Should Your Trust Be the Beneficiary of Your IRA or 401(k)?

We see clients whose retirement account beneficiary is their revocable living trust. Sometimes that is exactly what the estate plan requires. Often it isn’t.  Naming your “living” trust as beneficiary seems logical.  The purpose of a living trust is to receive and distribute your assets when you die.

Retirement accounts are different.

Retirement accounts are governed by beneficiary designations and specialized federal income tax rules. A beneficiary designation that makes perfect sense for a bank or brokerage account may produce a very different result when applied to an IRA or 401(k).  In the wrong circumstances, naming a trust can substantially accelerate retirement account distributions and create a significant income tax bill. Depending upon the retirement plan itself, it can even result in a lump-sum distribution.

A Little History

Traditional retirement accounts generally allow contributions to be made with pre-tax dollars, with income taxation deferred until money is distributed from the account.  Historically, an individual beneficiary could often take distributions from an inherited retirement account over their life expectancy. This was commonly called the “stretch IRA.”  Stretching distributions over a beneficiary’s life expectancy provided two important advantages. It spread the income tax consequences over many years, and it allowed the remaining retirement funds to continue growing on a tax-deferred basis.

Trusts presented a more difficult problem.

A trust is not an individual and therefore is not itself a “Designated Beneficiary” under the retirement account rules. However, the IRS developed regulations allowing us, in certain circumstances, to “look through” a properly structured trust and treat its individual beneficiaries as the retirement account beneficiaries.

This became known as a “see-through trust.”

The see-through trust rules are complicated. Certain trusts and certain trust provisions can cause problems because it may not be possible to identify the individuals who must be considered beneficiaries under the retirement account rules.  If a trust fails to satisfy the see-through requirements, the retirement account may have to be distributed substantially faster than anticipated. The exact result depends upon several factors, including the age of the retirement account owner at death and the terms of the particular retirement plan.

Trusts Can Also Create an Income Tax Problem

Even when a trust satisfies the see-through rules, there can be another problem: income taxes. After someone dies, the trust receiving the retirement benefits will frequently become an irrevocable nongrantor trust. Unlike a typical revocable living trust during the trust maker’s lifetime, the irrevocable trust may become a separate income taxpayer.

Nongrantor trusts are subject to highly compressed federal income tax brackets. A trust can reach the highest federal income tax bracket with a surprisingly small amount of retained taxable income—far sooner than an individual taxpayer. That does not necessarily mean all retirement distributions received by a trust will be taxed at the trust’s tax rate. Depending upon the trust provisions and distributions made to the beneficiaries, taxable income may instead be carried out to the beneficiaries and taxed on their individual income tax returns.  But this creates another layer of complexity to consider when deciding whether a trust should be the retirement account beneficiary.

There is also another issue with employer retirement plans such as 401(k)s. The tax laws may permit a particular distribution schedule, but the retirement plan itself may offer more limited distribution options. A trust that works perfectly under the IRS see-through rules does not necessarily guarantee that the plan administrator will allow the distribution schedule you expected.

Then the SECURE Act Changed the Rules

The SECURE Act dramatically changed the rules for inherited retirement accounts. For many nonspouse beneficiaries, the old lifetime “stretch” is gone. Instead, the entire inherited retirement account generally must be distributed by the end of the tenth year following the retirement account owner’s death.

There are important exceptions for certain “Eligible Designated Beneficiaries.” These include surviving spouses and, under particular rules, minor children of the account owner, disabled individuals, chronically ill individuals, and beneficiaries who are not more than ten years younger than the retirement account owner.

The rules can become even more complicated depending upon whether the retirement account owner died before or after beginning required minimum distributions. In some situations, annual distributions must continue during the ten-year period rather than simply waiting until year ten to empty the account.

The important point is not to memorize the rules.  The important point is that the rules changed.

Before the SECURE Act, obtaining decades of tax-deferred growth could be an important reason for carefully structuring a trust to receive retirement benefits. For many beneficiaries, that lifetime income-tax deferral is no longer available.

That does not mean trusts should never be named as retirement account beneficiaries. There may be very good reasons to use a trust. A beneficiary may be a minor, disabled, financially irresponsible, vulnerable to creditors, going through a divorce, or simply not someone who should receive immediate control of a substantial inheritance. A trust can also be important when you want to control who ultimately receives the remaining assets after the first beneficiary dies.  But today, the benefits of using a trust need to be weighed against the additional complexity and potential income tax consequences.

Check Your Beneficiary Designations

Sound complex?  We think so.

In our estate plans, we generally try to avoid naming a trust as the retirement account beneficiary unless there is a good reason for doing so. The retirement account rules are complicated, the see-through trust requirements are easy to misunderstand, and the SECURE Act has eliminated much of the lifetime income-tax deferral that once made these arrangements attractive.  Yet we continue to see clients coming in for estate plan reviews whose revocable living trust is named as the retirement account beneficiary. Sometimes that is intentional and appropriate. Often it isn’t.

If you have named a trust as beneficiary of an IRA, 401(k), or other retirement plan, consider having the designation reviewed by your estate planning counsel and financial advisor.