Beware of Trusts as IRA Beneficiaries

It is now more dangerous to name trusts as IRA beneficiaries because of recent tax law changes, but there’s a valuable exception when the surviving spouse is the sole beneficiary of the trust.

There always have been problems naming trusts as IRA beneficiaries when non-spouses are trust beneficiaries. The SECURE Act, enacted in 2019, increased the potential problems, but many people still aren’t aware of the pitfalls.

When income taxes aren’t considered, there are good reasons to name a trust as beneficiary of a large IRA and individuals as beneficiaries of the trust.

When an individual is the IRA beneficiary, the individual has complete discretion over the account. That raises the potential for bad investments, wasteful spending, fraud and more. Putting a trust between the beneficiary and the IRA can avoid these problems and add protection from creditors in most states.

But even before the SECURE Act, there were tax risks to having a trust as IRA beneficiary, and they still exist. To maximize the IRA’s tax deferral, a special type of trust must be used. Name the wrong type of trust, and the IRA balance must be distributed, and taxed, quickly.

Before the SECURE Act, a beneficiary could distribute the inherited IRA over his or her life expectancy. The product became known as a Stretch IRA.

The SECURE Act shortened the potential tax deferral, whether an individual or a trust is the beneficiary, by eliminating the Stretch IRA for most beneficiaries. Most non-spouse beneficiaries must fully distribute the trust balance within 10 years, and withdrawals might be required in each of the first nine years.

For most non-spouse beneficiaries, the 10-year rule accelerates the distribution of the inherited IRA and, for traditional IRAs, accelerates the taxes. The 10-year rule also increases the income taxes by bunching larger distributions into fewer years. See our May and June 2022 issues for more details about the 10-year rule and the SECURE Act.

The 10-year rule applies whether an individual or the right kind of trust is the beneficiary.

There still are non-tax benefits to naming a trust as IRA beneficiary. The trustee still invests and protects the assets. The money is distributed from the IRA and can be retained in the trust to be distributed to the trust beneficiary over a longer period than 10 years.

But there’s a major tax problem with that strategy.

Trusts are subject to unfavorable tax brackets. They have the same tax rates as individuals but jump into the higher tax brackets at much lower income levels. In 2023, a trust reaches the top tax bracket of 37% with a taxable income of only $14,451. A single individual hits the top tax bracket at $578,125 and a married couple filing jointly at $693,750.

The tax brackets significantly increase the cost of using a trust as an IRA beneficiary. The higher income taxes are certain while the nontax benefits are less certain.

For these reasons, naming a trust as an IRA beneficiary when a non-spouse is the trust beneficiary is unattractive in most situations. If you named a trust as IRA beneficiary, visit your estate planner right away and review alternatives. If you are considering naming a trust as beneficiary, examine other options.

Fortunately, there are alternatives that can accomplish your goals. You can convert all or part of a traditional IRA to a Roth IRA and name a trust as the Roth IRA beneficiary.

You’ll pay the taxes now instead of having your beneficiaries or the trust pay later. But the distributions from the IRA to the trust won’t be taxed. The trust will owe income taxes only on the investment income it earns, so trust tax brackets won’t matter as much.

You might be able to limit the taxes on the conversions, such as by converting a part of the IRA each year for several years.

Another option is to take distributions from the traditional IRA now and put the after-tax amount in a permanent life insurance policy. A life insurance policy can be owned by a trust or payable to a trust.

For more details about these strategies, see our March and April 2023 issues.

A trust can be a good tool, however, when the IRA owner’s spouse is the beneficiary of the trust.

An IRA owner might want to name a trust instead of the spouse as beneficiary when there is a blended family, and the IRA owner wants to be sure one part of the family isn’t disinherited eventually. A trust also might be a good idea when it’s desirable to have a professional trustee manage the assets.

The SECURE Act didn’t change the advantages when a spouse, or a trust with the spouse as beneficiary, is beneficiary of the IRA. The 10-year rule doesn’t apply in these cases. See our February and March 2020 issues for details.

Plus, the SECURE Act 2.0 potentially made it more attractive for a trust with the spouse as the trust’s sole beneficiary to be the IRA beneficiary.

First, the surviving spouse can treat the IRA as though it were his or her own IRA. The 10-year rule doesn’t apply, and the required minimum distributions can be made over the surviving spouse’s life expectancy.

Second, the SECURE Act 2.0 allows the surviving spouse to make an election to both delay the RMDs based on his or her life expectancy and use the more favorable uniform lifetime table to determine life expectancy and RMDs instead of the single life table most beneficiaries use.

This election takes effect beginning after 2023 and we’re waiting for IRS regulations.

But there’s a trap in the SECURE Act 2.0. The surviving spouse doesn’t receive all the benefits automatically but must make an election for the special treatment.

There always have been risks and complications with naming trusts as IRA beneficiaries. The recent laws increase those factors. If you have a trust as an IRA beneficiary or are considering having one, have a discussion with an estate or tax planner who’s well-versed in the rules on IRAs as trust beneficiaries.