When designating beneficiaries for a retirement account one option is to leave the money to a trust. In the financial community, the advantages and disadvantages of this route have been a topic of an ongoing debate between estate planning attorneys and financial advisors.
Naming beneficiaries for qualified retirement plans means that probate, attorneys' fees, and other costs associated with settling estates are avoided.
Naming a trust as a beneficiary is a good idea if beneficiaries are minors, have special needs, or can't be trusted with a large sum of money.
The major disadvantage of naming a trust as a beneficiary is required minimum distribution payouts.
Naming a Trust as Beneficiary of a Retirement Account: An Overview
Qualified retirement savings accounts are a great way to build a retirement nest egg. But what happens to the money in the account if the account holder passes away?
For retirement accounts, investors are given the opportunity to name both primary and contingent beneficiaries—that is, the person or entity who will inherit the account upon the original owner's death.
The exact mechanism for doing this can get complicated, and factors like taxes and required minimum distributions have to be taken into account. The number of beneficiaries named—and whether they are the benefactor's spouse or not—also make a difference.1
Naming a trust as the beneficiary has pros and cons that need to be considered. Read on to learn if it is the best option for you.
Pros of Naming a Trust as Beneficiary of a Retirement Account
Naming a trust as a beneficiary is advantageous if your beneficiaries are minors, have special needs, or cannot be trusted with a large sum of money. Some attorneys will recommend a special trust be established as the IRA beneficiary to avoid its assets becoming part of a surviving spouse's estate, all in an effort to avoid future estate tax issues.2
Since qualified retirement plans—such as a 401(k) or 403(b), an IRA or a Roth IRA—pass by way of contract directly to a named beneficiary, the often lengthy probate process, attorneys' fees, and other costs associated with wills and settling estates are avoided.
Cons of Naming a Trust as Beneficiary of a Retirement Account
The primary disadvantage of naming a trust as beneficiary is that the retirement plan's assets will be subjected to required minimum distribution payouts, which are calculated based on the life expectancy of the oldest beneficiary. If there is only one beneficiary, it does not matter as much, but it can be problematic if there are several heirs of varying ages: The ability to maximize the deferral potential of the qualified plan's interest is lost under this approach.
In contrast, naming individual beneficiaries will allow each beneficiary to take a required minimum distribution based on their life own expectancy, which can stretch an IRA's earnings out for a longer period of time.3
For trusts and accounts inherited after Jan. 1, 2020, there's another wrinkle. Under the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, most non-spousal beneficiaries of an IRA must take full distribution of all amounts held in the IRA by the end of the 10th calendar year following the year of the IRA owner's death.
The SECURE Act effectively eliminated the "stretch IRA," a financial planning tactic that allowed beneficiaries to stretch their required minimum distributions (RMDs) over their life expectancy and extend the tax-deferred status of an inherited IRA.
But exceptions to this SECURE Act rule do exist for certain people. Known as eligible designated beneficiaries (EDB), they include a surviving spouse, minor children of the IRA owner (until they reach the age of majority), disabled or chronically ill individuals, and individuals who are not more than 10 years younger than the IRA owner.4 For these beneficiaries, the 10-year payout rule does not apply, and the trust can stretch payments out over the EDB’s lifetime, subject to the same life-expectancy rules outlined above.5
It's also important for the trust containing the IRA to be a see-through trust.
While the IRA owner is alive, only the IRA owner can change the designated beneficiary of the IRA. Exceptions may apply if there is an attorney-in-fact, in which a power of attorney includes provisions that appoint that agent to act on the IRA owner's behalf. Similar exceptions apply to conservators, who can be appointed by a court to take care of legal matters for an IRA owner who is unable to do so.
After the IRA owner's death, the designated beneficiary, including a trust beneficiary, has the option of disclaiming the inherited assets. If the disclaimer is qualified, the assets will generally pass to the contingent beneficiary. If there is no other primary or contingent beneficiaries, the beneficiary will be determined according to the default provisions of the IRA plan document.