You wouldn’t trust your toddler with a pile of cash, right? Well, this estate-planning technique may allow you to safely pass your IRA on to future generations—if you do it right.
Some of the biggest blunders in IRA distributions come to those who inherit these accounts. On the bright side, if handled correctly, you can structure the distribution, so your children or grandchildren reap the benefits for many years, says CNBC in the article “Leaving an IRA to a loved one? How to avoid a tax bomb.”
Naming a trust as an IRA beneficiary is a good way to protect large IRAs, since it provides some means of control. By naming a trust, you can protect heirs who are minors, vulnerable to creditors, not able to handle large sums of money or disabled. Trusts only need $12,750 of taxable income in 2019 to be subject to the top tax rate of 37%.
If you don’t structure the trust right, you could accelerate the liquidation of the IRA at warp speed.
Most people think of their spouse, when it comes to naming a beneficiary for an IRA. Unless your spouse needs the funds, it’s best to name the next generation. What are the pitfalls? Not all IRA custodians allow you to list a trust on the beneficiary form. The tax code has very specific conditions, when trusts are the beneficiaries of retirement accounts. If you fail to follow the rules, your heirs could face huge tax bills. For a trust to be viable as a designated beneficiary, it must meet a four-step test:
It must be valid under your state’s laws.
It must be an irrevocable trust, or one that will become irrevocable upon your death.
Beneficiaries must be identifiable from the trust document.
The IRA custodian or trust administrator must have received a copy of the trust by October 31 of the year after the death of the IRA’s owner.
The beneficiaries must be people, not charities and not your estate. If your beneficiaries are not people, then your IRA may not have a designated beneficiary. In that case, your heirs can’t stretch the IRA by taking required minimum distributions, based on the longer life expectancy of a child or a grandchild.
Worse—if your trust fails to meet the test, it is subject to the same rules as if there was no designated beneficiary at all. That means it’ll be depleted faster than you may have wished. If you die before you start taking RMDs (70½) then the IRA must be distributed within five years after death. If you die after you start taking RMDs, then distributions pay out over what would have been your life expectancy.
Speak with an estate planning attorney about the type of trust that will work best. There are two to chose from: a conduit trust, which distributes the RMDs directly to the beneficiary, or a discretionary trust, if you’re worried about a child who can’t manage money or who may be indebted to creditors. Note that RMDs are taxable income to the beneficiary when they receive it, but if the distribution is held in the trust, then the trust owes the taxes.
Reference: CNBC (Dec. 9, 2018) “Leaving an IRA to a loved one? How to avoid a tax bomb”
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