Are you worried about what will happen to your retirement savings when you die? If your IRA is one of your biggest assets, like many people’s, you may be wondering how to make sure it goes to the right people and is used the way you wanted. That’s where an IRA trust comes in handy!.
I’ve spent years helping clients protect their retirement funds, and I’ve seen firsthand how an IRA trust can be a game-changer for estate planning. Let’s break down what these trusts are and how they might benefit your family’s future.
Understanding IRA Trusts: The Basics
An IRA trust is basically a special type of trust that’s specifically designed to be the beneficiary of your Individual Retirement Account. Instead of naming individuals directly as beneficiaries of your IRA, you create this trust and name it as the beneficiary instead.
Even though you set up the trust while you are still alive, it doesn’t get money until after you die. Until then, it just sits there, waiting, like a smart backup plan for your retirement funds.
Why Use an IRA Trust?
Your retirement account might be your largest asset. Many people are now using IRAs not just for their own retirement but as a way to pass wealth to future generations. But here’s the problem: when you name individuals directly as beneficiaries, they get unrestricted access to those funds.
This can raise some serious concerns:
- What if your beneficiaries are minors?
- What if one of your children has creditor problems?
- What if you want your spouse to benefit during their lifetime, but want the remaining funds to go to your children afterward?
That’s where an IRA trust shines! It gives you control over how your retirement funds are distributed after you’re gone
The Two Main Types of IRA Trusts
There are two primary flavors of IRA trusts, each with its own advantages and disadvantages. Let’s look at both:
1. Conduit IRA Trusts
A conduit IRA trust (sometimes called a “see-through” trust) works like this:
- The trustee collects the Required Minimum Distributions (RMDs) from the retirement account
- Then immediately distributes these RMDs to the beneficiary
- The beneficiary is guaranteed to receive the RMD each year
Major benefit: Since the funds don’t hang around in the trust, you avoid those nasty high trust tax rates. The distributions are taxed at the beneficiary’s individual rate instead.
Potential drawback: The beneficiary will definitely receive those distributions—which might not be ideal if you’re trying to limit their access to funds.
2. Accumulation IRA Trusts
An accumulation trust takes a different approach:
- The trustee collects the Required Minimum Distributions
- But keeps them in the trust to be invested
- The trustee has the option (but not the requirement) to distribute funds to the beneficiary
Major benefit: This gives you way more control over when and how much the beneficiary receives.
Potential drawback: Any funds kept in the trust get hit with trust income tax rates, which are typically higher than individual tax rates. For example, in 2023, the highest federal tax rate of 37% kicked in for trusts at just $14,450 of income!
When Should You Consider an IRA Trust?
IRA trusts aren’t for everyone, but they can be super helpful in certain situations:
For Minor Children
If your beneficiaries are under 18, an IRA trust ensures the funds are protected until they reach the age of majority—or even longer if that’s what you want. Without a trust, a court-appointed guardian would be needed to manage the assets.
For Beneficiaries Who Need Financial Protection
Putting some adult beneficiaries’ inheritance in a trust could also be good for them. This includes people who:
- Have creditor issues
- Are going through marital problems
- Struggle with financial stability or responsibility
- Have special needs or disabilities
For Blended Families
If you’re in a second marriage with children from a previous relationship, an IRA trust can ensure that your current spouse is taken care of during their lifetime, but the remaining funds ultimately go to your biological children.
Setting Up an IRA Trust: First Steps
If you’re thinking about creating an IRA trust, here’s what you’ll need to do:
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Consult with professionals: Work with an estate planning attorney and a tax advisor who understand the complexities of IRA trusts.
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Choose your trust structure: Decide whether a conduit or accumulation trust better suits your goals.
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Draft the trust document: Make sure it complies with IRS regulations and clearly outlines your wishes.
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Change the beneficiary on your IRA: You’ll need to officially name the trust as the beneficiary of your IRA.
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Provide documentation: Give a copy of the trust document to your IRA custodian.
Important Considerations for IRA Trusts
Before you jump in, there are some things you should know:
Distribution Requirements Have Changed
The SECURE Act of 2019 changed the rules for inherited IRAs. Most non-spouse beneficiaries now must withdraw the entire IRA balance within 10 years of the account owner’s death, rather than stretching it over their lifetime.
However, there are exceptions for certain beneficiaries (like those who are disabled or chronically ill) who may still use the old “stretch” provisions.
Trust Tax Rates Are Higher
Trust tax rates reach the highest bracket much faster than individual rates. In 2023, trusts hit the top 37% federal tax rate at just $14,450 of income, while an individual wouldn’t reach that rate until their income exceeded $578,125!
Revocable vs. Irrevocable
Most IRA trusts are set up as revocable trusts, which means you can change the terms during your lifetime. This gives you flexibility to adjust as family circumstances or tax laws change.
Benefits of Using an IRA Trust
Let’s recap some of the key advantages:
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Greater control over distributions: You decide who gets what and when.
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Protection from creditors: A properly structured trust can shield assets from your beneficiaries’ creditors.
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Privacy: Trusts aren’t part of the public record, unlike wills that go through probate.
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Avoids probate: Assets in trust pass directly to beneficiaries without going through the probate process.
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Succession planning: You can specify multiple generations of beneficiaries.
Potential Drawbacks to Consider
No estate planning tool is perfect, and IRA trusts have their limitations:
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Accelerated distributions: Under current law, most beneficiaries must withdraw all funds within 10 years.
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Potential tax burden: Higher trust tax rates can reduce the overall inheritance if funds are kept in the trust.
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Complexity: Setting up and administering a trust is more complicated than simply naming individual beneficiaries.
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Setup costs: Creating a proper IRA trust requires professional help, which comes with fees.
A Smart Alternative: The Charitable Remainder Trust
If you’re concerned about the tax implications of an IRA trust, another option is to have your IRA distributed into a charitable remainder trust. This wouldn’t be a taxable event!
This trust (sometimes called a “give-it-twice trust”) would:
- Pay income to your named beneficiaries for their lifetime or a specific period
- Then donate the remaining balance to a charity of your choice
- Potentially provide tax benefits to your estate
Final Thoughts: Is an IRA Trust Right for You?
An IRA trust can be a powerful estate planning tool, but it’s not for everyone. It works best when you:
- Have substantial retirement assets
- Want to maintain control over distributions
- Are concerned about protecting assets for beneficiaries
- Have complex family situations
The best way to decide is to talk with an estate planning attorney who specializes in retirement accounts. They can help you weigh the pros and cons based on your unique situation.
Remember, the goal is to ensure your hard-earned retirement savings benefit your loved ones the way you intend. With proper planning, an IRA trust might be just the tool you need to protect your retirement legacy.
Have you considered how your retirement accounts fit into your estate plan? It’s never too early to start thinking about it!
IRA Legacy Trusts Provide Vital Management
Finally, an IRA Legacy Trust offers crucial control over your legacy.
Pay-on-Death (POD) accounts are important, and you should make sure that the POD information in your IRA accounts is always up-to-date as your heirs are born, married, divorced, contemplating divorce, old, disabled, rich, or bankrupt. Let’s even assume they’re all informed enough to hit the proper RMD deadlines and take the proper withdrawals without a trustee to manage the process after you die.
Doing that management at multiple institutions, with multiple heirs and possibly their children, is truly fraught with peril. The slightest mistake can cause enormous headaches, including massive tax penalties for errors. Remember that the people who run banks and brokerages are not there to make sure that your money goes to the right people when you die. The rules are different at each place, and any delay helps them because they are the ones who have your money. Do not blindly rely solely on these institutions.
Also, you don’t know if your heirs will get divorced or go bankrupt after you die. They need you to protect the IRA investment they got from you while you still can.
Moving the Situs of an IRA Trust to Avoid or Delay State Tax
Perhaps most importantly for tax planning, an IRA Legacy Trust receiving money from a traditional IRA can be created in another state from your residence—a state where the trust can benefit from low or nonexistent state income taxes. An individual heir may live in high-tax California, but their IRA Legacy Trust may have its “situs” in say, zero-tax Nevada. Some other current options are Tennessee, South Dakota, and Alaska.
Locating a trust in Nevada is far easier than telling an heir to move to Nevada before they pull out your money. In fact, if your heir did move, their original state would probably hunt them down for the taxes.
I can’t go into all the details of the trust’s structure and legal status, but federal tax liability for a traditional IRA does arrive for your heir when the money comes out of the trust’s traditional IRA account and gets deposited into its bank account. Roth IRAs, of course, are already exempt from both state and federal taxation.
As a simple example: Suppose Phil inherits a $1 million IRA, and it becomes $2 million over the ten years in the traditional IRA Legacy Trust created by his father. If Phil were to take that money out as a California resident, over the years he would pay over $200,000 in California income tax alone.
With the trust located in Nevada, Phil will save, or at least defer, around $200,000!
Yes, some states do challenge the legal rulings around this from time to time, but as of this writing, it works in most states.
IRA Explained In Less Than 5 Minutes | Simply Explained
FAQ
What is the purpose of a trust IRA?
A Trusteed IRA can be an important part of your overall wealth plan because it lets you use your retirement savings to reach bigger goals for transferring your wealth. It combines the tax benefits of a traditional or Roth IRA with greater control over how your assets are distributed.
What is the downside of naming a trust as an IRA beneficiary?
You generally cannot place an IRA directly in a trust while you are alive, but you can name a trust as the beneficiary to manage assets after your death. The main reasons to avoid this include significant tax complications due to unfavorable trust tax brackets, potential for costly administrative errors, and the complexity of navigating ever-changing IRS regulations like the SECURE Act.
Who pays taxes on an IRA in a trust?
For income tax purposes, the individual trust beneficiaries pay income taxes on the RMDs at their own individual income tax rate, which is usually lower than the trust’s income tax rate.
What is the 10 year rule for IRA beneficiary trust?
The designated beneficiary must usually close the account by the end of the 10th year after the year the IRA owner died. This is called the “10-year rule.” An RMD may be required in years 1-9 when the decedent had already begun taking RMDs.