Should you name a trust as an IRA beneficiary?

Updated December 5, 2023

Most working Americans use an Investment Retirement Account (IRA) as their main vehicle for retirement planning. If your client also chooses an IRA to leave assets to their family, naming a trust as the beneficiary can have tax implications for their beneficiaries or heirs.

In this article, we’ll go over the complexities, potential benefits, and possible pitfalls of naming a trust as your client’s IRA beneficiary. You can use this as a client education piece on IRAs and establishing trusts as beneficiaries. It could also spark a conversation on estate planning options for your client.

Types of IRA beneficiaries

Before delving deeper into this estate planning strategy, it’s important to note that there have been recent changes in laws regarding the IRA. The SECURE Act, passed in December of 2019, included changes to what each type of beneficiary can do with an inherited IRA.

The SECURE Act provides guidelines for the different types of beneficiaries based on their relationship to the deceased, and the age of the IRA owner at the time of their death.

Under the Act, beneficiaries fall into three separate classes: eligible designated beneficiaries, designated beneficiaries, and not designated beneficiaries. They are defined as follows:

1. Eligible designated beneficiaries

The first classification comprises a person or persons whom the IRA owner designates. They are deemed eligible due to their relationship, health status, age, or simply because the IRA owner chose them.

Eligible designated beneficiaries include:

• the IRA owner’s spouse
• the IRA owner’s child or children who are less than 18 years old
• a disabled individual
• a chronically ill individual
• any other individual whose age is not more than 10 years than the deceased IRA owner

Due to the amendments of the Secure Act, any of these eligible designated beneficiaries are required to withdraw the money out of the IRA in the same period as the beneficiary’s or owner’s life expectancy, whichever is the longer of the two.

Surviving spouses are allowed to assume ownership of the IRA and withdraw the balance within their life expectancy. They also have the option of rolling over the inherited IRA into their own IRA.

2. Designated beneficiaries

A designated beneficiary is any individual named by the IRA owner as a beneficiary but does not fall under any of the categories on the list of eligible designated beneficiaries. For this type of beneficiary, the 10-year rule applies.

The 10-year rule

The 10-year rule simply states that designated beneficiaries are required to withdraw all the money within 10 years from the date of the death of the original IRA owner. This applies exclusively to designated beneficiaries.

3. Not designated beneficiaries

Entities, not individual persons, are usually Not Designated beneficiaries. This type of IRA beneficiary includes charities, estates, and trusts.

One of two rules applies:

1. If the owner passed away before the age of 72: the 5-year rule applies. This rule states that the beneficiary must withdraw any remaining balance within five years after the IRA participant’s death.

2. If the owner passed away after the age of 72: the payout rule applies. This rule states that the beneficiary must withdraw any remaining balance in excess of the IRA owner’s remaining life expectancy.

A trust designated as IRA beneficiary

An IRA owner can designate any person or entity as their beneficiary. In the case of a trust, the beneficiaries of the trust (not the trust itself), determine the classification of the inherited IRA’s beneficiary. Typically, there are two types of trusts:

1. Conduit Trusts

Should the trust name a specific beneficiary or beneficiaries to get all withdrawals from the IRA account, then they are treated as the direct beneficiary of the IRA. This applies only when the trust is unable to accumulate any funds before making distributions to the beneficiary or beneficiaries directly.

This is considered as a “conduit trust”, since the trust’s existence is ignored for the purpose of identifying the beneficiary.

Furthermore, if the beneficiary named by the trust is an estate or charity (meaning a non-person), then the IRA is as if it has a No Designated beneficiary.

Conversely, if the beneficiary of a trust is an individual, the IRA is considered to have either an:

• eligible designated beneficiary
• designated beneficiary

In either case, the appropriate rules apply such as the 5-year rule, the 10-year rule, or the payout rule. It all depends on the individual beneficiary’s type and relationship to the deceased IRA owner.

2. Accumulation Trusts

If the trust can accumulate funds from the IRA instead of paying out the entire sum to its beneficiaries, then this is considered as an accumulation trust. This type of trust distributes funds over time to its beneficiaries. Accumulation trusts can also name charities or estates as a beneficiary.

As those types of beneficiaries are not individuals, the trust is subject to either the payout rule or the 5-year rule as in Non-Designated beneficiaries.

Reasons to name a trust as IRA beneficiary

An IRA can be a complicated and tax-sensitive instrument. There are a few good reasons why people would choose to make a trust as their IRA’s beneficiary:

1. It’s a workaround for beneficiary ownership limits

Making the trust the beneficiary is a good strategy if:

• the beneficiary is still a minor and unable to legally own the IRA
• the account owner wishes to support someone with special needs, and they would lose government benefits if the IRA or its assets were placed in their name

In both cases, naming a trust as beneficiary of the IRA is the legally acceptable workaround. Upon the IRA owner’s passing, the trust becomes the legal owner of the IRA. The appointed trustees can manage the trust for the individual who cannot own the IRA.

2. It’s to limit the beneficiary’s access

If the IRA owner thinks that the beneficiary will take more than the Required Minimum Distributions (RMDs) should they inherit the IRA outright, a trust can limit the amounts they can withdraw.

A beneficiary who inherits the IRA outright can take out more than the RMDs or withdraw the entire amount. Placing the IRA in a trust can ensure that the IRA owner’s beneficiary doesn’t spend all of their hard-earned money in one go.

3. Addressing second spouse or other complicated family structure

A trust can ensure that the IRA owner’s wish for their second spouse to benefit during their lifetime is fulfilled. By naming a trust as their IRA beneficiary, the second spouse’s RMDs are given priority. The children from the account owner’s first marriage will receive their RMDs as well.  

On the other hand, if the account owner chooses to leave the IRA outright to their spouse, there’s no guarantee the children will get anything. The remedy is for the owner to leave their IRA to a diligently made trust, so the IRA owner’s desire of having both sets of beneficiaries get their due is assured.

4. For the benefit of successive beneficiaries

When someone inherits an IRA outright, they get the privilege of designating beneficiaries of their own after they pass on. Naming a trust as the beneficiary of an IRA preserves the original owner’s control over designating beneficiaries, even after their death.

5. To minimize estate taxes

Many high-net-worth individuals create estate plans meant to minimize and/or postpone estate tax payments. For such plans to work, an established trust is required as their IRA’s beneficiary. That way, a portion of the trust sheltered by the individual’s state or federal tax exemption must be funded once the IRA owner dies. Naming one or more trusts as the IRA owner’s beneficiary can further reduce or postpone the corresponding taxes on their estate.

6. To protect beneficiaries from creditors

While an individual IRA gets some degree of protection from creditors, this isn’t always the case when it comes to an inherited IRA. In Clark v. Rameker, the US Supreme Court ruled that inherited IRAs are not exempt from claims under the Federal Bankruptcy Code. IRAs are not considered “retirement funds”. But if an inherited IRA is placed in a properly structured trust, the IRA beneficiaries will have some protection against their creditors.

The pros and cons of naming a trust as IRA beneficiary

There are a few good and bad reasons for naming a trust as the beneficiary of your client’s IRA. Here are some of the pros:

IRA owners get a say in how the inheritance is dispensed and used

If your client chooses to make a trust as their IRA beneficiary, they have the benefit of creating a properly structured one that details all their wishes for their loved ones. Your client has a say in how much money can be disbursed, when, and for what purpose.

A trust is a good workaround for certain types of beneficiaries

Minors who would otherwise not be able to legally inherit IRAs can have their due inheritance via a trust. If your client has a beneficiary who is disabled, a trust can give them the financial support they need without having to risk losing any government-mandated benefits.

A trust can reduce taxes

For a client’s surviving spouse, a trust can ensure that they get whatever inheritance your client wants them to receive from their IRA. This is a better alternative than naming direct beneficiaries, who may or may not give the surviving spouse what your client intended. A trust can also reduce or avoid future estate taxes after the surviving spouse passes away.

A trust can protect assets from creditors

If your client has their IRA go into a trust instead of bequeathing it to their heirs directly, creditors cannot make claims on the inherited IRA to satisfy the beneficiary’s debts.

On the other side of the coin are the cons:

IRA assets cannot be placed into a trust while alive

This is important to note, especially if your client has yet to do their estate planning. Help them make an honest accounting of assets. After that, they should write a will, choose their beneficiaries, and make their stipulations regarding the trust. You can refer your clients to a lawyer for help.

The assets in the IRA will be subject to RMDs

With a trust as beneficiary, the assets in the IRA will have RMDs to give out, calculated based on the life expectancy of the oldest beneficiary. This can be a problem if there are several heirs with wide age gaps.

There may be no tax advantages

In most cases, IRAs with a trust as beneficiary will mean your client’s heirs may not enjoy income tax breaks. This can be especially true if the RMDs are substantial enough to put them in higher tax brackets.

There’s a new 10-year rule

If your client only has designated beneficiaries under the new Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, they must take the entire amount of the IRA within 10 years of your client’s death. This can severely limit their distribution options.

Here’s a video where the attorney-slash-financial adviser gives his two cents on the pros and cons of naming a trust as a beneficiary.

There are ways you can support your client in deciding whether to name a trust or a beneficiary for their IRA. Will giving the money straight to their beneficiaries provide them with long-term happiness? Or would that amount of money slip through their fingers quickly? An option to consider is a spendthrift trust to make the money benefit them for longer.

Your client may also consider converting their IRA (or a portion of it) to a Roth IRA. They could then make their inheritance earn interest for at least 9 years (following the SECURE Act’s new 10-year rule) in an accumulation trust, tax-free.  

Should a trust be the beneficiary of an IRA?

“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.”

There is no definite answer to this question as it varies from person to person, depending on their personal circumstances and estate planning goals. Help your client take stock of their assets, talk to them about their wishes and their beneficiaries’ best interests, then raise the option of estate planning. That way, you can help your client see if naming a trust as their IRA’s beneficiary is a viable option.

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