IRA: In a Trust or Not?
Hi, it’s your Money Mavens with a quick question…
You’ve heard about creating a trust, right?
You’re also familiar with retirement accounts like an IRA, Roth IRA, 401(k), 403(b). In fact, you likely have one or more of these accounts. (If not, that’s worth exploring, but we can chat about that later.)
When you pass out of this life and onto that Tropical Beach in the Great Beyond with a drink of choice, wide-brimmed hat, and perfect 82-degree temperatures, because that all sounds heavenly, what happens with your retirement accounts?
Each of these accounts should list at least one beneficiary – some accounts actually require you to list a beneficiary before you can open your account.
After your passing, funds in the retirement account transfer to the beneficiary listed.
But, what if instead of listing a person (or persons) as your beneficiary, you wanted to list another entity?
A family trust, as an example.
“Whoa! That’s an option?”
Yes, naming a trust as your IRA beneficiary is an option. The trust becomes the owner of the IRA and the IRA is an asset of the trust.
There are benefits to making that designation, but it can also create some unique challenges and tax implications.
Why would you want to name a trust as your IRA beneficiary?
The main reason a trust is named as a beneficiary is for you, the account owner, to maintain control over how the money is handled.
How do you want your hard-earned money distributed and used?
In a not-spooky-actually-cool sort of way, having a trust listed as your beneficiary allows you to continue controlling your money even after you die.
There are a few situations we typically see where account owners designate trusts as their IRA beneficiaries:
- You don’t want the beneficiary to have access to withdraw all the money in a lump sum. This can be avoided by naming a trust as the beneficiary and having the instructions in the trust distribute the funds over a period of time.
- You want the money to be used in a specific way or for a certain purpose by your beneficiary(ies). By naming a trust, the funds can be directed to pay for college or care for a minor.
- You are in a second marriage and you want to ensure your children from a previous marriage receive a certain amount of funds.
Whatever reason you’re considering, we highly recommend connecting with an estate planning attorney to ensure you’re making the best possible decision in line with your financial goals.
What are the pros and cons of naming a trust as your IRA beneficiary?
There are several pros and cons for designating a trust as your IRA beneficiary.
- More control of how and when the funds are dispersed
- You name the trustee (vs. the courts naming a custodian “person over age of majority”) to be in control of the funds until your child(ren) is of age.
- Reduces exposure to creditors
Although there are many situations where it is to your advantage to name a trust as your IRA beneficiary, the tax implications can be significant:
- Your spouse loses their ability to do a spousal rollover. If a trust is named as your primary beneficiary (instead of your spouse), your spouse can no longer benefit from the IRS Spousal Inheritance Provisions.
- Some trusts are subject to accelerated withdrawal requirements. In most cases, the funds must be fully withdrawn from the IRA within five years from your death. (This doesn’t necessarily mean that the funds are distributed to the beneficiaries of the Trust at that time. They can be deposited into an investment account titled to the Trust.) Depending on the size of the account, this can be quite a tax burden on your beneficiaries.
- Trust income tax rates reach the top tax bracket much faster than individual taxpayers. In 2022, a trust is at the top tax bracket of 37% when undistributed taxable income is $13,450. Conversely, an individual beneficiary wouldn’t reach that tax bracket until their income is $539,900 for singles and $647,850 for married filing jointly.
- The wording in the trust document, whether the trust beneficiaries are people or entities, and the ages of the beneficiaries lead to different rules on when and how the required minimum distribution payouts are calculated.
I have a Trust, should I have it reviewed before naming it a beneficiary of my retirement account?
Yes, absolutely, yes.
The rules for inheriting IRAs changed in 2020. So if your trust document was drafted before 2020, it would be wise to have it reviewed by an Estate Planning attorney to make sure that the proper wording is included if you want to name the Trust as a beneficiary of your retirement account.
Below are some key Trust terms and potential tax implications:
- Conduit Trusts (also called See-Through Trusts), which allowed the distributions to be made based upon inherited IRA RMDs and taxed at the recipient’s income tax bracket are no longer valid. Inherited IRA account owners are required to distribute the funds in 10 years, so some trusts with Conduit Trust language only allow the funds to be distributed in the 10th year, which can mean a HUGE tax bill in one year.
- Discretionary Trusts require that all or a substantial portion of retirement account distributions remain IN the trust. In this case, the funds are subject to trust tax rates, which are significantly higher.
Is it better for you to name a trust as your IRA beneficiary?
If you are using a trust as your beneficiary in your IRA, we recommend making sure your trust has specific terms such as “pass-through” and “designated beneficiary” to gain the maximum stretch option for the distribution of the account.
Work closely with an estate planning attorney and accountant to weigh all the factors of your specific situation to maximize your legacy.
To your prosperity,
Your HWM Money Mavens