Traditionally, many IRA accountholders designate family members as beneficiaries of their retirement accounts. Naming a beneficiary avoids the probate process and allows a seamless transfer of assets to the intended recipient without ambiguity. But for some IRA owners, and the wealth managers they work with, it might be more worthwhile to designate a trust instead.
Utilizing a trust retains many of the same benefits that come with naming an individual person as a beneficiary. However, a trust offers additional control over how and when the money within the account will be distributed after death. In this scenario, the trust assumes the role of primary beneficiary for the IRA while the intended recipients, often family members, are the beneficiaries of the trust.
Although some view establishing a trust as an extraneous and unnecessarily complex step within IRA planning, putting one to use could increase the chances of the owner’s estate plan being executed as intended.
Distributing from ‘beyond the grave’
One strong argument for assigning a trust as a beneficiary is to give IRA accountholders control over how their assets are distributed from “beyond the grave.” This could be valuable in instances where an IRA owner is concerned about their heir’s frugality and wants assurance that the funds will be preserved over time rather than spent in quickly.
Opting for a trust beneficiary can also be an effective strategy when the account owner’s spouse has children from a previous marriage. In that case, a trust helps ensure that the IRA assets remain accessible to the inheritor’s children and future generations.
Alternatively, the owner might prefer to give their current spouse access to the inherited IRA during their lifetime and then, upon the spouse’s passing, transition the remaining assets to children from a prior marriage. Trusts are an ideal vehicle for addressing these sorts of precise, individualized needs and ensuring they come to pass.Top of Form
Keeping creditors and others at bay
Enhanced asset protection is another benefit of designating a trust as the beneficiary of an IRA. Inherited IRAs are more vulnerable to creditors than regular IRAs and some other retirement assets. A trust curtails the extent to which beneficiaries are exposed to creditors. For example, inherited IRAs are not protected from creditors in bankruptcies, but irrevocable trusts usually are.
A trust can also be useful when the planned recipient of an IRA account is either a minor or an individual with special needs. Both kinds of inheritors present challenges: Minors cannot own IRAs directly and individuals with special needs who own assets in their name may jeopardize their eligibility for government benefits.
However, Secure Act 2.0, enacted last year, makes it easier to fund a special needs trust with an inherited IRA and apply the favorable stretch rule for distribution. IRA distributions can be extended over the lifetime of a special needs individual, even when the trust includes non-disabled beneficiaries. IRA accountholders looking to pass on their funds to a special needs individual through a trust should give careful consideration to ensuring the assets and account access are properly allocated to the recipient.
Different kinds of trusts
Trusts provide an opportunity to personalize and plan distributions to beneficiaries that are subject to different inherited IRA rules. The flexibility depends on the type of trust used.
See-through trusts come in two varieties: conduit or accumulation. Both trusts are appropriate avenues for owning IRAs and retirement accounts. With these vehicles, the trust document must explicitly identify the intended beneficiary.
A conduit trust, as its name implies, is designed so the inherited IRA is distributed directly to the beneficiaries in proportion to the trust document provisions. The required-minimum-distribution (RMD) rules for the IRA are based on the category of trust beneficiary.
In cases with multiple categories of beneficiaries, the least favorable RMD rules apply. When the beneficiaries of the trust are “eligible,” they’re subject to the favorable stretch distribution rules. “Non-eligible” beneficiaries are subject to the less favorable 10-year distribution rule. If the trust has both categories of beneficiaries, the less favorable 10-year rule applies.
Some financial advisors believe that the trust may create sub-trusts to partition beneficiary categories and allow eligible beneficiaries to keep the stretch. Many contend that this tactic is risky because the IRS has consistently held that when a trust is named as beneficiary, a single distribution must be applied to the entire trust, regardless of how the trust itself may be subsequently spilt. The sole exception allowing a sub-trust is when a beneficiary is disabled or chronically ill.
The other variety of see-through trusts are accumulation trusts. Inherited IRA distributions are subject to the same beneficiary category rules as the conduit trust. However, with an accumulation trust the trustee has the authority to disperse or retain inherited IRA distributions. In contrasts, IRA distributions from a conduit trust go directly to the beneficiaries. Accumulation trusts allow the trustee to schedule distributions to reduce income tax liability and control the amount of funds sent to the beneficiaries.
All other trusts fall into the non-see-through category and are generally subject to the five-year distribution rule or the life expectancy of the IRA owner if they pass away before withdrawing the required minimum distribution.
Integrating a trust into IRA planning also presents tax mitigation strategies that should be considered. For example, converting an IRA into a Roth IRA before one’s passing and leaving it to an accumulation trust could help minimize income taxes for the beneficiary.
Another approach for minimizing taxes is to authorize the beneficiary to withdraw from the trust. When a beneficiary possesses the right to invade the trust corpus and waives this right, they may be treated as the trust’s grantor. In this scenario, the IRA distribution to the trust receives the beneficiary’s individual tax treatment. It’s necessary to note that this strategy can prove risky: The distribution controls and credit protection may not be valid.
What to watch out for
Designating a trust as a beneficiary of an IRA carries inherent risks. For instance, depending on the trust type, eligible beneficiaries may be forced to forfeit their ability to make the most of the stretch rule. In addition, distributions from the inherited IRA may accumulate in the trust, potentially resulting in higher tax liabilities.
There’s also the risk that IRA distribution rules change in the future. The IRS is finalizing new RMD rules for non-eligible designated beneficiaries in 2024. As a reminder, non-eligible designated beneficiaries encompass anyone who is not a spouse, a minor child, a disabled or chronically ill individual, or a person 10 years and younger than the account owner. Trusts may fall into the category of non-eligible designated beneficiaries, and the outcome from the IRS later this year could have adverse effects on the previously available tax-planning strategies for IRAs held in trusts.
While leaving an IRA to a trust may be an effective strategy to control distributions, protect assets and help ensure the assets are inherited by the intended recipients, it’s also conditional. It’s imperative that both clients and advisors have a full estate plan and a clear understanding of what the ultimate intentions for the IRA account are before executing any fundamental changes.
Mallon FitzPatrick, CFP, is a principal and managing director at Robertson Stephens and heads the firm’s financial planning center. For more information about Mallon or Robertson Stephens, visit www.rscapital.com or email firstname.lastname@example.org. Please read important disclosures.