What happens if you named a trust as beneficiary of your IRA? With the passage of the SECURE Act in 2019, Ed Slott, a recognized IRA specialist, claimed that he could sum up the legislation’s effect on IRA trust planning in two words: “not good.” It may be time to review, rethink, and revise.
What changed? The SECURE Act eliminated the option of “stretching” distributions of an inherited IRA over the lifetime of the beneficiary. Now, the entire IRA must be distributed to the beneficiary within ten years of the account owner’s passing.
There are exceptions: This new rule does not apply when the IRA beneficiary is a surviving spouse, minor child of the account owner (until the child reaches the age of majority), or a beneficiary that is disabled, chronically ill, or less than ten years younger than the account owner.
Benefits of a Trust as IRA Beneficiary
The primary reasons for naming a trust as the beneficiary of retirement accounts are: 1) providing control over how the assets are distributed at your passing; 2) protecting the beneficiaries from risky spending, lawsuits, divorce or creditors; and 3) managing taxes.
A trust that qualified as a “see-through” trust before the SECURE Act could help achieve these goals, but that has changed if your trust beneficiaries are not exempted as noted above from the new rules. For example, your adult children are not exempt and would be subject to the new “distribute within ten years” rule.
Two Types of IRA Trusts: Conduit and Discretionary
Under the old rules, and assuming certain qualifications were met, distributions from the inherited IRA to either a conduit or discretionary trust could be stretched over the lifetime of the oldest trust beneficiary.
Conduit Trust: With a conduit trust, annual RMDs (required minimum distributions) are distributed from the inherited IRA to the trust, and then from the trust to the beneficiaries. Because the IRA distribution is disbursed from the trust, the income is taxed at the beneficiaries’ personal tax rates.
Given the provisions of the SECURE Act, a conduit trust will no longer work that way because there are no required minimum distributions until the end of 10 years. As a result, the trust will pay out all funds to the trust beneficiaries, who will then have total access to the funds and incur a large tax liability. The original intent of the trust (control distributions, protect the assets, and save taxes) has been eliminated.
Discretionary Trust: With a discretionary trust, the annual required minimum distributions are also distributed from the inherited IRA to the trust. However, the trustee has discretion as to whether the money is distributed to the trust beneficiaries or retained in the trust. A discretionary trust provides more control after death, but funds remaining in the trust are taxed at trust tax rates, which are significantly higher than individual rates. In 2020, a joint filer hits the top tax bracket of 37% at $622,050 of taxable income; a trust hits that same tax rate at $12,950. Therefore, a discretionary trust is not a tax efficient solution.
If a spend-thrift beneficiary is a major concern, a discretionary trust may still be a desirable option since the funds can remain protected in the trust even after ten years. However, those IRA distributions remaining in the trust will be taxed at the higher trust tax rates. Given the high costs, this is an expensive way to protect the assets.
Alternatives to Consider
Roth IRA Conversions: Start converting portions of your taxable IRA funds to a Roth IRA at today’s low tax rates. Once inherited, the Roth IRA can continue to grow tax-free for ten years and then withdrawn without tax consequences.
Charitable Intentions: There are several ways to utilize your IRA to benefit charities.
- Designate your favorite charity(s) as the beneficiary of all or a portion of your IRA. Upon distribution, the charity pays no tax and you can leave your more tax-efficient assets to other beneficiaries.
- Once you turn 70.5, you can make qualified charitable distributions up to $100,000 each year to qualified charities. These distributions count toward your required minimum distribution and are not included in your taxable income.
- Consider naming a Charitable Remainder Trust (CRT) as beneficiary of your IRA(s). The CRT would pay income to named beneficiaries quarterly as outlined in the trust provisions over a term of 10 years or longer, even for their lifetime (as you direct). At the end of the CRT term, the balance of the trust assets would pass to the named charities of the trust.
The provisions of the SECURE Act make a statement that the government intends for retirement accounts to be used for retirement and not for estate planning. If you have named a trust as beneficiary of your IRA, you may want to revisit to ensure the trust continues to meet your objectives.