Trusts as IRA Beneficiaries: Reaping the Benefits, Avoiding the Pitfalls

There are many good reasons to name a trust as an IRA beneficiary. But there also are some hazards to avoid.

Trusts can make an Inherited IRA last longer. Through the trust terms and appointment of the trustee, you control how much money is distributed to the trust beneficiaries. For example, the trust can retain money until beneficiaries are a minimum age, make distributions only for specific purposes, or make minimum distributions for years to ensure the bulk of the money is available for the beneficiaries’ retirements, grandchildren’s education, or some other future need.

A trust as beneficiary can reduce investment risk. Your trustee controls the IRA. The trustee can invest the IRA or select an investment advisor, instead of beneficiaries who might not know much about investing.

A trust also ensures the ultimate beneficiaries of the IRA are those you wanted. As we discussed in the April 2017 issue, without a trust the IRA custodian or your beneficiary might determine who inherits the IRA after your initial beneficiary passes away.

There also is creditor protection when an IRA beneficiary is a trust instead of an 4 May 2017 Bob Carlson’s RETIREMENT WATCH individual. That can be helpful when your intended beneficiary is at high risk of being sued, likes to gamble, or has a substance abuse problem. An inherited IRA also might be grabbed by a spouse in a divorce, which a trust can stymie.

In short, there are a lot of good reasons to consider naming a trust as an IRA beneficiary instead of one or more individuals. But there’s also a catch: IRS regulations. They make it difficult and even dangerous to name a trust as IRA beneficiary.

You give care and thought to naming the IRA beneficiary, because you want to maximize the tax deferral. In other words, you want a Stretch IRA that lasts for years or decades.

When a trust is the IRA beneficiary, a Stretch IRA is possible only for a certain type of trust. When you name the wrong type of trust as beneficiary, then required minimum distributions (RMDs) from the IRA 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 the original owner was using. But when a trust meets the IRS requirements, RMDs can be spread over the beneficiary’s life expectancy.

Because of the IRS regulations, many estate planners discouraged people from naming trusts as IRA beneficiaries. They believed the potential benefits weren’t enough to offset the potential problems with the IRS regulations. But after the Supreme Court ruled that an inherited IRA isn’t protected from creditors under federal bankruptcy law, many planners started to look more favorably at trusts as IRA beneficiaries.

The most common forms of estate planning trusts don’t qualify for tax deferral.

deferral. In general, to have the Stretch IRA and other benefits, your beneficiary must be a “see-through” trust, also called a lookthrough or conduit trust. That means all of the actual and potential beneficiaries of the trust must be individuals. Charities, other trusts, partnerships, and the like as even potential beneficiaries sometime in the distant future will disqualify the trust under the IRS regulations. There are other technical rules, but the see-through trust requirement is the main one that trips up people who try to use standard trusts and estate planning strategies with their IRAs.

You need to know that a standard trust could disqualify the trust and be sure you have an estate planner who is fluent in the IRS regulations. Your estate planner is responsible for making sure the trust meets IRS requirements and for working with your IRA custodian to ensure there won’t be problems after you pass away.

After your passing, RMDs are required from the IRA 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.

The trust prevents a beneficiary from draining the IRA quickly. Each year, the trustee withdraws from the IRA the required minimum distribution. What happens then depends on what you put in the trust agreement. The trustee might distribute the RMD amount to the trust beneficiary (or beneficiaries), or the RMD might be accumulated in the trust. The trustee also can take more than the RMD from the IRA and either accumulate it in the trust or distribute it. It all depends on the discretion and instructions you give the trustee.

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 with different beneficiaries. That allows the RMDs 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 $12,500. So, taxes often are lower when IRA distributions are taxed to the beneficiary.

A simpler alternative to naming a trust as an IRA beneficiary is to establish a trusteed IRA. 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. 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. You also don’t get to name an individual 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.

A trust as IRA beneficiary can bring you a step closer to achieving estate planning goals. But it does cost more to set up and has other pitfalls. Consider the pitfalls and the alternatives before making your choice.