It’s not a good idea to put a retirement account in a trust. In general, there are many good reasons to put an asset into a trust: a trust protects it from creditors after you pass away, can reduce estate taxes, can assist in long-term care planning, and offers more control than a will in regard to managing the distribution of assets. However, if you’re thinking about putting an individual retirement account (IRA) in a trust, that can have negative tax consequences.
IRAs and Trusts
An IRA is an account set up at a financial institution that allows an individual to save for retirement with tax-free growth (Roth IRA) or on a tax-deferred basis (traditional IRA). You pay no taxes when your investments in your IRA earn money. The only tax comes when you withdraw or “distribute” the money from your traditional IRA. (Roth IRAs offer tax-free withdrawals after five years or at age 59 ½ and over.) According to the IRS, only an individual can own an IRA.
A trust is a legal entity set up to hold and manage property and it’s often used for distribution to beneficiaries. The person who sets up a trust, called the grantor, transfers ownership of assets to the trust. Assets in a trust are taxable, sometimes to the grantor and sometimes to the trust, depending on the type of trust in use. When the grantor dies, a trustee administers the assets on behalf of the beneficiaries according to the instructions in the trust.
Negative Tax Consequences
To put an individual retirement account in a trust, you actually have to change the owner of your IRA to the name of your trust. Your trust isn’t considered an “individual,” so it now conflicts with the IRS rules regarding IRA ownership. The IRS sees it as if you’re cashing out your IRA and the money in the IRA is taxed as ordinary income. If you’re younger than 59 1/2 years old, this is an early distribution and you have to pay an additional 10 percent penalty tax. To make matters worse, your IRA funds are no longer in an IRA as far as the IRS is concerned, so the tax advantage of an IRA is lost.
Estate Planning Options for IRAs
There are good estate planning options for IRAs:
- Name a trust as the beneficiary of your IRA. Since naming a trust as beneficiary doesn’t affect your ownership of the IRA while you’re alive, there are no negative tax consequences. This would be an effective way to manage the distribution of your IRA assets to your children or other heirs after you pass. However, keep in mind that the trust has to make required annual distributions from the IRA, and these would be taxable as income.
- Make your spouse the beneficiary your IRA assets. Your spouse can roll over an IRA into their own IRA in order to maintain the tax advantage.
- You can list your trust as a beneficiary on retirement accounts, but you should only do this after consulting with an estate planning attorney since there can be an unfavorable tax outcome if not done properly.
Retirement accounts like an IRA, Roth IRA, 401K, 403b, 457 and the like don’t belong in your trust. Placing any of these assets in your trust would mean that you’re taking them out of your name to retitle them in the name of your trust. The impact this will have on your taxes can be disastrous.
Other Thoughts to Keep In Mind
- Make sure the financial institution(s) where your retirement accounts are held have the beneficiaries properly listed.
- Review those beneficiaries every few years to make sure they reflect your current wishes.
- When you don’t designate a beneficiary at all on your retirement plan, the funds in your plan go to your personal estate at the time of your death, which means the estate will be impacted by the cost and time of probate and likely a sizable tax burden.
As an experienced Massachusetts estate planning attorney, I’ll talk with you to understand your financial picture, your family dynamics, and your goals for your estate planning. Then we’ll work together to build a comprehensive estate plan, including designation of beneficiaries for financial accounts, to make sure that your assets and your family will be protected. Contact us today to schedule a confidential, no-cost consultation.