Using a Trust as a Beneficiary of an IRA

Using a Trust as a Beneficiary of an IRA

A good feature of an IRA is that a non-spouse beneficiary, after the death of the IRA owner, can “stretch” out the time period for taking distributions over their life expectancy. The compounding effect can create phenomenal tax deferred growth.

After the owner’s death but before taking any distributions the IRA beneficiary or beneficiaries can make a decision whether to “stretch” distributions or to take a lump sum withdrawal. This can be a concern of the IRA owner if the beneficiary is a minor, disabled, incompetent or unsophisticated in financial matters. Further a lump sum withdrawal can subject the money to creditor or marital risk or improper management or careless spending.

In these cases and similar others the IRA owner can remove the decision from the beneficiary by establishing a trust to be the beneficiary of the IRA. The trustee then becomes the decision maker.

The owner can further restrict the beneficiary’s access to the funds by limiting distributions from the trust to the discretion of the trustee. This is a method allowing the IRA owner to exercise “post mortem control” over the beneficiary’s access to funds.

While the trust limits control, there might be some adverse income tax results. If the trustee, using their discretionary power, decides to keep the IRA distribution in the trust instead of making a distribution to the trust beneficiary, the IRA distribution would be taxed at the trust level instead of the beneficiary’s level possibly creating a much larger tax. A trust reaches the highest tax rate of 39.6% when the trust’s income exceeds $12,500 while a single person bears the highest rate only when their income exceeds $418,400 using 2017 rates.

Accordingly, the IRA owner needs to determine which is more important – protection and control of the funds for the beneficiary or mitigating taxes.

There are some ways to reduce the trust’s taxes such as the IRA owner converting the IRA to a Roth IRA in a taxable transaction. This decision would also depend upon the IRA owner’s tax bracket and other assets potentially subject to estate tax. However, if the conversion is done, then after the IRA owner’s death the discretionary trustee would be able to retain or distribute funds from the Roth IRA without incurring income tax and the trust would not be penalized by the higher tax rates.

Using a discretionary trust as the IRA beneficiary is an important strategy and in the right situation can be very effective. If you are concerned about how a beneficiary would handle their inheritance then it is suggested that you meet with your tax advisor or attorney to discuss setting up a discretionary trust as the IRA beneficiary.

Robert Demmett, CPA, MS, a tax partner in our New York office, assisted in the preparation of this blog. Bob can be reached at [email protected].