One of the more common estate planning mistakes we have seen over the years is the use of a trust as a beneficiary of an IRA account. This is not to say that such a strategy never makes sense. However, it rarely does make sense for most investors.
A trust can serve several purposes depending on the type of trust that is drafted. A revocable trust exists to avoid probate and simplify the settling of an estate privately outside of the surrogate court. Whereas an irrevocable trust can serve many purposes, including credit protection, minimizing estate taxes, Medicaid planning and various other strategies.
When listing an individual as a beneficiary on an IRA, you already avoid probate as the assets pass directly to the beneficiary via a beneficiary IRA, also sometimes called an inherited IRA. However, IRAs inherited by a non-spouse are required to follow distribution rules that we have outlined in previous articles that typically require assets to be liquidated over a 10-year period. More information on these rules can be found here:
In the case of a traditional IRA, these distributions are taxable events. When an individual person is listed as the beneficiary, a beneficiary IRA is created on their behalf, and they realize the income directly, which is taxed at their own ordinary income tax rates. However, when a trust realizes the income, the situation often becomes unnecessarily much more complicated.
Remember that when a person creates and funds a trust, also known as the grantor, the trust becomes irrevocable upon their death, even if it was drafted as a revocable trust. If that trust is named as the beneficiary, it doesn’t matter if the trust names an individual or group of people as the ultimate trust beneficiary. The inherited IRA must be opened in the name of the trust, not the individual. In doing so, this means that an extra step is taken, along with possible negative tax consequences.
When a trust receives income, the income is taxed at trust tax rates, which are greatly accelerated to the highest marginal tax rate. This means that the money that is distributed will often be taxed at much higher rates than they otherwise would have before the money was contributed into the retirement account years earlier. The only way to avoid this is for the trust to then distribute the money to the named individual beneficiaries in the trust, and then issue each of them a K-1 form so they can realize the income at their individual tax rate. Then the trust must use that K-1 as a deduction against the income it received from the IRA to avoid the income at trust tax rates. All of this must be done annually until the distribution of the IRA is completed at the end of the 10- year period. This creates a lot of extra work to get the money to the same people that could have been listed directly on the IRA beneficiary form and would have received the money directly.
It’s also important to point out that while a trust still may not make sense as an IRA beneficiary, when it’s a ROTH IRA, the tax impact of the distribution is irrelevant, as the ROTH distribution is tax free no matter who is the beneficiary.
Does this mean that under no circumstances should a trust be listed as a beneficiary? Not necessarily. Some trusts are designed to be a conduit trust, which simply means that the trustee distributes the assets directly to the beneficiary, and then the trust is effectively closed out. While other trusts are accumulation trusts and continue to be used after the death of the grantor that funded it.
Unfortunately, many families have extenuating circumstances with some of their beneficiaries that might be a reasonable reason to limit their access to the money that was left to them. What if a beneficiary had a drug addiction, or a gambling problem, or possibly just a spendthrift that was irresponsible with handling money. In such cases it may make sense to have the trust receive the assets and name a trustee that will limit distributions to the beneficiary even after all of the IRA funds have been distributed to the trust. While any funds the trust receives from the IRA that are not distributed to the individual beneficiaries will be taxed at trust tax rates, the tax bill may be worth the cost to avoid placing the funds in the hands of someone that may be inclined to squander the money in ways that the grantor doesn’t approve of and would like to prevent.
Other scenarios in which a trust may be named as the beneficiary could be a special needs trust. Special needs trusts are created for individuals that suffer from various physical or mental disabilities and qualify for government benefits. The money held in the trust does not impact their benefits, whereas funds in their name directly may impact their benefits. If someone with such a disability were the beneficiary of an IRA, the use of such a trust may make sense.
However, in our experience most of the time when a healthy competent individual is the ultimate beneficiary, the use of a trust as an IRA beneficiary creates more problems than it solves. Yet often times an attorney may suggest that you list your trust as the beneficiary of your IRA. Why is that?
Well, with all due respect to attorneys, our view of wealth management is that it entails investment planning, tax planning, insurance planning, estate planning, and any area that may impact an individual’s financial life. In most cases, each professional has a high degree of expertise in their area, but not necessarily in the areas that are outside of their lane. Not all attorneys are experts in the IRA distribution rules and what the tax impact would be. As a result, it is crucial that the various professionals you work with in each area of expertise communicate with each other about your personal goals. A good financial planner will help organize a strategy to identify needs in the various categories referenced and help facilitate communication with each professional.
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The home purchase is one of the biggest investments the average American will make. Real estate can be expensive and comes with carrying costs to maintain a property. However, many real estate investors over the years have invested in secondary properties for either personal use, such as a vacation home, or solely as an investment property. In many cases, these investors have seen significant price appreciation in these properties. When it comes to selling a piece of real estate, the tax code is different between your primary residence and a secondary property.
Primary Residence
When selling your home, the calculation as to whether or not you owe taxes is based on the capital gain, after you exclude the first $250,000 per person ($500,000 for a couple). Imagine you paid $200,000 some years ago for your home, and yet today it sells for $1,000,000. In order to determine your tax liability, you first need to figure out what you spent on the home in capital improvements, such as new windows, new roof, new driveway, or kitchen and bathroom renovations. These are common examples of what homeowners spend money on to improve and maintain their home. Those costs get added to the original purchase price, and then you have an additional $250,000 per person exemption. As an example, the tax calculation for a married couple would look like this:
$200,000 – Purchase price
+$200,000 – Possible capital improvements
+$500,000 – Exclusion for a joint filer
=$900,000 – Total amount excluded from capital gains tax.
If the property sells for $1,000,000 – $900,000 exemption = a taxable amount of $100,000 subject to capital gains.
Secondary Property
When selling a property that is not your primary residence, you can still add in your capital improvements to the cost, However, there is no $250,000/$500,000 exemption. One of the other ways to reduce the cost is by applying capital losses against your real estate gains. As an example, if you lost money on a stock trade, that loss can reduce the amount of gain on the sale dollar for dollar. But what can you do if you don’t have any capital losses to use, and you still have a big taxable gain on the sale of the property?
Under the tax code there is an option known as a 1031 exchange that permits the transfer of one property into another property via a qualified intermediary without realizing a capital gain and continuing to defer the tax liability. The timing of the exchange is a challenge, as an investor has only 45 days to identify the next property and 180 days to close on the new property. Unfortunately, the IRS rules on direct 1031 exchanges have become more stringent and difficult to execute in a timely manner.
One of the other options is something called a Delaware Statutory Trust (DST). The DST was created in the late 1980’s as a special business trust to create a legally secure and clearly defined trust entity that establishes legal separation between the trust and its beneficiaries. Since the DST is a separate legal entity from its beneficiaries, creditors cannot seize or possess any assets held under trust.
DSTs are typically formed by real estate companies called sponsors, who purchase real estate assets that are placed under trust using their own funds. The DST sponsors then engage a registered broker-dealer to offer fractional shares of the trust, and individual investors purchase fractional shares of the DST. This process is another form of a 1031 exchange. However, as the individual investor, you are not required to seek out one or more properties on your own, as they are already part of what is typically a diversified real estate portfolio.
A DST may hold a series of properties related to commercial office buildings, multifamily apartment complexes, retail centers, industrial facilities, self-storage facilities, data centers or even medical facilities.
Once assets have been exchanged into the DST the investor has successfully deferred the tax liability on the gain and will now receive an income from the DST monthly that is typically in the area of 5%-9%. This income is representative of the investors’ proportionate share of the cash flow generated by the properties held in the DST after expenses. The capital gain is deferred until the investor chooses to sell the DST position, at which time they would incur the gain, as well as any gain on the property held in the DST. If the investor passes away while still invested in the DST, the assets receive the traditional step-up in basis, as with most other investments, and their heirs pay no taxes on the gains.
DSTs do not file a tax return as a trust, so as a result the investor receives their annual income at ordinary income tax rates as opposed to trust tax rates, which are less favorable.
The major benefits of the DST are:
Tax deferral
Cash flow
Instant real estate diversification
Passive approach to real estate investing
The potential drawbacks of the DST are:
There is limited liquidity
The real estate in the trust can still decline in value
Minimum investment to access
A DST may be a good option for investors sitting in a sizeable real estate position with significant capital gains. If you are concerned with generating a cash flow from the sale, don’t want to pay the taxes, and have no need for liquidity from the principal, a DST can be a possible option.
It’s important to understand that a DST is managed much like any other private Real Estate Investment Trust. As a result, it’s important to have a reputable sponsor with a successful track record of selecting and managing properties.
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In the decade ending in 2021, the Russell Growth 1000 Index doubled the performance of the Russell 1000 Value Index. That partially reversed in 2022 when the Russell Value outperformed the Russell Growth by 22%. Then in 2023, the Russell Growth index once again outperformed the Russell Value Index by 23%, negating the outperformance of the value index in 2022. This unusually large divergence has made growth versus value a popular discussion topic.
In 1934 Benjamin Graham, a British born financial analyst wrote “Security Analysis”. Graham is often thought of as the founder of value investing, as well as laying the groundwork for index funds. Graham suggested paying such a low price for a stock that if you were only partially correct you weren’t likely to lose much money. He believed a business value was closely tied to book value, which was a relatively stable number. However, stocks generally correlate more to earnings than book value, making them more volatile. Graham believed that investors could purchase depressed shares when earnings were low and then wait for better times when the price would climb back to book value. Essentially, value investing is simply buying at a discount.
Graham once said, “The intelligent investor is a realist who sells to optimists and buys from pessimists.”
Growth investors often pay little attention to book value, instead looking for growing earnings. Companies with above-average earnings growth tend to sell at high price-to-book ratios. Investors often think of value investing as cheap stocks that didn’t grow very much, and growth stocks as high-growth businesses that were very expensive. Growth investors believe they owned “exciting” businesses poised to outperform the market, while value investors expect to outperform because their “boring” stocks usually made more money.
The chart above provided by Dimensional Fund Advisors demonstrates that since 1927 value investing has outperformed growth by about 4.4% annually. However, this isn’t true in recent history.
What we can see from this chart is that since 2014, growth investing has dominated value investing as we referenced earlier. However, investing is typically counterintuitive to the instincts of the average investor. The greatest opportunity is usually found in that which has been out of favor. We are very much of the belief that there is always a reversion to the statistical mean. Whether or not we are about to see that reversion now is unknown. If there is a reversion, and value investing once again is the more favorable place to be, how long will it last? The reality is that nobody can time this with any degree of precision anymore than we can time markets in general. What we do believe is that rather than trying to pick the precise time to change a portfolio, an equal degree of exposure to both value and growth is the more ideal approach.
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