(Reprinted from the June 2016 edition of the Bath Country Journal and Richfield Times.)
For many Americans, the assets in their Individual Retirement Account represent a significant portion of the wealth they hope to leave to their loved ones. You may have heard that creating a trust and naming it as the beneficiary of your IRA is a good way to direct how your assets are distributed after your death and force your heirs to “stretch” the IRA and continue to receive tax deferral for generations. However, trusts and inherited IRAs are complex vehicles with many details to get right. Here are some of the pros and cons of naming a trust as a beneficiary of your IRA.
While directly inheriting an IRA is perfectly fine for many heirs, it can be inappropriate in some situations. Under these circumstances, a trust may be able to help you control how your IRA assets are distributed after you are gone and help protect your family’s wealth.
Protect minor children: If you name minor children or grandchildren as beneficiaries without additional instructions, a guardian will likely be appointed by a court, which can be a complicated and lengthy process with costs reducing benefits to your heirs.
Navigate blended family dynamics: For families with children from multiple marriages, a trust can help provide income for a surviving spouse and make sure every member of your family inherits according to your wishes.
Provide for children with special needs: If one of your beneficiaries has special needs, inheriting an IRA could jeopardize his or her ability to qualify for Social Security disability benefits or other forms of assistance.
Avoid spendthrift tendencies: It is worth considering whether you think your heirs can handle an inheritance responsibly once they reach adulthood. Young or spendthrift adults might be inclined to simply cash out the IRA and unwisely spend the money. A trust can detail how much your heirs are able to receive each year and delay when they gain control over the assets.
Protect family wealth from creditors: Trusts can also protect your family’s wealth from divorce and bankruptcy. A 2014 Supreme Court case found that, unlike your own retirement accounts, an inherited IRA is not protected from creditors in the event of a bankruptcy. A trust can provide valuable asset protection to your heirs in the event of a divorce, a failed business, or bankruptcy proceedings.
Mistakes are easy to make: Trusts are very complex instruments that must be carefully worded to be able to accomplish your objectives. If the trust is not accepted as a “see-through” trust, the trustee may be forced to distribute the IRA’s assets over a five-year period instead of stretching the distributions over a longer life expectancy. Simple mistakes like naming a charity as a trust beneficiary may be enough to trigger expensive tax consequences for your heirs.
Professional advice is critical: If you are going to name a trust as a beneficiary, it is critical to work with advisors who not only understand your personal situation and have experience with trusts and inherited IRAs but also understand income taxes. Taxation is not tested on the Ohio bar exam, and estate attorneys lacking well-rounded income tax knowledge are common. You or your financial advisor should also check with your IRA custodian to make sure that any beneficiary designations and trust provisions are compatible with the document governing your IRA.
Ultimately, choosing beneficiaries for your IRA is a task that is best accomplished with professional advice that coordinates all aspects of your estate strategies. Estate and tax planning are complex areas, and it pays to get the details right. If you have not reviewed your estate strategies recently or have questions about trusts, inherited IRAs, or beneficiary provisions, perhaps it is time to revisit this with your advisors.
Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and families with their overall wealth management, including retirement planning, tax planning and investment management needs.