Financial advisers may be wondering how to best bequeath clients' individual retirement account assets to heirs in the event of their death. The question becomes, should they name a trust rather than an individual as a beneficiary of the IRA?
There are many pros and cons to doing so, and practitioners often stumble through the web of complex rules, tax and estate planning experts say. But getting it right is critical.
"It's important because for the overwhelming majority of clients, it's their biggest asset," Richard Behrendt, an estate planner and former attorney at the Internal Revenue Service, said of IRAs.
"But it's tricky," he added. "Even a lot of attorneys don't know exactly how to do this, in my experience."
Individual retirement account assets can't be put into trusts directly during a client's lifetime without destroying the IRA's tax shelter. Rather, a trust must be named as the beneficiary of the client's IRA. The trust would inherit the IRA upon the client's death, and beneficiaries of that trust would have access to the funds.
Asset protection is the primary reason to do this. Trusts shield IRA assets in the event of lawsuits, business failures, divorce and creditors, for example. While taxpayers enjoy state and federal protections for IRA assets during their life, heirs who inherit an IRA directly — not through a trust — lose those protections.
Trusts also allow for a measure of control over the assets. The terms of a trust can dictate how distributions are made in the event that an heir is a minor, disabled, financially unreliable, incapacitated or vulnerable to being preyed upon, for example.
"Some people call it ruling from the grave," said Ed Slott, who heads an eponymous retirement advice firm.
Naming a trust as an IRA beneficiary is less practical for those who plan to bequeath their IRA to a spouse, as opposed to children, grandchildren or other heirs. Spousal rules are more lenient, said Mr. Behrendt. Spouses can roll over the decedent's IRA assets into their own IRA tax-free.
Clients may find the cost to create and maintain a trust, as well as the associated complexity, disqualifying.
"If you're going to inherit $50,000, by the time you pay the trustee or accountant, it's not worth it," said Steven Siegel, president of The Siegel Group.
There are many technical rules to follow. For one, the IRA beneficiary form must indicate before a client's death that the trust is the primary beneficiary. After death, the IRA must be retitled as an inherited IRA.
And required minimum distributions would still be required for the IRA. This is one area where selecting the proper type of trust is important — advisers recommend selecting what's known as a "see-through" or "look-through" trust.
Structuring a trust this way maintains the IRA's preferential tax treatment, allowing a trust beneficiary to spread RMDs over a long period of time based on his or her life expectancy, what's known as a stretch IRA. The RMD amount would be based on the oldest beneficiary of the trust. However, beneficiaries with separate trust shares would have different RMDs — a 30-year-old would take larger RMDs than a 16-year-old, for example.
The trust's language must also indicate that distributions from the IRA can only go to "designated beneficiaries," rather than going to pay expenses, for example, said Mr. Behrendt, owner of Behrendt Law.
The risk of not structuring the trust as a see-through or including this language, Mr. Behrendt said, is the IRA assets are distributed and the resulting tax paid within a much shorter time frame, potentially five years.
Trusts may also be structured as "conduit" or "discretionary" trusts, Mr. Slott said.
In a conduit trust, annual RMDs pass through the trust to beneficiaries, who pay tax at their individual rates. Discretionary trusts don't distribute the RMDs out of the trust, with the downside of paying tax at the more punitive trust tax rates but the upside of maintaining the most post-death control over assets, Mr. Slott said.
A Roth IRA, the assets of which have already been taxed, skirts the trust-tax issue of discretionary trusts, he added.