Creating a trust is a common estate planning tactic. There are many types of trusts, with a variety of purposes. One of the biggest reasons to create a trust is to protect assets from probate, which can cost from 5% to 7% of your estate. Other reasons for creating a trust: to lower estate and gift taxes, distribute assets to heirs more economically and efficiently and better protect assets from creditors and lawsuits.

Naming a beneficiary to an IRA to a trust may have unintended consequences. In general, money in an IRA, 401(k) plan403(b), or other retirement account isn't normally covered by a will. IRAs are transferred to beneficiaries as directed by the beneficiary designation form completed by the account holder. 

Thus, in order to pass an IRA to a trust, the account holder must name the trust as the beneficiary. (For related reading, see: 5 Common Mistakes When Creating a Trust Fund for Your Child.)

The Baseline Issues

There are both positive and negative consequences of transferring an IRA to a trust. Naming a trust as an IRA beneficiary can control how wealth is distributed and it may protect beneficiaries. The reasons to name a trust as a beneficiary:

  1. You are in a second marriage, with children from a previous marriage.
  2. You want to protect minor children.
  3. You want to create withdrawal controls in order to protect spendthrift beneficiaries from recklessly depleting the assets.
  4. To protect the account from potential creditors.
  5. To care for a special needs beneficiary.
  6. For the future, to protect the account in case a beneficiary is involved in a future divorce. (For related reading, see: Estate Planning Goes Digital: How to Get Started.)

Know the Negatives of Transferring

Although there are benefits of naming a trust as an IRA beneficiary, there may be negative tax and other consequences to this decision. Trusts are expensive to set up. If the client wants to allow the heirs to stretch the IRA distributions across longer periods of time to defer taxes, the trust must be structured with that end in mind. The advisor must understand that if the trust is improperly administered, there can be unintended tax implications.

The advisor should study the issue and consult an expert estate planning attorney when necessary. There are two types of trusts to understand when naming an IRA beneficiary; a conduit trust or an accumulation trust. The conduit trust has a single individual primary beneficiary and is required to withdraw the required minimum distribution (RMD) annually. Then the distribution is passed to the beneficiary of the trust. The distribution amount is calculated based upon the beneficiary’s life expectancy.

The accumulation trust encompasses all other trusts except the conduit trust. The trustee of an accumulation trust is allowed to hold withdrawals within the trust and isn’t forced to immediately distribute withdrawals from the IRA. Keeping the assets in the accumulation trust has advantages and disadvantages. What's good is that the trust continues to protect the assets and might be able to minimize taxes. On the other hand, the assets may also be taxed at the higher estate tax rate than the individual’s lower tax rate. This potential complication highlights the importance of recommending that the client consult an estate planning attorney.

The Bottom Line

The traditional IRA was initially created for an individual to save for retirement in a tax-advantaged account and then to spend in his or her own retirement — there were provisions to avoid continuing the tax-advantaged benefits from enduring indefinitely. That is why there are required minimum distributions. Fortunately, for estate planning, an inherited IRA benefits by drawing out based upon the heir’s life expectancy. Since a trust isn’t an individual but a legal entity, an improperly structured trust that is named as an IRA beneficiary has the potential to lose the advantage of stretching out benefits past the death of the original owner. The complicated estate planning decision of whether to name a trust as the beneficiary of an IRA or not should be carefully evaluated and discussed with an experienced estate planning attorney. (For related reading, see: How to Tell if You Need an Estate Planning Lawyer.)