Using a Trust as an IRA Beneficiary: Does it Make Sense?
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.
