Trusts are a key part of many estate plans. You can run into trouble, however, when you try to couple a trust and an IRA. You can use a trust to make your IRA last longer and control your heirs’ access to it, but you need an experienced estate planner to navigate the minefield of tax rules.
IRA custodians report that most beneficiaries withdraw inherited IRAs within a few years after inheriting them. That’s often not what their parents expected or wanted. They wanted to create “stretch IRAs” that would last for many years, even to help fund the beneficiaries’ retirements. IRAs often are the most significant assets held by parents, so they hope to create a legacy with them. Most parents don’t mind if the IRAs are spent wisely to improve their loved ones lives. They are concerned, however, that an inherited IRA might be considered “free money” and spent frivolously and quickly or even end up with an ex-spouse or with creditors. Of course, some parents worry that their children just don’t know how to invest the money well.
The classic way to avoid these outcomes is to leave the asset to a trust instead of directly to the children or grandchildren. You can name a trust (or several trusts) as the beneficiary of your IRA.
This is where it gets tricky. When the trust isn’t written to comply with complicated IRS regulations, the trust won’t qualify as a Designated Beneficiary. When the trust doesn’t qualify as a Designated Beneficiary, required distributions are accelerated. If the original owner of the IRA had not already begun required minimum distributions, the entire IRA must be distributed within five years. If RMDs already began, then the distributions continue on the schedule established by the owner.
I won’t go into details of what a trust needs to meet IRS regulations, because they’re detailed and technical. What you need to know is some standard trust language could disqualify the trust, and that’s why you need an experienced estate planner. 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.
After the owner’s death, required distributions must be taken from the IRA and paid to the 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.
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, unless the trustee is given to discretion to do so and decides a higher distribution is appropriate. This is known as a conduit trust.
The tax law discourages having the trustee accumulate the RMDs in the trust instead of distributing them to the beneficiary. 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 the following September 30, 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.
I’ve heard that the IRS rules on trusts as retirement account beneficiaries are so complicated and narrow that some estate planners won’t draft them or at least don’t recommend using them. Some people don’t want to incur the extra costs of drafting the trusts and paying the trustee.
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. They involve more overhead and 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 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 June 2011.