Individual Retirement Arrangements (IRAs) provide a unique challenge in the context of estate planning. IRAs are unique assets because they require the designation of a beneficiary in case of death of the account holder. So long as a beneficiary is designated, the administration of these types of accounts will be governed without regard to any provision in an existing trust or will. Because of this, the naming of IRA beneficiaries becomes a critical piece of one’s estate plan, with advantages and disadvantages to the various options available.
Option 1: Designating an Individual as Beneficiary
More often than not, individuals with IRA assets in their portfolio will choose to designate some combination of family members or friends as the beneficiary of an IRA. This is the most direct way of transferring assets to beneficiaries upon the death of the account holder. Once the custodian of the IRA is informed of the death, the custodian then sets into motion its own process of distributing funds to the designated individuals. Those individuals are often provided with the choice of:
- Performing a rollover of the inherited funds into the beneficiary’s own IRA,
- Converting the inherited funds to a Roth IRA owned by the beneficiary, or
- Receiving the cash outside of the Inherited IRA
While this is typically the simplest option when designating a beneficiary, this option lacks a critical feature that can make a great deal of difference in certain family structures: control. When designating an individual as an IRA beneficiary, the original account holder retains little control over how funds are used after his/her passing. This becomes especially important when beneficiaries are minors, financially irresponsible, or vulnerable to creditors or divorce. This beneficiary designation strategy does pose risk to a beneficiary may not be capable of managing the windfall that comes with an Inherited IRA, making it less attractive to those making the designation.
Aside from control, IRAs (specifically, Traditional IRAs) are typically expensive assets to inherit. Any distributions made to a beneficiary from a Traditional IRA are taxable to that beneficiary as ordinary income in the year the distribution is made. Furthermore, the SECURE Act 2.0 stipulates that most IRA’s that are inherited must be FULLY distributed within 10 years of the decedent’s date of death. “Eligible Designated Beneficiaries” that inherit IRA’s, however, are not required to adhere to this 10-Year Rule. Individuals such as surviving spouses, minor children, or chronically ill individuals fall into this category.
Regardless, beneficiaries that inherit large IRAs may be moved into higher tax brackets than they are accustomed to, leading to potential penalties or cash flow issues when tax becomes due.
Option 2: Designating a Trust as Beneficiary
The designation of a trust as the beneficiary of the IRA allows the account holder to have control of how assets are managed after their passing. Upon death, the trust instrument can determine how IRA funds are liquidated (either all at once, or over the term specified by the SECURE Act 2.0) and how they are distributed to beneficiaries. Furthermore, the trust agreement names a trustee and trust protector that ensures the settlor’s wishes are fulfilled through administration of the trust.
It is important that the trust is written such that it meets the see-through trust requirements espoused under IRC §401, Treasury Regulation §1.401, and IRS Publication 590-B. By meeting the following requirements, the trust will be “looked through” for purposes of Required Minimum Distribution determinations, to the ultimate beneficiaries of the Trust. If all Trust Beneficiaries are Eligible Designated Beneficiaries, then the Trust will be eligible to hold the Inherited IRA for 10 years instead of the 5 years that a non-designated beneficiary would be allowed to hold the IRA for:
- The trust is valid under state law or would be but for lack of corpus.
- The trust is irrevocable or becomes irrevocable at the IRA owner’s death.
- The beneficiaries who may receive the IRA interest through the trust are identifiable from the trust instrument.
- The trustee satisfies the documentation requirements, generally by providing either the trust instrument or a final beneficiary list by October 31 of the year following the year of death.
- See-Through Trusts can be further classified as either Conduit Trusts or as Accumulation Trusts. A Conduit Trusts requires that all IRA distributions received in a given year must be distributed to a specified beneficiary or beneficiaries. An Accumulation Trust does not carry such a requiurement, and it instead allows for IRA distributions to be held in Trust for the benefit of some potential future beneficiary. Accumulation Trusts tend to carry more uncertainty when determining RMD’s and the appropriate recovery period, as potential future beneficiaries could cause unfavorable RMD or recovery consequences due to age or relationship to the deceased.
The major disadvantage of the trust holding the IRA is the significantly higher tax brackets that trusts are subjected to compared to individuals. If the trust makes no beneficiary distributions, then the trust will be subjected to a considerably higher tax than it would be had an individual in a lower tax bracket directly inherited it. Furthermore, there are additional expenses associated with trusts such as, and tax return preparation fees that could make the trust a less attractive option. In essence, there is a price to pay for control of the IRA Assets after death, but it could be a price worth paying given a family’s unique situation.
Option 3: Designating your Estate as Beneficiary
Designating one’s estate as an IRA beneficiary is much simpler than creating a trust to manage IRA assets post-death. The estate option does provide some level of control over IRA distribution to beneficiaries as the beneficiaries do not receive direct access to the associated funds. The distribution of these funds is governed by the will of the deceased account holder.
While estates are taxed similarly to trusts, the Estate would need to recognize income from the IRA more quickly than it would in a trust since the estate is not considered a designated beneficiary. The SECURE Act 2.0 dictates that in this situation, IRA funds must be distributed over the 5 years immediately after death, instead of over 10 years with a properly created see-through trust.
Another consideration: assets inherited through an estate may be exposed to creditors or legal claims, including divorce settlements or lawsuits involving the beneficiary. This risk is not nearly as prominent with respect to an IRA inherited by a trust.
While there is no universal answer, your personal estate planning goals should drive the beneficiary designation that you make. If you value control, asset protection, and managing how beneficiaries receive funds, a trust may be your best option. However, if simplicity or ease of administration are more important to you, designating an individual or an estate as the beneficiary may be more practical. Always consult with your Estate Planning Attorney, CPA, or Financial Advisor before making the beneficiary designation.
