Trusts find their way into more and more estate plans, because they provide valuable benefits. Many people want to use trusts with their IRAs. I receive an increasing number of inquiries from readers asking how they can name a trust as beneficiary of their IRAs instead of individual heirs. That’s where they can get into big trouble.
Trusts can provide many estate planning benefits. They can ensure assets aren’t squandered through poor investments. A trust can prevent money from being distributed to beneficiaries who are too young to spend it wisely or when you want it accumulated for their future. A trust can ensure the wealth provides for your spouse and also that it goes to your children instead of the children from another marriage of your spouse. There can be other benefits.
The problem is the tax law makes it difficult to combine trusts with IRAs. In most cases, IRS regs provide that when a trust is an IRA beneficiary, the IRA must be distributed rapidly. If the original IRA owner hadn’t begun required minimum distributions, the entire IRA must be distributed within five years. If RMDs already began, then the distributions continue on the same schedule. The potential for a stretch IRA that lasts for decades over a young beneficiary’s life expectancy is gone.
You might be able to avoid this result by having a trust that’s written to comply with complicated IRS regulations. When you jump through all the hoops, the required distributions are spread over the oldest trust beneficiary’s life expectancy, and you have the benefits of a trust. The distributions go from the IRA to the trust. Then, the trustee and the terms of the trust determine when distributions are made to the individual beneficiaries. Once a proper trust is drafted and named beneficiary of the IRA, the estate executor and trustee must file paperwork with the IRA custodian by September 30 of the year following the year of the owner’s death, listing the trust as the designated beneficiary.
In general, to receive the good results a “see through” or conduit trust must be the IRA beneficiary. All of the actual and potential beneficiaries of the trust must be individuals. Chari-ties, other trusts, partnerships, and the like will disqualify the trust under the IRS regs. There are other technical rules that must be complied with, but that is the main one that trips up people who try to use standard trusts and estate planning strategies with their IRAs.
Another risk of naming a trust as an IRA beneficiary is high tax rates. Normally a goal of having a trust as an IRA beneficiary is for the trust to accumulate money for a future distribution to the trust beneficiaries. But trusts jump into the highest tax bracket at much lower income than other taxpayers, between $11,000 and $12,000 of income.
Because of the narrow rules and the potential problems, it is best not to use a trust with an IRA unless you believe it is essential to protect the assets. Even then, consider if there are ways to arrange your plan so that assets other than an IRA can be left in trust for those beneficiaries.
When you believe naming a trust as IRA beneficiary is essential, be sure to work with an estate planner who is well-versed with the rules or who will consult with someone who is. Even many experienced estate planners aren’t comfortable drafting trusts to meet the IRS’s rules. Keep in mind that because of the compliance issues, it will cost more money name a trust as an IRA beneficiary.
An alternative is the trusteed IRA. Most IRAs are known as custodied IRAs. But the tax law allows an alternative in which the financial firm sponsoring the IRA is a trustee, and these generally are called trusteed IRAs. A trusteed IRA has many of the benefits of naming a trust as an IRA beneficiary.
An advantage of the trusteed IRA is that, while it is more expensive than a custodied IRA, it is less expensive than setting up a trust as beneficiary of a custodied IRA. You also have a trust agreement that’s standardized and more likely to have passed muster with the IRS.
To open the trusteed IRA you complete a trust agreement provided by the firm that is trustee. The agreement can include language limiting the beneficiaries’ access to the money and giving the trustee some discretion to decide when to distribute assets. You also can name successor beneficiaries, and the trustee can make management and distribution decisions if the owner becomes disabled.
There are limits to trusteed IRAs. Each financial firm has a standard trust agreement that gives you options but not as many as when you draft your own trust. The trustee probably is the financial services firm, not someone you select. The investment options might be limited, and the trustee probably won’t accept discretion in adjusting distributions the way a trustee you selected might.
Many large financial services firms offer trusteed IRAs but often only through private banking or wealth management divisions. U.S. Bank, for example, offers a trusteed IRA through its Wealth Management Group and recommends them only when the IRA is worth $2 million or more. Other firms that offer trusteed IRAs include LPL Financial, Bank of America Merrill Lynch, KeyCorp, and USAA Federal Savings Bank.
When you name a trust as IRA beneficiary and the trust is for more than one child, consider creating a separate trust for each child or split your IRA into separate IRAs. That allows the required distributions to be determined by each child’s age instead of using the oldest child for all the distributions. Also, if only one child is the reason for needing a trust, you can set up a trust only for that IRA and not put the other IRA assets at risk of failing the IRS’s tests.
Another option is to empty your IRA early, pay all the taxes, and then leave the money to a regular trust. It’s definitely more expensive in the short run, but you can put the assets in a trust without worrying about the IRS regs.
Combining an IRA with a trust can bring you a step closer to achieving estate planning goals. It can ensure that most of your IRA wealth goes to whom you want and is preserved until your heirs are older, perhaps until their retirement. But it does cost more to set up and has other pitfalls. Consider the pitfalls and the alternatives before making your choice.
RW June 2014.