One of the key purposes of an estate plan is to ensure that assets pass to heirs smoothly and if possible, with less taxes and fees. Trusts are often promoted as a way to do this, but there are certain risks. You’ll want to understand how it works before going forward.
Trusts are estate planning tools that are used to control how assets in the trust are distributed or expended after you die. A recent article in Madison.com’s, “Consider This Before You Put an IRA in a Trust,” explains how two different kinds of trusts are used with a traditional IRA. However, proceed with caution, since there are tax implications that could be costly.
There are two types of trusts that can be used with a traditional IRA: a conduit trust and a discretionary trust. For each one, the required minimum distributions (RMD) from traditional IRAs flow directly to the trust, rather than the beneficiary. However, with a conduit trust, the RMDs go to the beneficiary and are taxed at the beneficiary's tax rate, not the trust's tax rate. In a discretionary trust, the trustees distribute assets or income to the beneficiaries, according to the trust's instructions, and RMDs are taxed at the trust's tax rate.
Trusts are frequently used when heirs are minor children, have special needs or are spendthrifts.
For passing along money to your heirs, a trust gives you more discretion. You can detail how the trust will distribute money to surviving family members, be sure money isn't spent recklessly and provide income to beneficiaries. If there is a beneficiary with special needs, a trust can help them avoid losing access to valuable benefits, like Medicaid. However, there’s a big downside to including a traditional IRA in a trust: more taxes for the IRS.
Traditional IRAs are funded with pre-tax dollars. Therefore, any growth in a traditional IRA is tax-deferred. The IRS hasn't collected taxes on this money, so it requires that non-spousal beneficiaries start taking money out of traditional IRAs following the account owner's death. If the beneficiary of a traditional IRA is a trust, the rules governing mandated withdrawals are more complex.
Example: Lewis leaves a traditional IRA worth $100,000 to a trust for his adult son, Thad. The trust's attorney must determine if the trust includes anyone else as a beneficiary. If not, then the amount that must be withdrawn every year is based on the adult son's life expectancy (found in the IRS Uniform Life Expectancy Table). Lewis's trust is a "see-through" or "look-through" trust. However, if Thad 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.
Except—if Lewis includes a charity or another non-person as a primary or remainder beneficiary, the trust can't be treated as a see-through trust, and the IRA must be liquidated more rapidly. Therefore, income taxes will be due based on IRS rules for IRAs without a listed beneficiary. All of the money in a traditional IRA must be withdrawn within five years of the IRA account owner's death. IRA withdrawals are taxable income, so it could be a monstrous tax bill.
If it’s a conduit trust, then RMDs will flow through to the trust beneficiary as they're taken and they would be taxed at the beneficiary's tax rate. If it's a discretionary trust, the assets don't flow directly to the beneficiary; income taxes are determined using the trust's tax rate, which could be much higher than the beneficiary's tax rate.
In 2017, trusts jump to the highest 39.6% income tax bracket, after only $12,400 in income. If RMDs exceed that amount, which is possible if trust assets are used to pay legal, accounting, and administration fees, then about 40% of any amount above $12,400 goes to the IRS, not to the beneficiaries.
An experienced estate planning attorney at Cottrell & Jacobs should be consulted before moving any assets into a trust to make sure that you are not leaving your heirs with a large tax surprise. You’ll also want to make sure that any move is aligned with your overall estate plan.
Reference: Madison.com (August 27, 2017) “Consider This Before You Put an IRA in a Trust”