IRA trusts may have lost some of their luster in the wake of the SECURE Act.
Under the act, long-term tax deferral is still permitted for certain IRA beneficiaries but others must empty the inherited account within 10 years. Beneficiaries of employer-sponsored qualified plans face the same new rules.
“The term ‘IRA trust’ may be used to describe an irrevocable trust established during IRA owner’s life that is named as beneficiary of his or her IRA,” says Adam Schucher, partner in the Miami office of the law firm Katz Barron. Many IRA trusts face this 10-year rule, which curtails tax-deferred buildup.
Nevertheless, IRA trusts still can be valuable. “A trust could make sense,” says Tania Sotelo, an estate planning attorney in Coral Gables, Florida, “when the IRA owner has a specific reason for this choice, perhaps to guarantee no change in contingent beneficiaries. Distributions might be paid to a surviving current spouse but children from a prior marriage could be assured of collecting the remaining balance after the survivor’s death.”
IRA trusts often are used for large accounts, but not always.
“If the beneficiary is a disabled or chronically ill person, a trust may be worthwhile for a relatively small account,” says Sotelo. “That’s because direct payments to the beneficiary might have an impact on government benefits that individual may be receiving.”
The decision to choose a trust as IRA beneficiary depends on what the account owner wants for the trust beneficiary, says Schucher.
“If a trust beneficiary is known to be a spendthrift, a trust can make sense regardless of the IRA’s value,” he says. ”Similarly, if the trust beneficiary has an outstanding judgment, which assets received directly from the IRA may be required to be used to settle, a trust can be a good choice.”
Costs count
Along with their multiple benefits, IRA trusts have drawbacks, including various expenses. Typically, drafting a trust that will be the IRA beneficiary won’t increase costs significantly if a client is having a will or a revocable trust prepared anyway, notes Jason Cross, an attorney and a wealth advisor with McGill Advisors, a division of Brightworth in Charlotte, North Carolina.
“The higher costs come on an annual basis with the annual tax return and associated forms that a CPA will have to put together,” he says. “Because it is trust work, these costs are typically higher.”
Moreover, trusts reach the highest tax bracket of 37% at $13,050 of taxable income in 2021; by contrast, married couples filing jointly don’t hit the 37% rate until $628,300 of taxable income. The painful tax bite on money retained in an IRA trust for control and asset protection can be another cost to consider.
Review and reconsider
How do the new rules impact IRA trusts? “The SECURE Act provides a benefit,” says Cross, “because it simplified naming a trust as beneficiary. It’s not necessary to worry about required income distributions to satisfy the RMD requirements. That allows a shift from complex drafting to a focus on whether to put the asset into a trust.”
However, Andy Ives, an IRA analyst with Ed Slott and Company, finds IRA trusts less appealing now because the account may have to be paid out within 10 years.
“Suppose an IRA owner has a son with a gambling problem. Prior to the SECURE Act, such a client might have named an IRA trust as beneficiary, limiting distributions to those required,” says Ives.
He continues that if the IRA owner were to die now, the trust would pay out nothing for 10 years and then distribute the entire balance to the son. Consequently, the IRS and more talented gamblers would be the probable winners.
“This is why all trusts named as IRA beneficiaries before SECURE need to be revisited and updated,” says Ives. “That’s also why they don’t work as well now.”
In such a situation, depleting the IRA is a possible remedy, he says, if the tax hit would be acceptable. “One idea is to use the withdrawn IRA dollars to buy life insurance, and then name the trust as the beneficiary of the life insurance policy. There are no 10-year payout rules for life insurance, and the proceeds from life insurance can be tax-free, so this would be a far better source to fund a trust,” says Ives.
In other words, if an IRA owner wants to leave those dollars to an heir who doesn’t know when to fold ‘em, a non-IRA trust may be a better place to hold ‘em.