Many people ask, Should I Name My Trust as Beneficiary of my IRA? The answer is, it depends. First we look at the features of IRAs and trusts. Then, we answer some frequently asked questions.
IRA stands for individual retirement account. An IRA provides tax advantaged retirement savings. While the money is inside an IRA, it grows without being taxed. In a traditional IRA, withdrawals from the IRA are taxed as income. In a Roth IRA, the withdrawals are tax free. For more detailed information, visit the article, IRAs: Roth, Rollover, Inherited and More.
Trusts provide the account owner the ability to limit how the money is invested and spent; and usually the most important part is to control the spending. A trust has a trustee who is different than the beneficiary; the beneficiary receives the money when the trustee allows them to have it. The trustee follows the rules of the trust to disburse the money and, when the rules are not explicit, uses their best judgement.
Both trusts and IRAs have named beneficiaries. When a person passes away, these named beneficiaries receive the assets in a trust and in an IRA without having to go through probate. This keeps things private, which might be important. It might speed things up, which is another advantage of the named beneficiary. However, if you choose the trust as beneficiary of an IRA, there are pros and cons that you want to be aware of.
- IRAs: Roth, Rollover, Inherited and More
- Which IRA to Choose? Traditional vs Roth IRA – Differences & Which is Better Explained
- SECURE Act and How it Affects Retirees
Advantages of Trust as IRA Beneficiary
One big advantage of the trust as beneficiary of an IRA is that it makes it easier to change beneficiaries at any time you choose. You could make the trust the beneficiary of all of your accounts. Then, if you need to change beneficiaries later in life, you just change the trust and all accounts are changed accordingly.
A second advantage of naming the trust as beneficiary of an IRA is that you can retain control of the distributions, and the investments, after you pass away. The trustee would follow the terms of the trust and use their best judgment for any decision not explicitly stated in the trust.
Disadvantages of Trust as Beneficiary
A trust as beneficiary of an IRA has downsides for the beneficiary and the trustee. Predictably, the downsides are the converse of the benefits.
In this situation, you have a trustee in charge who is likely not the beneficiary. This can cause unnecessary complications with family relationships. For example, imagine an inheritor of an IRA who is a responsible adult, but is not their own trustee. They will have to ask a brother, sister, or other trustee for permission to use their inheritance. It can cause financial stress for the beneficiary who has to wait and time stress for the trustee.
There is another downside to a trust as beneficiary of an IRA. The IRA is held at a custodian, usually a brokerage, advisory or bank. These institutions are most familiar with inherited IRAs with actual people as beneficiaries, not entities (like a trust). Different institutions may have different rules and requirements for the trust as IRA beneficiary. This may cause consternation, delays and possible financial stress too.
The inheritor’s IRA may want to move the inherited IRA to another custodian. The trustee is in charge, and not the inheritor, which can cause friction. A trustee will have to fill out paperwork at both the surrendering and receiving institutions. A trustee with multiple IRAs at multiple custodians may struggle with the complexities. In addition, the trustee will maintain relationships with the inherited IRA custodians and have to make distributions.
A potentially big downside to choosing the trust as beneficiary of an IRA is the tax burden. In 2020, the SECURE ACT changed the rules for inherited IRAs. Now every IRA must have all withdrawals made by the 10th year. When a person is a named beneficiary, they have the best chance to slowly make LEP distributions over all 10 years. But when an entity like a trust is a named beneficiary, the withdrawals may have to be made sooner than that, forcing more of an income tax burden on the inheritor. Keep reading for the tax rules for trust as IRA beneficiary.
General Rule of Thumb When Choosing Whether to Name a Trust as Beneficiary of an IRA
As a general rule, naming a trust as beneficiary makes it easier for the IRA owner to change beneficiaries across a number of accounts. Conversely, the IRA inheritors will have to abide by the trust rules, which can make it more difficult for the inheritors to control their own money and is more complicated for the trustee.
Tax Rules for a Trust as IRA Beneficiary
The older the owner of the IRA, the more likely the chance of causing a higher tax burden for inheritors. When the deceased is age 81 or older, a trust will force inheritors to make withdrawals faster than if they were outright IRA beneficiaries.
For an elderly IRA owner who does not want to complicate their inheritor’s lives, who trusts them to manage their own money, and who wants them to take as many years as possible to make (taxable) withdrawals, they should choose to name beneficiaries for the IRA instead of naming the trust as beneficiary of the IRA.
Here are the tax rules for an inherited IRA with a trust as beneficiary. First, the entity must make a Lifetime Expectancy Payment, or LEP, based on the age of the decedent. The LEP begins in the calendar year after death. The LEP uses the age the decedent would have been that first year and finds a factor using Single Lifetime Expectancy Table 1. The account value on December 31st of the year of death is divided by the factor. This is the required LEP. Every year thereafter, the factor is decreased by one.
Important: the decedent’s factor is calculated using the age of the decedent plus one year. The LEP begins the year after death and the factor depends upon the age that the decedent would have been, had they been alive one more year.
For example, a person dies at age 88 with a trust as beneficiary. The trust has five adult children named as equal beneficiaries.
The trustee creates five inherited IRAs. These accounts have the following titles: Beneficiary IRA with Trust Name as Beneficiary for Benefit of Child’s Name. The trustee puts one-fifth of the decedent’s IRA in each of the five inherited IRAs. Before the end of the year after death, the trustee makes an LEP from each account.
How large is the minimum required distribution from and inherited IRA?
First, the trustee finds out the value of the account on December 31 of the year of death. Next, the trustee looks up the age the decedent would have been this year in Single Lifetime Expectancy Table 1. In our example, the trustee uses the factor for a person age 89, not 88; this is one year older than the decedent. This age 89 factor is 6.6. The next year, the trustee will use the December 31st value of the prior year, and divide by 5.6. The following year, the trustee will divide the account value for the most recent year-end by 4.6. In this example, the inheritors will have less than 7 years before all of the account will be withdrawn. This is faster, and possibly more expensive, than if they had been named beneficiaries of the IRA.
All of the money must be pulled out by the 10th year, regardless of who has inherited the IRA. In most cases, a named beneficiary has 10 years. However, with an entity as IRA beneficiary, the inheritor may have to pull the money out faster.
Tax Rules for a Person as IRA Beneficiary
Here are the tax rules for an inherited IRA with a named beneficiary (a person, not an entity).
There are advantages to naming a person as beneficiary of the IRA. First, the person is in control of their own money. It is less complicated, because there is no trustee. The person has the best chance at paying the least tax by spreading out the required distributions over as many as 10 years.
When a person is a named IRA beneficiary, they must make a required distribution based off their Life Expectancy Payment (LEP). This lasts up to 10 years. By the 10th year, all of the money must be pulled out of the inherited IRA. In most cases, the beneficiary is non-spouse younger than the decedent and thus has a smaller LEP than the decedent’s LEP. Usually this reduces the annual tax burden compared to a trust as IRA beneficiary.
For more information, see SECURE Act and How it Affects Retirees
Tax Implications of an Inherited Roth IRA
An inherited Roth IRA provides tax-free distributions, regardless of the age of the beneficiary (inheritor). Roth IRAs provide tax-free distributions as long as certain rules are met. These rules include the five-year-rule and the age 59 ½ rule. The decedent must have met these rules before passing for the inheritor to receive tax-free distributions from an inherited Roth IRA.
Estate tax implications of Inherited IRA
The decedent’s IRA is included in their estate. Few Americans have an estate worth more than the current estate tax limits. For more information about the estate tax limits, visit Go Tax Free Resources. Thus,
- if there is a taxable estate, and
- if the decedent was above the age when they must make a required distribution, and
- if they did not make this distribution
then the decedent must make an IRA distribution. The decedent will receive an income tax deduction for estate tax paid. This is called income in respect of the decedent. Again, this situation is rare because most people do not have a taxable estate.
Summary of Tax Rules for Inherited IRAs
In summary, the inherited IRA requires all the money to be withdrawn from the inherited IRA by the 10th year regardless of who inherits the IRA. Distributions from traditional inherited IRAs are taxable to the inheritor at the inheritor’s marginal income tax rate. If the inherited IRA is a Roth IRA, distributions are tax-free, regardless of the age of the inheritor.
If the decedent is age 81 or older, and they chose to leave the IRA in a trust, then the inheritor will have to withdraw the money faster than 10 years. Plus, the inheritor will have to ask a trustee for withdrawals. So, for the elderly, it is usually a good idea to name a person (or people) instead of a trust as beneficiary.
In general, naming a person as beneficiary of the trust provides the inheritor more time, but no more than 10 years, to make required distributions from the IRA.
The tax information contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation.