Most people think that when they write a will or a trust, those documents will cover how all of their assets are going to be distributed. However, accounts like your IRA are the exception to the rule. These accounts have their own beneficiary forms that ultimately determine how IRA assets are distributed after death.
People often think, “Not a problem. I’ll just name my trust as the beneficiary of the IRA.” After all, they spent good money to have the trust so it must be the best choice, right?
Not so fast. Like anything else in life, you’ll want to weigh the below pros and cons before you decide to make your trust the beneficiary of your IRA.
Main Takeaways
- You have the ability to name your trust as the primary or contingent beneficiary of your IRA.
- Trusts can be a good choice for your beneficiary when you have minor children, a spendthrift spouse, or if asset protection is important to you.
- Naming a trust as your beneficiary can cause unwanted taxes, unfavorable inherited IRA distributions, and untimely restrictions for your spouse and children.
Three Pros of Naming Your Trust as an IRA Beneficiary
1. Planning for Minor Children
Young, wealthy parents can have an estate planning conundrum if they have both a tremendous amount of wealth and young children. A trust can allow parents to safely place their assets aside for children below the age of 18 and ensure that they will be there when the children come of age. I’ve even seen parents structure access to those funds over a period of time, such as giving them a 1/3rd at 25, 30, and 35.
2. Planning for a Spendthrift Spouse
A trust can be useful if you want to ensure that some of your estate will go to your children even if your spouse has bad spending habits. You can even appoint a third-party trustee (e.g. trusted friend or attorney) to help manage the decision-making when it comes to distributions. This can help balance things to allow your spouse to live comfortably without burning through your entire estate within a few years.
3. Protection from Creditors
This is not applicable to all individuals, but extremely beneficial to those who might need it. Certain trusts can be structured in a way that helps protect your beneficiaries and your wealth from creditors or lawsuits. This could be useful to consider for those in high-profile or high-risk jobs, such as a doctor.
Three Considerations Against Having a Trust as an IRA Beneficiary
1. Taxes
While naming a trust can increase your control over assets after death, it can create a significant tax problem for those who do not plan properly. Unless trusts are structured correctly and income is annually distributed to the beneficiaries, income left in the trust will be taxed at the trust tax rate. This reaches the highest tax bracket much more quickly than individual tax brackets.
2. Inherited IRA Distributions
Today, most individual beneficiaries get 10 years to distribute the assets out of an inherited IRA (with exceptions). However, leaving assets to a trust could trigger unfavorable distribution rules. If a trust does not qualify as a “see-through” trust, you may only get 5 years to distribute the assets out of the trust.
Even if it does qualify, you may have to use the oldest beneficiaries age to calculate yearly distributions over the 10-year period. In both cases, you are accelerating taxable income which may cost the beneficiaries dearly in tax dollars.
3. Overly Restrictive Trusts
Let’s use the same example in Pro #1 where you drafted a trust to ensure that your children receive 1/3rd of your wealth at age 25, 30, and 35. This was drafted when they were in high school and you passed away during their college years. You felt that you could fully trust them by the time they hit college but you never changed your trust document to give them earlier access to the trust.
At age 25, your son would have liked to start a business and you would have given him the funds to do so, but unfortunately, you’re no longer here and the trust document indicates that he will have to wait another five years to get the next 1/3rd of your estate. You can see here that sometimes reasonable restrictions can become more harmful than helpful.
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What Steps to Take Next?
This decision ultimately comes down to one thing: priorities. It’s important that you are honest with yourself about the importance of control over your assets versus how much that may cost your family in trust administration or taxes.
A trusted advisor can be a good source to talk this through, as we have seen the long-term effects of both decisions on your family’s dynamics and generational planning goals.
At the same time, trusted advisors can help steer you towards effective estate planning professionals for further clarification and discussion to ensure you make an informed decision.
Trust & IRA Beneficiary FAQs
If I name my trust as the beneficiary of my IRA, is that a permanent decision?
No, you have the ability to change your beneficiary designation at any point in time while you are alive and can manage your own affairs.
When is the best time to name your trust the beneficiary of your IRA?
In my opinion, when your main priorities are protection and control of your assets after death.
When is the worst time to name your trust the beneficiary of your IRA?
In my opinion, when minimizing taxes is your most important priority.
