New Reasons a Trust Shouldn’t Be an IRA Beneficiary

You probably don’t want to name a trust as beneficiary of your traditional IRA. If a trust is a current beneficiary, consider making a change soon.

There are several potential non-tax benefits to having a trust as IRA bene- ficiary. But, after the SECURE Act and IRS regulations under it, the negative tax consequences override non-tax benefits.

A non-tax benefit of a trust is that it prevents an individual beneficiary from having complete discretion over the account, reducing the potential for bad investments, wasteful spending, fraud and more. Even before the SECURE Act, a trust as IRA beneficiary created tax risks, which continue

. 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 distribut- ed, and taxed, within five years. Now there are additional tax prob- lems. The SECURE Act imposes a 10-year distribution rule on most inherited IRA accounts.

The entire account must be distributed and taxed within 10 years after the original owner passed away. In addition, the final regulations make clear that if the original owner was past the beginning age for re- quired minimum distributions, the beneficiary must take at least annual RMDs during years one through nine and still have the account distributed by the end of year 10.

There are a few exceptions to the 10-year rule. The exceptions are when the beneficiary is a surviving spouse, a minor child of the deceased owner, a disabled or chronically ill individual or a non-spouse beneficiary who is not more than 10 years younger than the original owner.

When a trust is the IRA beneficiary, the 10-year rule applies if the trust beneficiary were the direct beneficiary of the IRA. In addition, if the right type of trust isn’t used, the IRA must be distributed within five years, as was the case before the SECURE Act.

The big problem with naming a trust as a traditional IRA beneficiary now is that it likely increases the income tax bill on the inherited IRA while pro- viding fewer of the non-tax benefits, though the exact trade-off depends on the details. A trust reaches the highest tax brack- et at a much lower income level than an individual does. In 2024, a trust begins facing the 37% rate when tax- able income exceeds $15,200. For an individual, the top rate kicks in when taxable income exceeds $609,350.

Usually when a trust is named an IRA beneficiary, it is done to protect assets from potential mistakes of an individual. The individual is the bene- ficiary of the trust, and the trust is the beneficiary of the IRA. In this case, the trust often is an accumulation trust, meaning the trust- ee can hold money in the trust and reinvest it.

The income and principal are distributed to the beneficiary at the discretion of the trustee. When IRA distributions and invest- ment income are accumulated in the trust, the trust probably pays income taxes at or near the top tax rate during the first nine years when annual RMDs are taken from the IRA.

An even bigger tax bill might be incurred in the tenth year when the remainder of the IRA is distributed. More of the IRA is likely to be de- pleted by income taxes. An alternative is a conduit trust. The trustee takes distributions from the IRA and distributes them to the trust beneficiary.

The trust avoids income taxes, and the beneficiary pays taxes on the distributions at his or her tax rate. That doesn’t increase the tax bill, but it negates the trust’s non-tax benefits. The costs of creating and operating the trust are incurred but no non-tax benefits are realized. Plus, the IRA still must be distributed and taxed within 10 years. The final regulations from the IRS do have a couple of improvements over previous law.

The trustee no longer has to submit certain documents to the IRA custo- dian for the trust to be recognized as the beneficiary. But the documentation requirement is still in place for 401(k)s and other employer retirement plans. Another improvement is that a trust with multiple beneficiaries can be split into sub-trusts tax-free after the owner passes away. That allows each trust to determine IRA distribution requirements based on the status of its beneficiary.

Previously, the status of the oldest beneficiary determined the distributions for all the beneficiaries. But these are minor improvements that don’t solve the main problems with naming a trust as an IRA beneficiary. When your goals are to protect assets from the foibles of beneficiaries or allow the IRA to last for more than 10 years, consider alternatives to trusts. These are the same strategies I recommend for those who want to avoid the 10-year rule when individuals are IRA beneficiaries.

You can convert all or part of a tradi- tional 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 them later. The distributions from the Roth IRA to the trust won’t be taxed. If the trust accumulates the money, it will owe income taxes only on its investment income, so trust tax brackets won’t matter as much.

Also, because an original Roth IRA owner doesn’t have to take RMDs, there are no RMDs for years one through nine after the original owner passes away. The entire Roth IRA does have to be distributed to the trust by the end of year 10.

You might be able to limit the taxes on the conversions, such as by con- verting a part of the IRA each year for several years. Another option is to take distribu- tions from the traditional IRA now and put the after-tax amount in a permanent life insurance policy.

The life insurance can be owned by a trust or payable to a trust. For more details about these strat- egies, see the March and April 2023 issues of Retirement Watch. A trust can be a good tool, howev- er, when the IRA owner’s surviving spouse is the trust beneficiary. An IRA owner might want to name a trust instead of the spouse as beneficia- ry when there is a blended family and the IRA owner wants to be sure one part of the family isn’t disinherited.

A trust also might be a good idea when it’s desirable to have a professional trustee manage the assets. The 10-year rule doesn’t apply when the surviving spouse is beneficiary of either the IRA or of a trust that is beneficiary of the IRA. Plus, the SECURE Act 2.0 potentially made it more attractive for the IRA ben- eficiary to be a trust with the surviving spouse as the trust’s sole beneficiary.

The IRA can be treated as though it were the surviving spouse’s own IRA, not an inherited IRA. The 10-year rule won’t apply, and required minimum distributions can be made over the surviving spouse’s life expectancy. In addition, the RMDs can be based on the more favorable life expectancy factors in the uniform life table instead of the single life table most beneficia- ries use.

But the surviving spouse doesn’t receive these benefits automatically. He or she (or the trustee) must make an election for the special treatment. The risks and complications of naming trusts as IRA beneficiaries were increased by recent laws. If you have a trust as an IRA beneficiary or are considering having one, discuss al- ternatives with an estate or tax planner who’s well-versed in the rules.