Trusts can make an inherited IRA last longer. They can control how an IRA is invested after you’re gone and when distributions are made to beneficiaries. Unfortunately, the tax law throws some obstacles in your way. Standard trusts and IRAs don’t mix. To reap the benefits of combining an IRA with a trust, you and your estate planner need to work carefully.
A trust is for someone who wants the beneficiary to have a “stretch IRA” that will last a long time, perhaps funding the beneficiary’s retirement. But the beneficiary might not be able to resist spending the account quickly. Perhaps the beneficiary has poor financial acumen, is a spendthrift, or has special needs. Or perhaps the beneficiary is having marital problems, gambles, or abuses substances.
The IRA is one of your most valuable assets, so you want it spent and invested well, even after you’re gone. It’s part of your legacy.
With other assets, you simply leave them to a trust instead of directly to a loved one. You can do that with an IRA, if you jump through all the hoops.
When the trust isn’t written to comply with complicated IRS regulations, the trust won’t qualify as a Designated Beneficiary. Then, required distributions are accelerated. If the original owner of the IRA had not 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. When a trust meets the IRA requirements, RMDs can be spread over the beneficiary’s life expectancy.
Your estate planner is responsible for making the trust meet IRS requirements. What you need to know is standard trust language could disqualify the trust. 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.
Each year the trustee withdraws from the IRA the required minimum distribution, and then the amount is distributed from the trust to the beneficiary. This prevents the beneficiary from withdrawing more from the trust than the RMD. The trustee can be given discretion to take more than the minimum when he deems it appropriate. This is known as a conduit trust.
The required distributions are based on the life expectancy of the oldest beneficiary of the trust. If the beneficiary is relatively young, the distributions will be low. They could even be less than the annual returns of the IRA, allowing the IRA to increase for years despite the distributions.
When you have children of different ages, you might want to create a separate trust for each of them or split your IRA into separate IRAs. That allows the required distributions to be determined by each child’s age.
The tax law makes it expensive for the trustee to accumulate the RMDs in the trust. A trust is taxed on income it does not distribute to beneficiaries. Trusts have compressed income tax brackets, reaching the top tax bracket when the income is around $11,000. So, taxes often are lower when the annual distribution is taxed to the beneficiary.
You might not want the trustee to distribute the RMD when the beneficiary has a substance abuse problem, will squander the money, or could lose it to creditors or a divorcing spouse. To protect against these cases, some estate planners recommend you write a conduit trust with a toggle switch. The toggle switch is an option for the trustee to decide, between the original owner’s death and September 30 of the following year, to change the trust from a conduit trust to a protective one that limits distributions made to the beneficiary. The IRS approved such a trust in 2005.
An alternative to naming a trust as an IRA beneficiary is to establish a trusteed IRA. This is much simpler. Most IRAs are custodial IRAs, but the tax law also allows trusteed IRAs. The taxes are the same as under a custodial IRA, but the firm sponsoring the trusteed IRA acts as trustee, holding title to the assets for the benefit of the owner and beneficiaries.
The IRA owner, instead of simply filing out an application, completes a trust agreement that incorporates many of the benefits of a trust. The agreement can include language limiting the beneficiaries’ access to the money and giving the trustee some discretion to decide when to distribute assets. The owner also can name successor beneficiaries, and the trustee can make management and distribution decisions if the owner becomes disabled.
Very few firms offer trusteed IRAs. There are higher costs and more legal liability than custodial IRAs. Trusteed IRAs also have higher fees than custodial IRAs, though they might not be as expensive as drafting a trust agreement for a custodial IRA and paying a trustee. If you can find a trusteed IRA sponsor you are happy with, consider using that as an alternative to the custodial IRA with a trust as the beneficiary.
Another option is to empty your IRA early, pay all the taxes, and then leave the money to a regular trust. I discussed this in past visits (available on the web site) and in my book, The New Rules of Retirement. Or you can use the IRA to make the charitable contributions in your will and leave other assets to your heirs.
A trust as IRA beneficiary can bring you a step closer to achieving estate planning goals. It can ensure that most of your IRA wealth 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 October 2012.
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