Should a Trust be an IRA Beneficiary?
Most owners of IRA accounts name a beneficiary or beneficiaries to receive the assets upon the death of the IRA owner. But much like the passing of other assets to heirs, IRA owners may be concerned about how the ultimate heirs will handle a potential lump sum of taxable money distributed directly to the heir or heirs upon the IRA owner’s death. Should a trust be an IRA beneficiary?
What is an IRA owner trying to accomplish by naming a trust as the IRA beneficiary?
A trust can be a useful planning tool, and I would argue it is a reasonable decision for persons who wish to direct or control how heirs are to receive assets once the owner of the assets passes away. Most “fill in the blank” beneficiary arrangements do not provide any direction or control over assets once they are distributed to the heirs. The IRA owner passes away, and the beneficiary(ies) have full access and control of the account. Proper language in a trust agreement may provide what the account owner was looking for from a control and direction perspective.
When a trust is named the beneficiary of an IRA, the trust typically receives the IRA proceeds upon the IRA owner’s death. The IRA is then a separate trust asset and should be held as a separate account. We will discuss later whether it is the trust, or the beneficiaries who will pay tax on the IRA proceeds.
What can the IRA owner accomplish by naming a trust as the IRA beneficiary?
- Controlling receipt of the IRA proceeds by the beneficiary(ies). A potential beneficiary could be a minor child who can’t own an IRA until he or she reaches the majority’s age in his state.
- Control over receipt of IRA assets by a special needs beneficiary. Naming a trust as the beneficiary makes the trust the legal owner of the IRA (and therefore, by extension, puts the fiduciary of the trust in control). A special needs beneficiary may not be capable of managing assets on his own. The individual may be receiving need-based government benefits, which could put the assistance at risk if assets are in the name of the special needs beneficiary.
- Second marriage or blended family issues. The IRA owner may wish for benefits (proceeds) to be paid to their current spouse during the spouse’s lifetime and then have any remaining IRA assets pass to their own children or heirs, not from the current marriage. Suppose the IRA owner leaves the IRA directly to their spouse. In that case, the spouse is in complete control of the IRA, and there can be no assurance any assets will remain for other beneficiaries. When a trust is named the beneficiary, the IRA owner’s multiple beneficiary goals can be addressed.
- Controlling how much a beneficiary receives. IRA beneficiaries are often shown as taking only what is required from an IRA (RMDs). Still, a named individual who inherits an IRA can do whatever he wants, including closing out the entire account. With the trust as the owner, only the terms of the trust dictate how funds are to be distributed.
- Naming additional beneficiaries. Much the same as the second marriage or blended family issue, when an original beneficiary inherits an IRA, that beneficiary takes control of the assets and can designate whomever they wish as subsequent beneficiaries. These may not be the same persons as the original IRA owner intended. Having the trust as the IRA’s beneficiary will permit the original IRA account owner to name the beneficiaries for the entire disposition of the IRA account.
- Protection from creditors. IRAs do have a level of protection from creditors, but this is not always true for inherited IRA accounts. With a trust as the beneficiary of the IRA account instead of named beneficiaries, there should be some level of creditor protection for the beneficiaries. The IRA assets belong to the trust, not to the beneficiaries.
When the SECURE Act was passed in December of 2019, RMDs were impacted significantly, especially regarding so-called “stretch” IRA RMD arrangements. For most beneficiaries, the SECURE Act now requires IRA assets to be distributed within ten years after the year the IRA owner died. There is no requirement for annual distributions, as long as the full amount is distributed by the end of the tenth year.
These new rules don’t apply to certain classes of beneficiaries known as Eligible Designated Beneficiaries:
- The IRA owner’s surviving spouse,
- The IRA owner’s minor children,
- Chronically ill or disabled persons, and
- Any person who is not more than ten years younger than the owner of the IRA.
The stretch IRA option is still available for these eligible designated beneficiaries.
There are still RMD rules for Trusts as IRA beneficiaries.
RMDs for a trust IRA beneficiary will be calculated under either the stretch payout rule (if the named beneficiaries are eligible designated beneficiaries), the 10-year rule, or the 5-year rule, depending on the wording of the trust and who are the beneficiaries of the trust.
It matters whether the trust is a see-through trust (meaning the beneficiaries are named persons), whether the trust is a conduit or an accumulation trust, and whether the trust beneficiaries are non-individuals, regular beneficiaries, or part of the eligible designated beneficiaries.
Which RMD rule applies is somewhat difficult to determine, and there are provisions of the SECURE Act that will need IRS interpretation and regulations.
A person wanting to name a trust as the IRA beneficiary needs to confirm why they want the trust to be the beneficiary and to make certain the terms of the trust can be met, or perhaps will the RMD rules invalidate what the IRA owner was trying to accomplish.
RMD payout rules are different than the distribution rules spelled out in the trust. Even if an IRA must payout under the 5-year rule to a trust/IRA beneficiary, it does not mean the IRA assets will be end up in the hands of the trust beneficiaries within the same time frame. The terms of the trust will decide when distributions to trust beneficiaries will apply. Therefore, the trust may end up paying tax because of the RMD rule but still retain the assets because of the trust language.
The good news is that when the trust makes a distribution to the beneficiaries per the trust language, it will be tax-free money because the trust already paid the tax.
RMD rules for Common Types of Trusts When the Trust is the IRA Beneficiary
- See-Through Trusts. The trust must be considered valid under state law; the trust arrangement must become irrevocable upon the IRA owner’s death, and, most importantly, the ultimate beneficiaries must be readily identifiable, eligible, or named. If it is a conduit trust, the trust distributes the assets to the beneficiaries when received by the trust. Eligible designated beneficiaries can then choose a stretch option if desired. If not an eligible designated beneficiary, then all distributions must be completed by the end of the tenth year after the original IRA owner’s death. The assets are going to pass directly through the trust and the beneficiaries will pay the tax. In my opinion, the conduit trust seems to provide little difference from just naming direct beneficiaries of the IRA and not bother with establishing a trust. Conversely, if the see-through trust document calls for IRA assets to be accumulated by the trust, the trust follows the non-eligible designated beneficiary rules. It must take all distributions from the IRA by the end of the tenth year after the IRA owner’s death. The trust pays the tax, and the terms of the trust determine when distributions are paid out to the identifiable beneficiaries.
- Other types of trusts as IRA beneficiaries. If the beneficiaries are not readily identifiable, the trust is not a see-through trust. If the IRA owner died before reaching age 72, the trust must receive all distributions (and pay tax) within five years after the owner’s death. If the IRA owner was age 72 or older, then the trust can receive RMD payouts based on the life expectancy of the now deceased IRA owner or use the five-year rule. The terms of the trust will drive ultimate distributions to beneficiaries and likely will constitute tax-free monies since the trust already paid the tax.
I have often stated that, in my opinion, persons establish trusts because they have an agenda they are trying to address once they have left this world. Naming a trust as an IRA beneficiary may not be the most practical way from a tax standpoint to structure the payouts after death. Still, the tax cost may pale in comparison to the IRA owner’s desire to direct and control who and how the IRA assets are ultimately disbursed.
by Tom O’Saben, EA