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It is not uncommon for the owners of an individual retirement account (IRA) to designate a trust as their beneficiary. By utilizing a trust, an IRA owner retains some degree of control over how assets are distributed after they die. However, while a trust is an effective estate-planning tool, IRA owners must take steps to ensure the desired outcome is consistent with their needs.
Before we look at designating a trust as the beneficiary of an IRA, we need to understand how the SECURE Act, passed in December 2019, changed requirements for inherited IRAs. This legislation modified the treatment of distributions from an inherited IRA for any IRA owner who dies on or after Jan. 1, 2020.
The classification of the individual or entity designated as a beneficiary to an IRA is important, as well as their relationship to the decedent. Additionally, the age of the IRA owner at their date of death is important, depending on the beneficiary's classification. The SECURE Act separates beneficiaries into three categories: eligible designated beneficiaries, designated beneficiaries, and others that are not considered designated beneficiaries.
There are five categories of individuals included in the eligible designated beneficiaries classification:
As a result of the SECURE Act, any eligible designated beneficiary must withdraw the balance out of the IRA account over the longer of the beneficiary’s or the owner’s life expectancy. Surviving spouses also receive special treatment where they are allowed to step into the shoes of the owner and withdraw the balance out of the IRA over their life expectancy, or they can roll the inherited IRA into their own IRA.
A designated beneficiary is any individual named as a beneficiary of an IRA that is not included in the list of eligible designated beneficiaries above. For designated beneficiaries, the 10-year rule applies. The 10-year rule does not apply to eligible designated beneficiaries or anyone in the third category below who is not a designated beneficiary at all. The 10-year rule states that the beneficiary must withdraw the full balance of the IRA account within the 10 years following the date of the owner’s death.
Estates, charities, and trusts (typically) are not designated beneficiaries, as they are not individuals. One of two other rules apply based on the age of the owner at their date of death:
A beneficiary of an IRA can be any person or entity the IRA owner chooses. In the case of a trust, the trust beneficiaries, rather than the trust itself, are used to determine the classification of the beneficiary of the IRA.
If the trust identifies a specific beneficiary or beneficiaries to receive all withdrawals from the IRA account, that individual or entity is treated as the direct beneficiary of the IRA. This is only the case when the trust is unable to accumulate any funds prior to disbursing IRA withdrawals directly to its beneficiaries. It is considered a “conduit trust,” as the trust’s existence is ignored for the purpose of identifying a classification of the beneficiary.
For example, if the beneficiary identified by the trust is an estate or charity (a non-person entity), the IRA is treated as having no designated beneficiary. But if the beneficiary identified by the trust is an individual, the IRA is treated as having either an eligible designated beneficiary or a designated beneficiary, and the respective rules apply, depending on the individual’s classification and relationship to the decedent.
Alternatively, if the trust can accumulate withdrawals from the IRA, rather than disbursing withdrawals in their entirety to the beneficiaries, it is considered an “accumulation trust.” This is the type of trust used to disburse funds to its trust beneficiaries over time, such as in the instance of a spendthrift protection trust described below. Most accumulation trusts name estates or charities in some capacity as a beneficiaries. Because those are not individuals, the trust is typically subject to either the five-year rule or the payout rule for non-designated beneficiaries.
In most cases, an IRA owner designates a trust as the beneficiary of the IRA to have control over the disposition of the assets after they die. The following are some reasons why an IRA owner might do this.
An IRA owner might worry that a beneficiary will squander the inheritance. They might prefer that the IRA's assets be disbursed according to a schedule instead of handed out in a lump-sum payment. The IRA owner could also earmark funds for specific purposes, such as financing the beneficiary's education. The IRA owner could ensure these conditions in the trust's provisions, which the trustee would be responsible for implementing.
An IRA owner may want to ensure that a current spouse as well as children from any previous marriages receive their share of the assets. This can be accomplished by designating a trust that meets certain requirements, such as a qualified terminable interest property (QTIP) trust.
It can be advantageous to name a trust as a beneficiary of a retirement account if your beneficiaries are minors, have a disability, or can't be trusted handling a large sum of money. Some advisors will also recommend establishing a trust as the IRA beneficiary to ensure its assets don't become part of a surviving spouse's estate in order to avoid future estate taxes.
An eligible designated beneficiary is a surviving spouse, minor children of the IRA owner (until they reach the age of majority), disabled individuals, chronically ill individuals, and those who are not more than 10 years younger than the IRA owner. According to the SECURE Act, an eligible designated beneficiary can withdraw the balance out of the IRA account over the longer of the beneficiary’s or the owner’s life expectancy.
A qualified terminable interest property (or QTIP) trust allows an individual, or grantor, to leave their assets to a surviving spouse and also to determine how the trust's assets are divided after the surviving spouse dies. Under a QTIP trust, a surviving spouse gets income from the trust, but the balance of funds is held in trust until that spouse dies. At that point, the remaining assets are paid to beneficiaries designated by the grantor. A QTIP can be helpful in estate planning to leave assets to beneficiaries from a previous marriage when the grantor dies before the subsequent spouse does.
Designating a trust as the beneficiary of an IRA can be an effective estate-planning tool. However, this already complex topic has become even more complicated by the passage of the Secure Act. It is effective only if all the parties involved—especially the IRA owner, the IRA custodian, the trustee of the trust, and any attorneys representing the beneficiary—agree on the interpretation of the provisions of the trust and applicable laws. Conflicting interpretations could result in a delay in disposition of the assets and can be quite frustrating for those involved.
The longer an individual or entity has to withdraw funds from the inherited IRA, the better it is from a tax-planning perspective because the funds can continue to grow tax-free for a longer period. Because the length of time allowed for withdrawals from an inherited IRA changes based on the age at which the IRA owner passes away, the best tax strategy for an inherited IRA may change over time. The relationship of the beneficiary to the decedent also plays an important role in deciding the most effective strategy.
As always, speak to your financial advisor or attorney to ensure your estate planning needs are met and maximized. A tax professional can help you identify the advantages and disadvantages of different strategies from a tax-planning perspective.
