Naming a Trust as an IRA Beneficiary

This article is a follow-up to our most recent commentary on Naming Minor Children as IRA Beneficiaries.

The beneficiaries we designate to inherit our retirement plan assets often get revisited when completing or updating our estate planning documents.  In certain cases, IRA owners may feel the need to leave retirement assets in trust for their children instead of leaving the assets to them outright (in their names).  This may be because the IRA beneficiary is a minor or where we want to ensure that the assets are passed on only to our lineal descendants (remain in our family) or where we feel the need to protect our beneficiaries from themselves (spending their inheritance improperly).

While trusts offer potential advantages in terms of asset protection and distribution control, they also introduce additional complexities and considerations that require extra review.

The decision to name a trust as an IRA beneficiary is driven by various factors, including the IRA owner’s estate planning goals, the nature of the intended beneficiaries, or the desire to retain post-death control over the distribution of assets. The final reason, and what is typically a more common answer, “My kids are minors and I don’t know who else to name!”

As we discussed in our last commentary, it’s important to remember how the inherited IRA rules work today before making the decision to name a trust as the beneficiary of your IRA.   In the past, children who inherited IRAs from their parents could “stretch” out annual Required Minimum Distributions (RMDs) over their life expectancy.  This allowed more funds to remain in the IRA for a longer period of time and to retain the tax-deferral on any earnings and growth on the assets held within the IRA.

Today, most children who inherit an IRA from a parent have 10 years to completely distribute the IRA and are required to take RMDs during years 1-9.  One exception is minor children of the IRA owner, who can stretch RMDs from the IRA until the minor beneficiary turns 21 years old, at which point the 10-rule kicks in and the entire IRA must be distributed within 10 years (by the time the trust beneficiary is 30 years old).

The new inherited IRA distribution rules are important to recognize because the compressed distribution schedule means that income taxes are going to be paid sooner and having an individual pay income taxes at their own personal tax rates (the top 37% tax bracket for single filers starts at > $609,000) is typically preferable to having a trust pay the income taxes based on the much more compressed trust income tax brackets (the top 37% tax bracket for trust starts at > $15,200).

2024 TRUST INCOME TAX BRACKETS

As a result, and from an income tax perspective, it’s typically much better for a family to have an individual IRA beneficiary pay the income taxes on IRA distributions versus having a trust pay the income taxes.  Naming a trust as an IRA beneficiary also means that you have to choose a trustee and that the trust will need file federal and state income tax returns every year.

The next consideration, when naming a trust as an IRA beneficiary, is the type of trust to use. Unless there is specific language included in a trust, most trusts are unable qualify for any stretching of IRA distributions, and are instead either subject to a 5-year distribution period or a full account liquidation.  As a result, naming a trust improperly may defeat your intended purpose and leave your intended beneficiaries with a large and unexpected tax liability.

The two common types of trusts that are named as IRA beneficiaries are Conduit Trusts and Accumulation Trusts. Both of these trusts maintain what the IRS deems a “Look-Through” or “See-Through” trust provision, which allows the trust to use the trust beneficiary’s life expectancy to calculate any IRA Required Minimum Distributions (RMDs).

Conduit Trust

In the case where a trust is named as an IRA beneficiary, a conduit trust has one beneficiary and provides that all distributions from the IRA to the trust must, in turn, be distributed to the trust beneficiary in the same tax year and the trust beneficiary pays any income tax at their personal rate.  This ensures that the trust isn’t taxed on the IRA distribution, which is helpful because trust income tax brackets are significantly compressed, but this may also defeat the purpose of even using a trust for control purposes as the IRA distributions are passed through to the trust beneficiary anyway.  In the case of a IRA beneficiary who is a minor child, naming a custodial account as the IRA beneficiary for a minor as we described in our last commentary essentially serves the same purpose and provides some protection up to age 21.

Accumulation Trust

If you want to maintain more control over the required IRA distributions, then naming an “accumulation” trust as an IRA beneficiary is the last resort.

When an accumulation trust inherits an IRA, IRA distributions are still subject to the 10-year rule, which means that the IRA assets must be completely distributed from the IRA to the trust within 10 years.

Any distributions from the IRA to the trust that remain in the trust within the 10-year window are taxable to the trust, which in most instances will result in more income tax paid based on the compressed trust tax brackets.  In addition, any subsequent earnings on the IRA distributions within the trust will also be subject to trust rate income tax rates.

Where the terms of the trust agreement provide only for distributions based on the beneficiary’s health, education, support, etc., this may result in funds remaining in the trust well beyond the 10-year IRA distribution limit and any ongoing earnings to continue to be taxed at the compressed trust income tax rates for years.  The trustee you’ve named will also be responsible for ensuring that income tax returns are properly filed every year.

If properly drafted, an accumulation trust may provide the trustee with the flexibility to either have IRA distributions accumulate in the trust or to be paid out to the trust beneficiary per the terms of the trust agreement in order to manage and minimize the income tax impact.

Ultimately, the decision to name a trust as an IRA beneficiary requires a comprehensive evaluation of an IRA owner’s goals, the needs of the beneficiaries, and the potential trade-offs between control, flexibility, and tax efficiency.   Naming a trust may initially seem appealing, but it may not actually serve the purpose you intend and we often observe that it creates an additional and potentially unnecessary level of complexity for your heirs.

Consulting with experienced estate planning professionals and financial advisors is essential to navigate these complexities and to develop a strategy that aligns with your estate planning objectives.  As always, please reach out to your dedicated ACM Wealth Advisor, if you have questions.

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