Naming a Trust as Your IRA Beneficiary: Do's and Don'ts
Naming a trust as an IRA beneficiary can trigger costly tax mistakes. Learn when it makes sense, how see-through trusts work and what changed under the 10-year rule.
Trusts and individual retirement accounts are complicated. When they converge – for instance, when someone names a trust as a beneficiary to an IRA – things can go very wrong, and that can be very expensive.
The first thing to consider is whether to do it at all. Trusts as beneficiaries of IRAs can be very complicated, and if it is not done properly, immediate income tax consequences could result.
Still considering naming a trust as the beneficiary of your IRA? Here are some do’s and don’ts.
Do have a good reason to leave your money in a trust
Thinking of naming a trust as your IRA’s primary beneficiary? Make sure you’re doing it for the right reason. Leaving an IRA to a trust will likely not make things easier or save on taxes.
There are some good reasons to leave IRA money to a trust: typically for the benefit of someone who can’t be trusted with the money. That might be a minor child, a spendthrift or the spouse of a 2nd marriage. In the last instance, a trust is often set up for those who want to leave enough money for the care of their spouse and then direct any remaining funds to go to their children after the spouse passes.
Trusts should be used in their full capacity as a protector and should not do more harm than simply leaving IRA money outright to a listed beneficiary.
The trick is for trust preparers to insert proper IRA terms so the trust doesn’t become legal fiction or conflict with IRS rules.
Don’t trust the job to just anyone
Leaving an IRA to a trust is different from putting other assets into a trust after death.
It’s an area where you need specialized expertise. There is often no fix for these mistakes, and they can be multimillion-dollar mistakes with a trust. The improper knowledge can wipe out the trust faster than if you just named the person as the beneficiary.
The attorney setting up the trust should be very familiar with terminology specific to inherited IRAs, such as “see-through (opens in a new tab),” “dropdown and out of trust procedure,” “designated beneficiary” and “disregarded beneficiaries.”
If your trust adviser can’t handle the proper definitions and explanations of just this short list of specialized terms, find another one.
Do be sure the trust beneficiaries are clearly people
When inheriting an IRA, one of the goals is to preserve the tax-advantaged status of the account for as long as possible. In order for the IRA to be distributed through a trust on a favorable schedule, the trust must have beneficiaries and they must be people. A charity doesn’t count.
An IRA is a stream of untaxed income, and the objective generally is to defer taxation of income as long as one possibly can. Since the SECURE Act (opens in a new tab) took effect in 2020, though, most non-spouse beneficiaries, including most trusts, must empty an inherited IRA by the end of the 10th year after the owner’s death. If the owner had already reached the age at which required minimum distributions (opens in a new tab) begin, annual distributions are generally required during those 10 years as well. Stretching distributions over a beneficiary’s life expectancy is now limited to “eligible designated beneficiaries (opens in a new tab)”: a surviving spouse, the owner’s minor child, a disabled or chronically ill person, or someone not more than 10 years younger than the owner.
To qualify as a “see-through” trust, the trust must be valid under state law, be irrevocable at the owner’s death, have beneficiaries who can be identified from the trust document, and the trustee must give the IRA custodian the required documentation. The IRS then looks through the trust to the people who benefit from it, and distributions are made to the trust over the schedule that applies to those individuals.
Don’t overlook the benefits of a spousal rollover
Where life expectancy still applies, the age of the oldest beneficiary is used to set the life expectancy on which the required minimum distributions from the inherited IRA will be based. If a spouse is going to be the first beneficiary of IRA money, it can be more advantageous to younger heirs if the IRA is initially passed on as a spousal rollover. A rollover lets the surviving spouse treat the IRA as his or her own, name new beneficiaries and delay distributions until his or her own required beginning age. After the surviving spouse dies, it can be left to younger heirs, who will generally have 10 years to empty the account, which preserves the tax benefit for as long as possible.
By using the spousal rollover option, couples can keep the account growing tax-deferred for a long time.
Smart estate-planning advisers use a cascading beneficiary system. Name a spouse as the primary beneficiary and the trust as a contingent beneficiary. This allows more flexibility, as the spouse can choose to roll over the assets or disclaim his or her position to the trust within 9 months. The trust then serves as the backup if the spouse disclaims.
Do consider separate trusts for multiple beneficiaries
People generally use trusts as IRA beneficiaries so they can defer distribution. Using separate trusts for each beneficiary can simplify things for everyone, and where life-expectancy payouts are still available, each individual beneficiary can use his or her own age for the purposes of determining the required minimum distributions.
Oftentimes, it is easy to split the IRA into multiple IRAs if you have multiple beneficiaries, rather than use a trust.
Sometimes, the easiest solution is the best, and that may mean skipping a trust altogether.
Editorial note: Inherited-IRA and trust rules are technical and have changed since 2020; the IRS continues to issue guidance. Have a tax or estate professional review any beneficiary designation.