In this month’s installment of The Monthly 5 and 5, I will be discussing five advantages and five disadvantages of designating a trust as an IRA beneficiary. In part one below, I will discuss five advantages; I will post part two discussing five disadvantages next week. While this post will focus on IRAs, much of it may also apply to designating a trust as a beneficiary of other kinds of retirement assets. As you will read below, designating a trust as an IRA beneficiary may allow you to achieve many of your estate planning goals; but, if the trust is drafted improperly, the results could have a substantial unintended impact on your estate plan. It should be noted that the discussion below is very summarized and only covers general rules; an experienced professional should be contacted before designating a trust as a beneficiary of your IRA (or other retirement asset).

Five advantages to designating a trust as an IRA beneficiary:

      1.  Stretch-Out the IRA Balance

When an individual is designated as a beneficiary of an IRA and the owner of that IRA passes away, the beneficiary becomes the owner of an “inherited IRA.” With an inherited IRA, the IRC allows the beneficiary to “stretch out” the IRA balance over their life expectancy instead of being required to either withdraw all of the IRA funds within five years of the deceased owner’s death or take required minimum distributions over the deceased owner’s life expectancy (which may be much shorter if the beneficiary is much younger, i.e., the beneficiary is the owner’s kid). If only the required minimum distribution based on their own life expectancy is withdrawn every year, the balance is left to grow, thus creating more wealth to be transferred to the beneficiary.

Likewise, if a trust is set up properly and designated as a beneficiary of an IRA, this same stretch-out is allowed. The IRC allows you to “look through” the trust and base the required minimum distribution on the trust beneficiary’s life expectancy. Thus, the trust can achieve the same stretch-out discussed above as if the individual was named personally. The added bonus that the trust provides is that the beneficiary cannot cash in the entire IRA balance immediately after the death of the IRA owner; like they could if they were named personally. The IRA balance is protected by the trust and only the trustee of such trust would be allowed to cash it in or take distributions greater than those required each year. This protects the beneficiary from squandering all of the money immediately after the owner’s death on something that may not be as advantageous as saving the money for the future, which may be what the deceased owner would have wanted.

      2.  Defer Taxes

Another benefit of stretching out the inherited IRA over the beneficiary’s life expectancy is greater tax deferral. Since taxes on the funds in the IRA will not be paid until they are withdrawn from the IRA, that leaves more in the IRA to grow and compound, thus creating more wealth to be transferred to the beneficiary. By designating a trust as an IRA beneficiary instead of the individual personally, the trust can ensure that the beneficiary takes advantage of this tax deferral by not allowing the beneficiary to cash in the IRA immediately after the owner’s death, which the beneficiary could do if they were personally designated as the IRA beneficiary.

Additionally, suppose that the beneficiary is personally designated as the IRA beneficiary and does cash in the entire IRA immediately after the owner’s death. This may cause the beneficiary’s total income for that year to jump up into a higher tax bracket. The result: the beneficiary ends up paying more in taxes on that IRA balance than they would have had they spread it out and withdrawn it over their life expectancy instead. Again, the trust can ensure that the beneficiary does not immediately cash in the IRA and increase the overall tax liability on the IRA funds.

      3.  Asset Protection

If a trust is designated as beneficiary of an IRA, all of the traditional trust asset protections could apply to that IRA. This means that if the trust is properly drafted, the IRA balance may be protected from creditors, bankruptcy, and/or a divorcing spouse. While an IRA is typically afforded bankruptcy protection if the original owner of the IRA files bankruptcy, it is not afforded that same protection if a beneficiary later inherits the IRA personally and files for bankruptcy (see the U.S. Supreme Court’s 2014 decision in Clark v. Rameker). However, by properly drafting a trust and designating it as the beneficiary instead of the individual personally, the IRA could be afforded bankruptcy protection.

      4.  Protect Minor and/or Disabled Heirs

Another reason why individuals set up trusts is to protect and provide for their minor and/or disabled heirs. If the trust is properly drafted, it can be designated as the IRA beneficiary and those IRA funds can be protected and used accordingly to provide for any minor and/or disabled heirs. If instead the minor and/or disabled heirs are personally named as the IRA beneficiary, the IRA funds may not be managed and controlled like they would be in a trust for the minor and/or disabled heirs. Additionally, if they are designated personally as an IRA beneficiary instead of a trust, the minor heirs could get outright access to the funds at age 18 (or age 21 in some states) and the disabled heirs may lose their public benefits until they spend down the IRA funds.

      5.  Control Distributions

Furthermore, individuals will typically include trusts in their estate plan if they would like to have some say in, limit or completely control distributions to the beneficiaries. If properly drafted, the same can hold true for a trust that is a beneficiary of an IRA. The IRA owner may designate a trust as the IRA beneficiary because the owner wishes to control when or how the beneficiary receives the IRA distributions. This can be for a variety of reasons: to provide spendthrift protection, to transfer some of the wealth to future generations, etc. The same would not hold true if the beneficiary was personally designated as the IRA beneficiary instead of the trust.

As you read above, the advantages to designating a trust as an IRA beneficiary can be great. It can really help you accomplish your estate planning goals. However, as you will read in the second part of this post next week, there are disadvantages that need to be considered. Some of these disadvantages are caused by poor trust drafting and are avoidable, while others you are stuck with. Designating a trust as an IRA beneficiary should never be done on the whim; but, with proper professional advice and drafting, and after fully considering the advantages and disadvantages associated with designating a trust as an IRA beneficiary, you can make an informed decision. It certainly is not for everyone, but for some it is certainly necessary.

– Attorney Matthew D. Brehmer

© 2014 Matthew D. Brehmer and Crummey Estate Plan.