Naming a trust as a beneficiary of an IRA

This discussion comes up a lot in my estate planning – should I name a trust as a beneficiary of an IRA? The answer is almost always no, although the pros and cons need to be weighed on a case by case basis. Typically this question boils down to whether the tax consequences of naming a trust as the beneficiary are outweighed by the original purpose of the trust.

To address this question, we first need to think about why the trust was created. It might be a trust designed to protect beneficiaries from themselves or from creditors, or perhaps it is one designed to take advantage of certain tax rules, such as a credit shelter trust or generation skipping trust. In the former case, you might decide that the need for protection exceeds the tax consequences and go ahead with naming the trust. In the latter case, you generally will be choosing from a variety of assets, only some of which need to go into trust. In that case, you should absolutely avoid naming the IRA as a beneficiary.

But what are these tax consequences of which I write? It boils down to how quickly the IRS forces the beneficiaries to withdraw the money after your death. These rules (called the required minimum distribution (“RMD”) rules) dictate that, when you reach 70.5 years of age, you have to start taking money out of your IRA. The RMDs are based on your estimated life expectancy, according to tables published by the IRS.

We generally want to stretch out these distributions, because they result in taxation. So, upon your death, if we can find a younger person who could use his or her own life expectancy to govern the RMDs, that would save taxes. If you leave the account to your spouse, he or she can roll over the balance into his or her own account, or take over your account as his or her own. These are excellent options, although since people often marry close to their own age, it doesn’t change the tax situation too much.  If you leave the account to any human (other than or including your spouse), that human can keep the account as an “Inherited IRA.” That human (lets say she’s your daughter) will have to begin distributing out the account, but she can use her own estimated life expectancy to govern the RMDs. This is usually an excellent option, too, particularly if that person is significantly younger than you.

By contrast, if you leave the account to some legal “thing” that isn’t a human, such as a trust (or your estate), and you die before you reach the age of 70.5, the IRS gives that trust five years to get the money out of the account, or else. (The “or else” here is that the IRS takes half. Ouch.) If you die after you reach 70.5, the trust distributes based on your estimated life expectancy at the time you died, resulting in no “stretch out.”

It is possible to create a “see-through” trust, that the IRS will ignore for purposes of RMD calculations, but it is hard to do. The IRS has several rules for such trusts and, if the trust fails the rules, the money will still be distributed to the trust and the trust will have to take RMDs as described above.

So, to summarize, for most people in most situations, you would not want to name your trust or your estate as the beneficiary under your IRA. You should, however, review your beneficiary designations at least annually and make sure that you have named the correct human or humans, including a secondary beneficiary in the event your primary beneficiary dies before you do.

4 comments

  1. Mark Learned · · Reply

    Finally? Where has the learned lawyer been?
    🙂

    Sent from my iPhone

    >

  2. Ha! I’ve been busy helping people, of course! But I’m recommitted to writing every few days, so we’ll see if I can keep it up.

  3. Kevin Learned · · Reply

    Scott, really good article. I learned some new things from it.

    1. Glad you enjoyed it! More to come soon.

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