When an IRA Should Be Held in a Trust

In doing an estate planning review for a client recently, the subject came up of whether their three children should inherit his substantial IRA outright versus going to them in a trust.  This is actually a pretty sophisticated question since trusts for IRAs are fairly rare.  For context, let’s review the nature and characteristics of the typical inherited IRA.

First, if the IRA owner is married, the spouse is typically the beneficiary.  At death of the owner, the surviving spouse can either:

  1. Rollover the IRA- As an IRA rollover, the surviving spouse transfers the IRA into his or her own name. From that point forward the rules and regulations are the same for any IRA held in his or her name including Required Minimum Distribution (RMD) rules.
  2. Treat the IRA as an ‘Inherited IRA’- Here the deceased spouse’s name remains on the IRA account and the surviving spouse remains as the beneficiary. One advantage of this strategy is that if the surviving spouse is under the age of 59½, a distribution from the IRA is not subject to the 10% federal penalty.  However, RMDs begin based on the date of birth of the deceased spouse.  TIP:  If the surviving spouse is younger than age 59½ and may need access to some portion of the funds, an inherited IRA is a good choice.  He or she can ‘rollover’ the IRA after he or she turns age 59½ if desired.

If there is no surviving spouse, typically the children are listed as the beneficiary.  When children (or other non-spouse persons) inherit an IRA, they must either:

  1. Begin taking distributions by December 31st of the year following the year of death of the IRA owner. The amount of the required distribution is based on an IRA table based on the life expectancy of the oldest of a group of beneficiaries.
  2. Take distribution of the entire IRA by December 31st of the fifth year following the year of death of the IRA owner.

In each of the examples described above, the beneficiary controls the money both during his or her lifetime and at death.

So under what circumstances should someone consider making a trust the beneficiary of his or her IRA versus naming a spouse or child?

Second marriage.  In a second marriage, naming the surviving spouse as beneficiary means that you give up control of the ultimate disposition of your IRA assets.  If it’s your intention that any remaining money go to your children, a trust may be a better choice.

Spouse or child is poor money manager.  Not all people are good at managing money but a trust allows for professional investing as well as providing a trustee who can administer distributions according to a set of guidelines you choose.  I was recently involved in a case where an adult child had a serious drug problem.  Cases where children face some form of addiction scream for a strongly worded IRA trust.

Asset protection.  With a divorce rate of 50% and a litigation crisis in America, asset protection is always a concern.  A trust, properly worded, can protect IRA assets from divorcing spouses and legal judgments.  Under certain circumstances, a trust can also avoid possible estate taxes on the succeeding generation.

Minors are involved.  There can be good economic reasons to make grandchildren the beneficiary of your IRA.  They too get to ‘stretch’ the IRA distributions over their own life expectancy thus significantly postponing income taxes.  If they are minors, they cannot own assets in their name so a trust is a good solution.

So why not use an IRA Trust?

So far I’ve made the IRA trust sound pretty good.  What are the reasons you would want to avoid doing one?  While an IRA trust can be written to allow continued deferral of IRA assets as with an IRA rollover (often called a ‘see-through’ trust), these trusts are highly technical in both their drafting and ongoing administration.  It certainly requires the expertise of an attorney (and trustee) who specializes in this area.  The laws governing these trusts are unforgiving and mistakes can be difficult to fix and very costly. In most of the cases we deal with, unless there are extenuating circumstances, we prefer to have the IRA transfer to an individual or individuals by beneficiary designation and often place the other assets in asset protection-style trusts.