Using a Traditional IRA to leave wealth saved in retirement accounts to loved ones is a smart move. Combined with a trust, it can be even better. IRAs provide the greatest possible freedom in selecting beneficiaries, as you can name nearly anyone as an IRA beneficiary: grandchildren, an unmarried domestic partner, even a friend. And you can change your beneficiaries whenever you want. In contrast, under federal law, employer-sponsored qualified retirement plans, such as 401(k)s, require one’s spouse to be the default beneficiary, and you must get your spouse’s written permission to change that.
So if you want to have maximum freedom in leaving retirement funds as you wish, consider saving in an IRA and rolling over funds from your employer plan accounts into a Traditional IRA.
The benefit is that you can use your control over beneficiary designations to maximize your family’s long-term wealth and welfare.
Smart IRA Bequests
- Child and non-spouse beneficiaries. Tax-wise, the greatest benefit comes from leaving an IRA to a person who is as young as possible because a beneficiary can take minimum required distributions from the IRA that are spread over his or her entire life expectancy. The younger the beneficiary, the smaller are the required annual distributions and the greater is the “stretch out” number of years of tax-deferred investment returns compounding in the IRA. For a young grandchild, compounding may run for decades, building wealth intergenerationally.
- Spouse beneficiaries. If providing for your spouse is your first priority, you can name your spouse as your IRA beneficiary and children or others as contingent beneficiaries who receive whatever balance remains in the IRA after your spouse dies.
These strategies are simple and low-cost; with the help of your professional advisor you can make the best IRA beneficiary designations.
But Will All Your Wishes Be Fulfilled?
These strategies have potential problems that can keep them from working and thwart your intentions.
- Individual beneficiaries of an IRA are free to do whatever they wish with inherited IRA funds. They can choose to spend them all immediately, in spite of your having intended to provide your beneficiaries the opportunity to keep the funds invested in the IRA for many years.
- A spouse beneficiary of an IRA has the right to roll over the IRA into a new IRA of his or her own. The spouse takes full control over the new IRA, including naming its beneficiaries. This may result in the spouse replacing your preferred contingent beneficiaries with other people.
- Under federal law, IRAs provide no protection against general creditor claims, such as those that may arise from auto accidents or business liability lawsuits. Any protection that exists does so only under state law. So IRA funds left to a beneficiary with legal problems may be taken by creditors—and you can’t know what legal problems your beneficiaries may face in the future.
An IRA Trust as the Solution
A solution to these problems can be to create a trust and name the trust as beneficiary of your IRA, with your spouse, children or others as beneficiaries of the trust. (You can’t put your IRA in a trust while you’re living.) The terms of the trust control its distributions so it can assure that your intentions are fulfilled. For instance:
- After your spouse is provided for, remaining funds pass to your children or whomever else you wish.
- Child beneficiaries receive distributions only under a schedule and on terms determined by you.
- Because the inherited IRA funds are owned by the trust, not the beneficiary, they can be much better protected against creditor claims.
As these examples show, a trust can provide great flexibility in controlling the distribution of IRA funds to heirs.
Consider the Tradeoffs
Trusts have some drawbacks, too.
- There are set-up and management fees, which increase with the complexity of the trust and demands on the trustee. Note: When a minor child is an IRA beneficiary some kind of custodial arrangement is required under state law in any event, offsetting some of this cost.
- “Stretch out” distributions may be limited when a trust has more than one beneficiary because minimum distributions are set by the life expectancy of the oldest. You can avoid this by creating separate IRA trusts for different beneficiaries—such as a spouse and child—although this increases trust costs.
- Trusts must satisfy both state law and complex IRS regulations. Technical mistakes may prove very costly.
To make the best decision about whether to use a trust with a Traditional IRA, consider the tradeoffs with the help of an expert.
A growing number of financial firms that sponsor IRA services now offer “trusteed IRAs” as a product for customers. These provide trust arrangements that cover many of the most common situations experienced by IRA owners, and the firms’ expertise assures all technical rules are met. The cost is more than that of a simple, no-trust IRA, but may be much less than creating a custom trust of your own. Firms offering trusteed IRAs now include Merrill Lynch, USAA, Key Bank, MassMutual and others.
Check with an Expert
Highly technical rules apply to both IRA distributions and trusts, so be sure to discuss these ideas with an expert advisor before acting.