Should You Use a Trust to Manage Inherited IRAs?
Deciding how to handle inherited assets is a significant responsibility, particularly when it involves retirement accounts, such as an IRA. Many people wonder about the best way to manage these funds to protect them for their beneficiaries.
When an IRA is passed down, the rules governing its distribution can be surprisingly strict. Naming a trust as the beneficiary of an IRA, rather than an individual, can offer greater control and protection, but it requires careful planning to be effective. An improperly structured trust can lead to unintended tax consequences and rapid depletion of the account. Seeking guidance from an attorney is a practical step to structure your estate plan correctly and safeguard the financial future of your loved ones.
The Elder & Disability Law Firm, APC, located in Redlands, California, assists families in understanding their estate planning options. The firm offers personalized and comprehensive services to help clients develop tailored estate plans, meet their unique needs and objectives, and make informed decisions about how to handle inherited assets, such as IRAs.
What Is an Inherited IRA?
An Individual Retirement Account (IRA) is a powerful tool for saving for retirement due to its tax advantages. However, when the owner of an IRA passes away, the account becomes an "inherited IRA" for the beneficiary. The rules for these accounts have changed significantly in recent years, affecting how and when a beneficiary must withdraw the funds.
Before the SECURE Act was passed in 2019, many non-spousal beneficiaries could "stretch" the distributions from an inherited IRA over their own life expectancy. This allowed the funds to continue growing tax-deferred for decades. However, the SECURE Act essentially eliminated this stretch provision for most beneficiaries.
Today, most non-spousal beneficiaries, such as children or grandchildren, are subject to a 10-year rule. This rule requires the entire balance of the inherited IRA to be withdrawn within 10 years following the death of the original owner. This accelerated distribution schedule can push beneficiaries into higher income tax brackets, potentially reducing the total value of the inheritance.
The Role of a Trust in Estate Planning
A trust is a legal arrangement where a person, known as the grantor, gives a trustee the responsibility of managing assets for the benefit of a third party, the beneficiary. Trusts are a cornerstone of modern estate planning as they offer a high degree of control over how and when assets are distributed.
Unlike a will, which goes through public probate, a trust is administered privately. This privacy, combined with the grantor's ability to set specific terms for asset management, makes trusts very useful. For example, a grantor can specify that a beneficiary receives funds only after reaching a certain age, graduating from college, or for specific purposes, such as education or a down payment on a home.
When considering an inherited IRA, a trust can act as the beneficiary. This arrangement allows the grantor to maintain control over the retirement funds even after they have passed away, directing how the assets are managed and distributed to the final beneficiaries.
Benefits of Naming a Trust as Your IRA Beneficiary
Using a trust to manage an inherited IRA offers several key advantages that are not available when naming an individual directly. These benefits are centered on protection, control, and providing for beneficiaries with specific needs.
Asset Protection from Creditors
One of the primary reasons people use trusts is to protect their assets. When a beneficiary inherits an IRA directly, those funds may be exposed to their personal creditors, lawsuits, or divorce proceedings. By placing the IRA assets into a properly structured trust, you can shield them from these risks. The trustee will oversee the funds and distribute them in accordance with the trust's terms, thereby protecting most of the assets from the beneficiary's potential financial challenges.
Control Over Distributions
The 10-year rule means a beneficiary could withdraw the entire IRA balance at once. This might not be what the original account owner wanted, especially if the beneficiary is young, financially irresponsible, or prone to making poor decisions. A trust solves this problem. As the grantor, you can specify exactly how the funds should be distributed. You could instruct the trustee to make annual payments over the 10 years or hold the funds in the trust and distribute them for specific needs, thereby providing long-term financial stability.
Planning for Beneficiaries with Special Needs
For families with a loved one who has a disability, a trust is an essential tool. A direct inheritance could disqualify a person with special needs from receiving vital government benefits, such as Supplemental Security Income (SSI) or Medicaid. A Special Needs Trust can be named as the IRA beneficiary. The trustee can then use the funds to cover supplemental needs—such as education, recreation, and medical care not covered by benefits—without jeopardizing the beneficiary's eligibility for public assistance.
California Laws and Inherited IRAs
In California, state laws align with federal regulations, such as the SECURE Act, regarding the 10-year rule for most inherited IRAs. This means beneficiaries throughout the state must empty the account within a decade of the original owner's death. This state-level adherence reinforces the need for careful tax planning, as large distributions can lead to a significant state and federal income tax bill.
California is a community property state, which can add another layer of challenges. If an IRA was funded with community property during a marriage, the surviving spouse may have a right to half of the account's value, regardless of who is named as the beneficiary. This is an important detail to address during the estate planning process to prevent potential disputes and legal issues in the future.
Creating a trust that qualifies as a "see-through" or "conduit" trust is also guided by specific state and federal requirements. For a trust to be considered a designated beneficiary and still apply the 10-year rule (rather than the more rapid five-year rule), it must meet specific criteria. These include being valid under state law, being irrevocable upon the owner's death, and having identifiable individual beneficiaries. An experienced attorney familiar with California estate planning law can help you establish a trust that meets these standards.
Potential Downsides of Using a Trust for an IRA
While trusts offer numerous benefits, they may not be the ideal solution for every situation. There are potential drawbacks to consider before naming a trust as the beneficiary of your IRA.
One issue is the cost and administration. Setting up and maintaining a trust involves legal fees and ongoing administrative duties for the trustee. For smaller IRA balances, the costs might outweigh the benefits. Additionally, trustees are entitled to a fee for their services, which is paid from the trust's assets, thereby slightly reducing the amount available to your beneficiaries.
Taxation can also be a factor. If the trust is set up as an "accumulation trust," where the trustee retains the earnings inside the trust, those earnings are taxed at compressed trust tax rates. These rates are much higher than individual tax rates, which can result in a greater tax burden if the funds are not distributed to the beneficiaries. Therefore, it's essential to carefully draft the trust document to manage these tax implications effectively.
Estate Planning Attorney Serving Redlands, California
The Elder & Disability Law Firm, APC, is a hands-on practice that guides clients through every step of the planning process. Led by Attorney Esther C. Wang, the firm focuses on creating estate plans that can avoid probate, reduce estate taxes, and help you qualify for other important benefits. The firm is dedicated to helping your family preserve your assets for future generations.
Many people are often worried about what will happen after their passing and how things will be taken care of. Attorney Wang can help ease these fears by preparing you for the future and clearly dictating your wishes. A well-crafted estate plan can make everything much smoother for your family.
Located in Redlands, California, the firm serves communities throughout Southern California, including Riverside, Rancho Cucamonga, and Palm Springs. Reach out today to schedule a consultation.