Putting assets into a trust can assist in long-term care planning, protect them from creditors after you die, reduce estate taxes and allow for greater flexibility in how assets are managed for minors compared to a simple will. However, putting certain assets into trust may create unintended consequences. An IRA is one such asset because transferring an IRA to a trust can have negative tax consequences that need to be taken into account. There may be better planning options available to protect IRAs as part of your overall estate plan.
IRAs and Trusts
The money in an IRA isn’t taxed while it stays in the account, allowing it to grow tax-free. The IRS has ruled that only an individual can own an IRA. A Trust, on the other hand, is created to take ownership of certain assets on behalf of the beneficiaries (either the person setting up the trust or someone else).
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 given by the grantor.
Negative Tax Consequences
The problem with putting an IRA into a trust is that a trust is not considered an ‘individual’ and therefore conflicts with IRS rules regarding ownership of the IRA. If you transfer an IRA to a trust, the IRS considers this a taxable distribution, just as though you cashed out your IRA. That means all of the money in the IRA is immediately taxable as ordinary income. If you are not yet 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-deferred status of any future earnings is lost.
Estate Planning Options for IRAs
One option to help manage your IRA through an estate plan is to name a trust as the beneficiary of your IRA. Since naming a trust as beneficiary does not affect your ownership of the IRA while you are alive, there are no 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. Nevertheless, the trust has to make required annual distributions from the IRA, and these would be taxable as income. Another option if you want to leave your IRA assets to your spouse would be to make him or her the beneficiary instead of a trust. This is because a spouse can roll over an IRA into his or her own IRA in order to maintain the tax-deferred status of the funds.