Traditionally, many individuals with IRA accounts choose to name their family members as beneficiaries, thus sidestepping the probate process and facilitating a seamless transfer of assets to their intended heirs. Nevertheless, for certain IRA owners and the wealth managers who assist them, designating a trust as the beneficiary might be a more advantageous option.
Employing a trust preserves many of the same advantages associated with designating an individual as a beneficiary. However, a trust offers greater control over the timing and manner in which the funds within the account are distributed following the account holder's passing. In this arrangement, the trust assumes the primary beneficiary role for the IRA, while the intended recipients, often family members, become beneficiaries of the trust.
Although some view the establishment of a trust as an unnecessary and overly complex step in IRA planning, its utilization could enhance the likelihood of the owner's estate plan being carried out as intended.
Facilitating Posthumous Asset Distribution
One compelling rationale for designating a trust as the beneficiary is to grant IRA account holders influence over the distribution of their assets "from beyond the grave." This proves valuable in situations where an IRA owner is concerned about their heirs' financial responsibility and desires assurance that the funds will be preserved over time rather than spent hastily.
Opting for a trust as the beneficiary can also be an effective strategy when the account owner's spouse has children from a prior marriage. In such cases, a trust helps guarantee that the IRA assets remain accessible to the inheritor's children and future generations.
Alternatively, the owner may prefer to grant their current spouse access to the inherited IRA during their lifetime and, upon the spouse's passing, transfer the remaining assets to their children from a previous marriage. Trusts offer an ideal mechanism for addressing these specific, personalized needs and ensuring they are realized.
Shielding Assets from Creditors
Enhanced asset protection is another advantage of designating a trust as the beneficiary of an IRA. Inherited IRAs are more susceptible to creditors compared to regular IRAs and some other retirement assets. A trust limits the extent to which beneficiaries are exposed to creditors. For example, inherited IRAs are not safeguarded from creditors in bankruptcy, but irrevocable trusts generally are.
A trust can also prove beneficial when the intended recipient of an IRA account is a minor or an individual with special needs. Both categories of beneficiaries pose challenges: minors cannot directly own IRAs, and individuals with special needs holding assets in their name may jeopardize their eligibility for government benefits.
However, Secure Act 2.0, enacted recently, simplifies the funding of a special needs trust with an inherited IRA and allows the favorable stretch rule for distribution. This enables IRA distributions to be spread over the lifetime of the special needs individual, even when the trust includes non-disabled beneficiaries. IRA account holders looking to pass on their funds to a special needs individual via a trust should carefully consider the proper allocation of assets and account access to the recipient.
Diverse Types of Trusts
Trusts offer the opportunity to customize and plan distributions to beneficiaries who are subject to different inherited IRA rules, depending on the type of trust employed.
See-through trusts come in two varieties: conduit and accumulation. Both types are suitable for owning IRAs and retirement accounts, with the requirement that the trust document clearly identifies the intended beneficiary.
A conduit trust, as its name implies, is designed to directly distribute the inherited IRA to the beneficiaries in accordance with the trust document's provisions. The required minimum distribution (RMD) rules for the IRA are determined based on the category of trust beneficiary.
In cases involving multiple beneficiary categories, the least favorable RMD rules apply. When trust beneficiaries are "eligible," they are subject to the favorable stretch distribution rules. "Non-eligible" beneficiaries are subject to the less favorable 10-year distribution rule. If the trust includes both categories of beneficiaries, the less favorable 10-year rule applies.
Some financial advisors believe that creating sub-trusts within the trust to separate beneficiary categories can allow eligible beneficiaries to maintain the stretch. However, this strategy is considered risky since the IRS has consistently held that when a trust is named as the beneficiary, a single distribution rule must be applied to the entire trust, regardless of subsequent division. An exception permitting sub-trusts is made when a beneficiary is disabled or chronically ill.
The other variety of see-through trusts is accumulation trusts. Inherited IRA distributions follow the same beneficiary category rules as conduit trusts. However, with an accumulation trust, the trustee has the authority to distribute or retain inherited IRA distributions. In contrast, distributions from a conduit trust go directly to the beneficiaries. Accumulation trusts enable the trustee to schedule distributions to reduce income tax liability and control the amount of funds sent to the beneficiaries.
Non-see-through trusts fall into a different category and are typically subject to either the five-year distribution rule or the life expectancy of the IRA owner if they pass away before taking the required minimum distribution.
Incorporating a trust into IRA planning also offers opportunities for tax mitigation that should be taken into account. For instance, converting an IRA into a Roth IRA before the account holder's passing and leaving it to an accumulation trust could help minimize income taxes for the beneficiary.
Another tax-saving strategy involves authorizing the beneficiary to withdraw from the trust. If a beneficiary possesses the right to access the trust's assets and waives this right, they may be considered the trust's grantor. In this situation, the IRA distribution to the trust is subject to the beneficiary's individual tax treatment. It's important to note that this strategy carries certain risks, as the distribution controls and creditor protection may not be valid.
Points of Caution
Selecting a trust as the beneficiary of an IRA carries inherent risks. Depending on the type of trust, eligible beneficiaries may lose their ability to leverage the stretch rule. Additionally, distributions from the inherited IRA may accumulate within the trust, potentially resulting in higher tax liabilities.
There is also the risk that IRA distribution rules may change in the future. The IRS is finalizing new required minimum distribution (RMD) rules for non-eligible designated beneficiaries in 2024. 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 IRS's decision later this year could have adverse effects on previously available tax-planning strategies for IRAs held in trusts.
While designating a trust as the beneficiary of an IRA can be an effective strategy for controlling distributions, protecting assets, and ensuring that assets are inherited by the intended recipients, it comes with conditions. It is imperative that clients have a comprehensive estate plan and a clear understanding of the ultimate intentions for the IRA account before implementing any significant changes.