Your IRA allows you to designate one or more beneficiaries to receive your account funds in the event of your death, so why would you want to go one step further and create an IRA trust? There are a couple of reasons why you might opt to include this tool in your estate plan.
First, a brief overview of how an IRA trust works: it’s a revocable trust that you establish, naming the trustee as beneficiary of your IRA. When you pass away, the balance of your IRA will pass to your trustee, who will be obligated to manage and distribute the funds according to the terms you’ve established for the trust. You can name your children, grandchildren, or any number of individuals as beneficiaries of the trust. So, your IRA funds will flow through the trust and be distributed to the ultimate beneficiaries according to your instructions. When is an IRA trust useful?
As one example, an IRA trust can prove useful when one or more of your beneficiaries have not yet reached legal adulthood when you pass away. Whether you’re leaving an inheritance to your child, your grandchild, or another young loved one, the law prevents children from directly inheriting all but the smallest sums of money. So, unless you’ve made prior arrangements for a trusted adult to manage the funds on behalf of the child, an inheritance will mean a trip to probate court so that a judge can appoint someone to take control of the funds until the child reaches adulthood. Not only can this prove time consuming and expensive, this option also involves the risk that the court will appoint an adult whose style of money management you disagree with.
Even if your beneficiaries are all adults, an IRA trust can still be a valuable tool. When you simply name a loved one as the direct beneficiary of your IRA, that person has a great deal of latitude when it comes to withdrawing funds from the account. If your beneficiary wants to, he or she can take the entire balance in one lump sum distribution. This is usually a bad idea, because your beneficiary is responsible for income taxes on a distribution in the year it’s taken, and because once money is withdrawn from the IRA, it loses its power to grow over your beneficiary’s lifetime. So, your beneficiary could end up shortchanging himself when it comes to the ultimate amount of his inheritance, not to mention paying a whopper of a tax bill.
When you establish an IRA trust, you can specify that your beneficiary only takes the Required Minimum Distributions (RMD’s) from the account, thus stretching out the number of years the account balance lasts. This allows the IRA to reach its full growth potential while minimizing your beneficiary’s annual income tax bill. Taken together, these two factors can result in your beneficiary receiving the largest possible IRA inheritance.
Your estate planning attorney can help you determine whether you should include an IRA trust as part of your overall plan.