You cannot put your individual retirement account (IRA) in a trust while you are living. You can, however, name a trust as the beneficiary of your IRA and dictate how the assets are to be handled after your death. This applies to all types of IRAs including traditional, Roth, SEP, and SIMPLE IRAs. If you establish a trust as part of your estate plan and want to include your IRA assets, it is important to consider the characteristics of an IRA and tax consequences associated with certain transactions.
What Is an IRA?
IRAs were created in 1974 under the Employee Retirement Income Security Act, or ERISA, to help workers save for retirement on their own. At the time, many employers could not afford to offer traditional-style pension plans, leaving employees with only Social Security benefits after they stopped working.
The new IRA accounts achieved two goals. First, they provided tax-deferred retirement savings for those not covered under an employer-sponsored plan. Second, for those who were covered, IRAs provided a place for retirement-plan assets to continue to grow when and if the account holder changed jobs via an IRA rollover.
Who Can Own an IRA?
As the name implies, individual retirement accounts can only be owned by an individual. They cannot be held in joint name, nor can they be conducted by an entity, such as a trust or small business. Additionally, contributions can only be made if certain criteria are met. For example, the owner must have taxable earned income to support the contributions. A nonworking spouse can also own an IRA but must receive contributions from the working spouse, and the working spouse's income must meet the criteria.
Regardless of where the contributions originate, the IRA owner must remain constant. Only certain ownership transfers are allowed to avoid being categorized as a taxable distribution. If transferred to a trust, IRA assets become taxable as this transfer is seen as a distribution by the IRS. In addition, if the owner is under age 59½ at the time of distribution, an early withdrawal penalty is imposed. The trust can accept IRA assets of a deceased owner, however, and establish an inherited IRA.
Advantages of a Trust Beneficiary
Naming a trust as the beneficiary to an IRA can be advantageous because owners can dictate how beneficiaries use their savings. A trust instrument can be designed in such a way that special provisions for inheritance apply to specific beneficiaries—a helpful option if beneficiaries vary greatly in age, or if some of them have special needs to be addressed. Many people also believe the trust provides tax savings for beneficiaries, but that is rarely the case.
Important factors to consider are how beneficiaries take possession of the IRA assets and over what time period. Seek advice from a trust adviser well-versed in inherited IRAs. To gain the maximum stretch option for the distribution of the account, the trust must have specific terms such as "pass-through" and "designated beneficiary." If a trust does not contain provisions for inheriting an IRA, it should be rewritten, or individuals should be named as beneficiaries instead.
Disadvantages of a Trust Beneficiary
Although moving all assets into the name of a trust and designating it as the beneficiary on retirement accounts is commonplace, it is not always a good decision. Trusts, similar to other non-individuals that inherit IRA assets, are subject to accelerated withdrawal requirements, most often within five years from the original IRA owner's death. Without the proper "pass-through" terminology referenced above, stretching the withdrawals over a lifetime is not an option. Depending on the size of the account, this could place a burden on beneficiaries. Particularly detrimental is eliminating the spousal inheritance provisions by naming a trust instead of a spouse as the beneficiary.
While trusts can streamline most estate-planning areas, they can create more paperwork and even additional tax burdens for beneficiaries of an inherited IRA. Work closely with an estate planner, attorney, and accountant, who are all knowledgeable about trusts and IRAs, to maximize a legacy.