Generally, most people today have some sort of Individual Retirement Account (“IRA”) set up in order to protect their finances in preparation for retirement and their eventual passing. In order to pass their accumulation of wealth on to their spouse, children, or anyone else, most people designate a beneficiary on their IRA to receive the value once the person has passed away. However, most people do not realize that an IRA subjects the beneficiary to a number of rules and restrictions regarding the ability to withdraw and receive income from the account.

The largest restriction on the beneficiary’s use of an inherited IRA is the Required Minimum Distribution (“RMD”) rules, as well as several tax consequences. Broadly speaking, the Internal Revenue Service requires that participants in an IRA must take required distributions from their IRA beginning April 1 of the year following the calendar year in which the participant reaches age 70 1/2 or the calendar year in which the employee retires from employment (Treas. Reg. § 1.401(a)(9)-2). After the original participant passes away, generally the beneficiary is required to take RMDs based on the participant’s original life expectancy, thus subjecting a beneficiary to income taxes and RMDs, even though the beneficiary may not require the RMD at that time. Additionally, if the original participant passes away prior to the RMD, then the IRS requires the entire IRA to be distributed within 5 years (the dreaded “5 Year Rule”) to the beneficiaries, resulting in huge negative tax implications to the beneficiaries. Most people would like to pass on their IRA accumulation not only to an individual beneficiary, but to multiple children and grandchildren. However, this is almost impossible with a standard IRA account, and almost certainly liable for significant tax consequences to their children and grandchildren. If only there was a way….

Introducing the IRA Trust (ta da!). The IRA Trust (also known as an IRA Living Trust, IRA Inheritor’s Trust, IRA Stretch Trust, or IRA Inheritance Trust) is a special type of revocable living trust that’s designed to hold your IRA assets after your death. Within the IRA Trust agreement you will establish different subtrusts for the benefit of your spouse and/or other beneficiaries. If you want to create a lasting legacy for your family, then the subtrusts established within the IRA Trust agreement can be set up as lifetime Dynasty Trusts that can continue for many years into the future.

An IRA Trust should be considered if any of these issues are a concern for your estate plan:

  • Controlling distributions after death;
  • Maintaining accounts as separate property upon divorce;
  • Ensuring accounts will pass to descendants upon death of beneficiary;
  • Compelling long-term tax deferral;
  • Providing asset protection for IRA assets;
  • Ensuring that the benefits stay in the family;
  • Ensuring estate tax savings for children or grandchildren.

Essentially, the IRA Trust is initially structured as the beneficiary of your IRA account. That IRA Trust is then structured into several Sub-Trusts, which would be individual separate accounts for each one of your Designated Beneficiaries. You then have the power to control which percentage of your IRA is distributed to each beneficiary (ex: Bill gets 10%, Bob gets 15%, Sally gets 10%, etc.). Note that each Sub-Trust account is viewed as a separate account for each Designated Beneficiary, thereby providing maximum asset protection from creditors while avoiding the negative tax implications of the Traditional IRA account. Importantly, there is no tax penalty or fees for an early withdrawal on the Sub-Trust, so that each Designated Beneficiary can take out as much as he or she would like or need at any time.

Why should you consider an IRA Trust? Well, if your IRA is left directly to your beneficiaries outside of a trust, then your beneficiaries can immediately cash out your IRA and spend the money as they see fit. What happens if a beneficiary chooses this option? Then not only is a stretch out of the required minimum distributions, or RMDs, over the beneficiary’s remaining life expectancy lost, but 100% of the amount withdrawn will be included in the beneficiary’s taxable income in the year of withdrawal.

A different type of problem can be created if you name your minor grandchild as the direct beneficiary of your IRA. If this is the case, then a guardianship or conservatorship will need to be established to manage the IRA for the benefit of the grandchild until he or she reaches the age of 18. Then, once the grandchild reaches 18, he or she can withdraw 100% of what’s left in the IRA.

On the other hand, if your IRA passes to your beneficiaries through an IRA Trust, then you can put restrictions on how your IRA is spent and when and how much the beneficiary can withdraw. This can create an ongoing legacy for your family since the IRA assets that aren’t used during a beneficiary’s lifetime can continue in trust for the benefit of the beneficiary’s descendants. This can also be important if the beneficiary already has a taxable estate since the IRA Trust can be drafted to minimize or even eliminate estate taxes in the beneficiary’s own estate. An IRA Trust can also be used to insure that the RMDs are stretched out over the entire lifetime of each of your beneficiaries, thereby preserving assets left in the IRA for the benefit of future generations.

Aside from these benefits, if you’re in a second or later marriage and want your current spouse to have access to your IRA, but insure that what’s left after your spouse dies goes to your children or other beneficiaries, then an IRA Trust is a must for you. Additionally, IRA assets passing into a subtrust created for the benefit of an individual beneficiary under the terms of an IRA Trust will continue to be protected from creditors. This will insure that the IRA assets will remain intact for the benefit of the beneficiary in the event a lawsuit is filed against the beneficiary, if a married beneficiary later divorces, or if a single beneficiary gets married and later divorces.

However, that being said, there are several downfalls to an IRA Trust that you should strongly consider before making a decision. With an IRA Trust, an RMD still must be made annually to the Designated Beneficiary of each Sub-Trust. However, this RMD is distributed according toeach Designated Beneficiary’s life expectancy and not the original IRA account holder’s life expectancy, thus avoiding “The 5 Year Rule”. Furthermore, there are several tax consequences of administering and receiving distributions from the IRA Trust. When the grantor of the IRA Trust passes away and distributions are made, the IRA Trust is taxed as any other non-grantor trust, and a fiduciary income tax return, Form 1041, must be filed each year. Each distribution from the initial IRA account must be reported as income to the IRA Trust. However, the IRA Trust gets a tax deduction for any income it distributes and this income is then taxed to the Designated Beneficiary of the trust at that person’s individual income tax rates.

If you find yourself wondering how to distribute your IRA account among multiple beneficiaries, I suggest that you consider the possibility of creating an IRA Trust account with the separate Sub-Trusts for your estate planning needs. Our office has experience in drafting IRA Trusts in order to achieve the most tax-favorable strategy for both you and your beneficiaries. If you believe that an IRA Trust is the perfect tool for you, please contact our office so that we can meet with you discuss this wonderful (and still unknown) tool to satisfy your testamentary desires and estate planning needs!