Individual retirement account owners often name an individual or individuals on their beneficiary designations, i.e., Jane Jones leaves her IRA to her children, Ken and Linda.
In some cases, though, Jane will designate the Jane Jones Trust as IRA beneficiary, and then Ken and Linda can be the beneficiaries of this trust.
When does using a trust make sense?
“Naming a trust as a beneficiary of an IRA is an effective means to maintain control over how wealth is distributed and protect beneficiaries,” says Timothy J. Keefe, senior vice president and trust consultant with Raymond James Trust in Chicago. “IRA owners typically consider naming a trust as their IRA beneficiary if they are in a second marriage with children from a prior marriage; want to protect minor children; want to control distributions to spendthrift beneficiaries; have a special-needs beneficiary; or want to provide creditor protection.”
Clients also may use a trust as the beneficiary of a large IRA when they are concerned about protecting the account if the intended heir is someday involved in a divorce, says Michael Repak, vice president and senior estate planner at Janney Montgomery Scott in Philadelphia.
To get such security, trusts cost time and money to set up and administer. Moreover, trusts that inherit an IRA may not offer ideal income tax benefits.
“If a client’s goal is to allow beneficiaries to stretch IRA distributions for tax deferral, the trust must be structured very carefully, but it can be done,” Repak says. “If the trust isn’t handled correctly, there can be an unfavorable tax surprise.”
TWO PATHS FOR TRUSTS
A trust named as an IRA beneficiary may be either a conduit trust, which passes IRA distributions through to the beneficiaries, or an accumulation trust, which retains the money, Repak says.
“Trusts structured as conduit trusts, where all IRA distributions must be paid immediately to the underlying income beneficiary used to calculate the [required minimum distribution], are useful in forcing the beneficiary to use the life expectancy payout,” Keefe says.
“However, they do not protect the beneficiary from creditors,” he says. “This type of trust for IRA distributions is also inappropriate for special-needs trusts where the objective is to make certain that supplemental government benefits to the beneficiary are not jeopardized.”
Conversely, an accumulation trust doesn’t require IRA distributions to be paid immediately to the trust beneficiaries. Such trusts can provide creditor protection and help special-needs beneficiaries, but they raise other concerns.
“The main drawback is that accumulating IRA distributions in the trust will cause income tax to be taxed at a much higher trust level rate than income paid out and taxed to the beneficiary,” Keefe says.
This year, for instance, the top 39.6% tax rate on trust income kicks in at just $12,150 of taxable income.
Donald Jay Korn is a New York-based financial writer who contributes to On Wall Street and Financial Planning.
This story is part of a 30-day series on retirement planning strategies.