What are Benefits of Using a Trust, Instead of a Person as IRA Beneficiary?

The question is simple. The answer is not. This is an area where you’ll need to rely on a very experienced professional, since the rules for using a trust as an IRA beneficiary are extremely complex.

In the right situation, and when handled with great proficiency, there can be advantages to naming a trust instead of an individual as a beneficiary of an IRA. However, before putting what may well be your largest asset at risk, make sure that the person who is helping you is well-educated and up-to-date on the latest tax laws. A mistake here could leave your heirs with an unexpectedly large tax bill.

Investment News’ recent article on this subject asks, “Should you name a trust as an IRA beneficiary?” The article explains that individual retirement account assets can't be put into trusts directly during a person’s lifetime without destroying the IRA's tax deferred structure. Therefore, a trust may only be named as the beneficiary of the IRA. The trust would inherit the IRA upon the owner’s death, and beneficiaries of that trust would have access to the funds.

Asset protection is the main rationale for making this move because trusts shield IRA assets from lawsuits, business failures, divorce, and creditors. Taxpayers enjoy state and federal protections for IRA assets during their lifetime. However, heirs who inherit an IRA directly—not through a trust—don’t receive those protections unless provided by state law. Trusts also allow for some control over the assets. The terms of a trust can stipulate the way in which distributions are made if an heir is a minor, disabled, financially unreliable, incapacitated or vulnerable.

Naming a trust as an IRA beneficiary may not be practical for people who plan to bequeath their IRA to a spouse, rather than their children, grandchildren or others. Spouses are allowed roll over the decedent's IRA assets into their own IRA tax-free.

There are many technical rules to follow, like the IRA beneficiary form must indicate before a person’s death, that the trust is the primary beneficiary. After death, the IRA must be retitled as an inherited IRA. Required minimum distributions (RMDs) would still also be required to be taken by the IRA beneficiaries following the principal's death, regardless of whether the principal was taking RMDs or not. This is an area where using the right type of trust is important. A "see-through" or "look-through" trust may be the best bet.

Structuring a trust as a "see-through" or "look-through" Trust maintains preferential tax treatment, by allowing a trust beneficiary to spread the RMDs over a long period based on his life expectancy. This is called a “stretch IRA.” The RMD amount would be based on the oldest beneficiary of the trust. However, beneficiaries with separate trust shares would have different RMDs.

In addition, the trust's language must also state that distributions from the IRA can only go to "designated beneficiaries," not to pay expenses. The risk of not creating the trust as a see-through or including the proper trust language is that the IRA assets are distributed and the resulting tax paid within a much shorter time frame—potentially five years.

Trusts may also be set up as "conduit" or "accumulations" trusts.  As was already mentioned with  a conduit trust, the annual RMDs pass through the trust to beneficiaries, who pay tax at their individual rates. Accumulation trusts don't distribute the RMDs out of the trust and pay tax at the more punitive trust tax rates. However, they keep the most post-death control over assets.

Taking this approach may require the input from several of your advisors. Speak with your estate planning attorney, CPA, and financial advisor to gather information from three independent sources to ensure that the IRA and heirs are protected.

At the Soto Law Firm we can help you make the best decision for your family based on your goals and asset values.  Contact us today to schedule a free consultation to discuss your estate plan and retirement accounts.

Reference: Investment News (February 22, 2019) “Should you name a trust as an IRA beneficiary?”