A plan to transfer assets to an heir smoothly is important, and sometimes using a trust to holds assets and dole out income over time can be savvy. However, a trust can expose your family to a big income-tax bill if it's funded with a traditional IRA, so it's important to know the risks before listing your trust as a beneficiary on your IRA.
What's a trust?
A trust is an estate-planning tool that spells out how assets will be handled after you're gone. There are two types of trusts that can be used with a traditional IRA: a conduit trust and a discretionary trust.
In both cases, required minimum distributions (RMD) from traditional IRAs flow directly to the trust, not the beneficiary. However, in a conduit trust, the RMDs go to the beneficiary, and thus they're taxed at the beneficiary's tax rate, not the trust's tax rate. In a discretionary trust, the trustees distribute assets or income to beneficiaries based on the trust's language, and therefore, RMDs are taxed at the trust's tax rate.
If your heirs are minor children, have special needs, or are spendthrifts, a trust might be particularly useful.
The big downside to stashing an IRA in a trust
When it comes to passing along money to your heirs, a trust gives you more discretion. By spelling out how the trust will distribute money to your surviving family members, you can make sure money isn't spent recklessly and that it provides income to your beneficiaries for a long time. When special needs heirs are involved, a trust can help them avoid losing access to valuable benefits, such as Medicaid and disability income.
There is, however, a big downside to including a traditional IRA in a trust: It can mean far more money ends up in the IRS' hands than you want.
Traditional IRAs are funded with pre-tax dollars, and any growth in a traditional IRA is tax-deferred. Since the IRS hasn't collected taxes on this money, it mandates that beneficiaries begin taking money out of traditional IRAs following the account owner's death.
If the beneficiary of a traditional IRA is a trust, then rules governing mandated withdrawals become a bit complex.
Let's say Jim leaves a traditional IRA worth $100,000 to a trust for his adult son, Rick. The trust's tax attorney will need to determine is if the trust includes anyone else as a beneficiary. If it doesn't, then the amount that must be withdrawn every year is based on the adult son's life expectancy, as spelled out by IRS tables, such as the Uniform Life Expectancy table. In this instance, Jim's trust is considered a "see-through" or "look-through" trust.
However, if Rick isn't the trust's only beneficiary, then RMDs are calculated using the life expectancy of the oldest person listed as a beneficiary, including anyone listed as a primary beneficiary and remainder beneficiary.
If Jim includes a charity, or any other non-person, as a primary or remainder beneficiary, then the trust can't be treated as a see-through trust, and the IRA must be liquidated -- and income taxes due -- based on IRS rules for IRA's without a listed beneficiary. That means all the money in a traditional IRA must be withdrawn within five years of the IRA account owner's death. Because IRA withdrawals are considered taxable income, withdrawing money on such an accelerated schedule could result in a hefty tax bill.
If the trust is a conduit trust, then RMDs will flow through to the trust beneficiary as they're taken, and therefore they'll be taxed at the beneficiary's tax rate. However, if it's a discretionary trust, then the assets don't flow directly to the beneficiary, and income taxes are determined using the trust's tax rate, which could be much higher than the beneficiary's tax rate.
In 2017, for instance, trusts jump to the highest 39.6% income tax bracket after just $12,400 in income. If RMDs exceed $12,400, which is certainly possible if trust assets are used to pay legal, accounting, and administration fees, then nearly 40% of any amount above $12,400 ends up in uncle Sam's pocket, not your beneficiary's.
A final thought
Tax consequences often take a back seat when it comes to considering legacy planning options, but in cases where significant assets are held in traditional IRAs, it's critical to have a frank discussion with attorneys, tax professionals, and family members about the tax ramifications associated with the use of a trust. Failing to do this could result in a big surprise for your heirs at tax time.