Naming a Trust as a Beneficiary of a Retirement Account

In 2015, the federal estate tax exemption is $5.43 million dollars, per person. Married couples, therefore, can shield $10.86 million dollars without having to pay any estate taxes to Uncle Sam. Because of this increasingly high (indexed for inflation) estate tax exemption, the focus of estate planning has shifted away from avoiding estate taxes to more practical considerations, such as asset protection and income tax planning.

The two largest assets in most people’s estates are their home and retirement accounts.  Of the two, the most misunderstood is the retirement account. Determining who should receive the benefit of these accounts upon your death and how best to structure such bequests will have a major impact on your overall estate plan.

The rule of thumb has typically been to name individuals, rather than trusts, as beneficiaries of these accounts for simplicity purposes and fear of the super high income taxes attributed to trusts. This rule is true, even today, if the primary beneficiary is a surviving spouse. If you name a spouse as the primary beneficiary of a retirement account, he or she will be able to roll-over the account into his or her own retirement account and postpone distributions until turning 70½. By rolling over the account into their own, the surviving spouse can also utilize the asset protection benefits of a retirement account. If you’re married, naming your spouse as the primary beneficiary is the simplest and most effective way to save taxes.

If you’re not married and are left with the decision of naming a non-spouse as a beneficiary or your trust, the analysis is a little more complicated. The high income tax rates for trusts, as mentioned above, are stark when compared to the income tax rates for individuals. For example, in 2014, the 39.6% top income tax bracket for individuals begins at $406,750, whereas for trusts, it begins at $12,150. These tax rates, however, are somewhat misleading. When a retirement account is “inherited” either by an individual, individuals, or a qualified trust, the retirement account needs to pay out, at a minimum, the Required Minimum Distributions (RMDs) over the life expectancy of the oldest beneficiary. (To see how much your beneficiary would need to take out of your IRA in RMDs, click here for a RMD calculator.) The trust only pays taxes on that amount of RMDs the trust accumulates each year.

For example, if you have a 30 year old child making $75,000/year and you die owning a $500,000 IRA, the RMD in the first year after your death to your child will be roughly $9,000.00. If you named your child as a beneficiary of your retirement account, he or she would pay tax on that $9,000.00 at their individual tax rate.  If you named a Trust as the beneficiary, depending on how the trust is drafted, the Trustee could accumulate some of the RMDs in the trust and distribute a portion of the RMDs to the beneficiary of the trust.  The amount of RMD that is distributed out of the trust to the trust beneficiary will be taxed at the beneficiary’s individual tax rate. Only if the trustee accumulates the RMD in the trust will the RMD be subject to the higher trust tax rates.

One important reason why you should consider naming a trust, rather than a non-spouse, as a beneficiary of these accounts, despite the higher tax rates, is asset protection. In Clark v. Rameker, the United States Supreme Court recently held that an IRA account inherited by a non-spouse (child, grandchild, niece, nephew, etc.) is not entitled to creditor protection and is available to that beneficiary’s creditors.  The only way around this reality, if your intended beneficiary has creditor issues, is to name a trust as beneficiary. While there are some technical requirements that must be respected when a trust is named as a beneficiary of a retirement account, we can assist you in making sure those requirements are met.

In the right circumstances (i.e. where there is no surviving spouse and a beneficiary has creditor issues or behavioral issues), naming a trust as a beneficiary of a retirement account can be very effective. Please feel free to contact any of our estate planning attorneys to learn more about whether naming a trust as a beneficiary of your retirement accounts makes sense for you.