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Avoid the New Pitfalls of Naming Trusts as IRA Beneficiaries After the SECURE Act

Last update on: Jun 22 2020

IRA estate planning was revolutionized by the Setting Every Community Up for Retirement Enhancement (SECURE) Act. Few discussions so far have focused on the major changes made for situations in which a trust is the IRA beneficiary.

There are good reasons to name a trust as an IRA beneficiary. But the SECURE Act changed the results. A plan with a trust as IRA beneficiary must be reviewed and updated or the results will be much different than what was intended and what they would have been before the SECURE Act.

Naming a trust instead of individuals as the IRA beneficiary can provide several benefits.

Of course, the trust prevents the money from being mismanaged or misspent by a beneficiary who is young, immature, or financially imprudent. The trust also can protect the IRA assets from creditors of the beneficiaries. The protection can extend to divorce, bankruptcy, garnishment and other actions. The extent of the protection depends on federal and state laws.

A trust also can prevent beneficiaries from spending the money too quickly or unwisely.

Some people want their IRA surpluses to help the beneficiaries with specific future spending, such as their own retirements, educating their children, or other expenses. Others want to ensure the IRA is spent gradually over a period of time instead of in a short spending splurge soon after the IRA is inherited. Naming a trust as beneficiary helps achieve those goals.

The basic set up is to name the trust as the IRA beneficiary, and then name the individuals you want to benefit from the IRA as the beneficiaries of the trust. The trustee controls the IRA investments and distributions. Those distributions from the IRA go to the trust. The trustee invests the distributions and, in turn, distributes money to the trust beneficiaries as directed by the trust agreement and the tax code.Before the SECURE Act, when a trust was the beneficiary of an IRA, the IRA had to be distributed and taxed within five years after the original owner died unless the trust met specific tests that  qualified it as a “see-through trust.”

Standard trusts didn’t qualify, and many heirs paid too much in taxes too quickly because the wrong type of trust was named the IRA beneficiary.The see-through trust rules still apply after the SECURE Act. The terms are technical. As an individual planning an estate, you don’t need to know the details. You only need to be assured that the estate planner is aware of the see-through trust rules and that any trust you name as an IRA beneficiary qualifies. Within the see-through trust rules, there are two types of trusts for you to consider naming as IRA beneficiaries.

One type is the conduit trust. This trust has only one beneficiary. The trust agreement provides that all distributions from the IRA to the trust must, in turn, be distributed to the trust beneficiary.

The trustee can decide whether to take distributions from the IRA that exceed the required minimum distributions (RMDs), and the trustee decides how the IRA is invested. But whatever distributions are taken from the IRA must be promptly distributed to the trust beneficiary. An advantage of a conduit trust is that the trust isn’t taxed on distributions. Under the tax law, the trust beneficiary is treated as receiving the IRA distributions and is taxed on them.

This can reduce income taxes, because a trust reaches the top tax bracket at a much lower income level than an individual. The problem with conduit trusts after the SECURE Act is the IRA might have to be fully distributed to the beneficiary long before the original IRA owner would like.Under the SECURE Act, when a conduit trust is the beneficiary, the IRA must be distributed in most cases within 10 years after the IRA owner died. The main exceptions are when the trust beneficiary is the surviving spouse, a minor, or a disabled or chronically ill individual.

Suppose a conduit trust is named as a beneficiary when the trust beneficiary is a minor. In that case, annual RMDs based on the beneficiary’s age are required as long as the beneficiary is a minor. Once the beneficiary reaches the age of majority (18 in most states), the entire IRA must be distributed to the beneficiary within the next 10 years. When the conduit trust beneficiary already is the age of majority or older at the time the original IRA owner passes away, then the entire IRA must be distributed within the next 10 years. The conduit trust provides the protections of a trust only for up to 10 years after the beneficiary reaches the age of majority.

For many people looking to the protection of a trust as IRA beneficiary, that isn’t long enough. They’ll need to seek an alternative.The alternative is the accumulation trust. As the name implies, the accumulation trust doesn’t automatically dis-tribute all IRA distributions to the trust beneficiary. The trustee can accumulate distributions within the trust.

The trustee invests the accumulated distributions and, in turn, distributes them to trust beneficiaries under the terms of the trust agreement.The IRA must be fully distributed to the trust within 10 years after the IRA owner passes away. But the money can be retained in the trust for whatever period is stated in the trust agreement.

Accumulation trusts currently are more complicated for estate planners to draft, and the IRS regulations have more potential pitfalls. That might change somewhat once the IRS updates the regulations for the SECURE Act, but we don’t know yet.The big disadvantage of naming an accumulation trust as an IRA beneficiary is the tax brackets. A trust reaches the top tax bracket much sooner than an individual. In 2020, taxable income of $12,950 puts a trust in the top tax bracket. The accumulation trust can be an expensive way to receive the non-tax benefits of having a trust as IRA beneficiary.

One alternative is to have a trust with multiple beneficiaries and give the trustee broad discretion to determine how annual distributions are dispersed among them. The trustee could assess the tax rates of the trust and the beneficiaries each year, as well as make distributions that will minimize the overall tax burden while achieving the other goals of the trust.

That strategy will not work in a lot of situations, can be difficult to implement and, over time, could result in uneven after-tax results for the beneficiaries.Another alternative to either type of trust is to look at long-term strategies other than naming a trust as the IRA beneficiary. These strategies generally involve distributing the IRA early, paying the taxes and putting the after-tax proceeds in a more tax-efficient vehicle.

Consider the five strategies discussed in our March and April 2020 issues.

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