26 Dec What Is an IRA Trust, and When Do I Need One?

In the estate planning world it can be easy to get confused. There are many available tools and advice on how to best use them. You may have heard your colleagues, friends, or family talk about how they’ve created an IRA inheritance trust to pass the remainder of the account to their grandchildren after they die. This could leave you thinking, doesn’t the remainder of an IRA account automatically avoid probate and pass to a beneficiary if designated properly? Do I need an IRA trust?

First, we’ll go over the details of what an IRA trust is, how it works. Then you may see why someone would choose it. Next, we’ll discuss how it’s a beneficial tool for protecting the inheritance you’ll leave to your children or grandchildren. 

What Exactly Is an IRA Trust?

An IRA inheritance trust is a trust that is designed specifically for retirement funds. For many of our clients, their company retirement plan or IRA is one of their largest financial assets. In fact, it’s often the second-largest asset in their estate, after their home. Because an IRA is such a significant asset, it’s vital to plan ahead so you can maximize its benefits.

Here are some quick answers to the two most common questions:

Can you place an IRA in a trust?

No—that’s not exactly how trusts and retirement accounts work together. A more appropriate question would be, “Can I name a trust as the beneficiary for my IRA account?” The answer to this question is yes! 

How do I know if I need an IRA Trust?

If you want to make sure the remainder of your IRA can be used to provide for certain types of beneficiaries, you might need an IRA Trust. In cases where the intended beneficiaries are minors, have special needs, or require someone else to manage their money for them, an IRA trust is a good idea. You will be able to leave specific instructions regarding the distribution and management of your IRA funds. 

What Are the Benefits of an IRA Trust?

One of the best features of an IRA inheritance trust is that you can protect the funds by naming a trust as a beneficiary instead of an individual. This action prevents creditors from coming after the assets. 

If you name an individual as the beneficiary of your IRA, their creditors may be able to claim the funds instead. A bankruptcy proceeding, for example, could put an IRA inheritance risk. The Supreme Court has ruled that there should be no federal protections for IRA funds. However, Arizona has a state law exempting IRA beneficiaries from all claims of creditors. If you live in Arizona but your IRA trust was started in another state, it could be at risk.

Another benefit of an IRA trust is that you can control the distributions. The trust allows you to decide when and how your beneficiaries receive the funds, providing protection for young beneficiaries or those with financial difficulties. If your beneficiary is not financially savvy, you can hire a professional trustee who will ensure that the assets are handled properly.

What Are the Rules for an IRA Trust?

In order for your IRA inheritance trust to be legally recognized as a valid beneficiary, it must meet the following conditions:

1. The IRS requires that the trust qualify as a “look-through” or “see-through” trust. This means the trust’s beneficiaries must be living and identifiable, so their life expectancies can be determined. This enables the account to take advantage of the IRA stretch strategy, where the distributions are stretched over the life expectancy of the trust beneficiaries. For example, only individuals like spouses and children, not charities or corporations, are eligible to receive IRA distributions. 

2. The trust needs to have the correct documentation. You will need to ensure that the trust is structured properly and executed by a qualified attorney. A simple will or generic trust will not suffice, nor will it hold up in court.

3. The trust must be legally valid and comply with Arizona state law. It’s essential to work with a lawyer or estate planning firm that is well-versed in Arizona trust laws and can handle the complexities of tax planning. 

How Do the Taxes Work with an IRA Trust?

Understanding all the tax implications of IRAs and IRA inheritance trusts can be quite challenging, because they’re complicated and subject to change. However, we can give you an understanding of the basics, so let’s break down the most important things you need to know. 

Contributions to a Traditional IRA are typically tax-deductible in the year they are made, reducing your taxable income for that year. This is subject to income limits, eligibility, and other factors. The funds in the account continue to grow, tax-deferred. You do not pay taxes on the earnings (interest, dividends, or capital gains) until you withdraw the money. 

Contributions to a ROTH IRA, on the other hand, are made after taxes, meaning you pay the tax when you put the money in. These contributions do not reduce your taxable income, however, Roth IRAs will continue to grow tax-free. Qualified distributions from a Roth IRA are tax-free, as long as the withdrawals are made after age 59½ and after at least 5 years of owning the account.

Secure Act Requirements

Under the SECURE Act, most non-spouse beneficiaries must withdraw the full balance of the inherited IRA within 10 years of the original account holder’s death. This rule applies to both Traditional and Roth IRAs, but the key difference is that Roth IRA withdrawals are typically tax-free. 

However, there is a portion of the SECURE Act that allows eligible designated beneficiaries to continue to take distributions over their lifetime. Eligible beneficiaries include the surviving spouse of the IRA owner, a minor child, a disabled or chronically ill individual, or individuals who are not more than 10 years younger than the IRA owner.

Required Minimum Distributions (RMDs)

Just like individual beneficiaries, the trust must collect the required minimum distributions. If the trust is a “look-through” trust (which is required for IRA Inheritance Trusts), the RMDs are calculated based on the life expectancy of the oldest beneficiary of the trust.

Taxation of Funds Inside the Trust

The IRA funds that are transferred to the trust are subject to income tax when withdrawn. However, since the trust is a separate legal entity, it will be taxed at the trust’s rates. These rates are more compressed than individual tax brackets. This means that the trust could pay higher taxes if it holds onto the IRA funds for too long before distributing them to the beneficiaries.

When the IRA funds are distributed to the beneficiaries of the trust, the beneficiaries are then responsible for paying income taxes on their distributions. 

Set Up an IRA Trust with Help from Phelps LaClair

While an IRA Inheritance Trust can offer flexibility and control, it must be structured correctly. It also must be updated regularly to comply with changes in tax laws. Considering the complex rules surrounding IRAs, you need to make sure you work with a team of qualified legal professionals to set up the trust. 

The experienced tax attorneys Phelps LaClair understand every complexity of the IRS distribution rules, and we are uniquely equipped to offer you this ground-breaking trust. An IRA Inheritance trust is a powerful, cutting-edge planning technique that has received a favorable ruling from the IRS. 

Do you have IRAs and company retirement plans totaling over $150,000? If so, you could benefit from taking advantage of this estate planning tool. Meet with us or sign up for a webinar to receive a free consultation and learn more about our services. We are confident that we can help you preserve your family’s legacy. 

 

Images used under creative commons license – commercial use (12.10.2024). Photo by Jay Alexander on Unsplash. Image was cropped. Background was blurred.