to grant the taxpayer an exemption or exception from the tax rules. But a PLR cannot give anyone a personal exception to a tax rule. Rather, the function of a PLR is to confirm how a universally applicable rule applies to a particular case. Nevertheless, unfortunately, some IRA providers require the fiduciary to get its own PLR and/or legal opinion, and may even require indemnification agreements from the fiduciary and trust beneficiaries, before allowing a transfer. Since obtaining a PLR is expensive and time consuming, the fiduciary may find it easier to simply transfer the account (still in the name of the trust) to a more cooperative IRA provider.
5. Can an estate do this, too? An estate can do such a transfer as well. The rules and considerations are the same as for a trust.
6. Can other types of retirement plans be transferred? In my opinion, other types of plans also can be transferred by a trustee to carry out the terms of the trust.
For example, if the trust is terminating, and it holds an inherited 401(k) plan that still has several years left on its payout period, I believe the trustee can transfer the 401(k) account out to the trust beneficiary. However, it is rare or unheard of to find a plan administrator who would agree with my conclusion. You cannot do the transfer if the plan won’t permit it, and (unlike with IRAs) you do not have the option of transferring the account to a more cooperative plan administrator. So in the real world the answer to this is, “probably not.”
7. Anything else I need to know? Final reminder: In a small number of cases, transferring an IRA out of an estate or trust shortly after the participant's death can improve post-death payout options (for example by enabling a spousal rollover or "eliminating" nonindividual beneficiaries). However, generally such a transfer does not change the "applicable distribution period" for computing required minimum distributions from the IRA.
For example, suppose Father dies at age 65 leaving his IRA is payable to his estate, and the decedent’s daughter is the executor and sole beneficiary of the estate. Can she as executor transfer the IRA to herself as estate beneficiary? Yes she can--see questions #1 and #6 above.
But will that transfer mean that she is now the “designated beneficiary” of the IRA, entitled to take RMDs over 10 years following father’s death?
No it will not. At the time of father’s death, his estate was the beneficiary of the IRA and an estate is not a “designated beneficiary.” That “non-DB” status cannot be changed by transferring the IRA out of the estate, so unfortunately daughter is stuck with the five-year rule as the payout period for father’s IRA.