More than a third of American adults today utilize an IRA as part of their retirement planning strategy. But what happens if an investor doesn’t spend all of the money they’ve saved there before they pass away? It goes to a beneficiary.
Choosing the right beneficiary for an IRA is an important decision for any investor to make. After all, this person will be entrusted with the account owner’s funds after they’re gone. One option is to make a trust the beneficiary of an IRA, rather than a single individual. Here’s how that process might work and why an investor might choose to go this route.
Can an IRA be in a trust?
A trust can indeed hold IRA assets and investments. Here’s how it works: An IRA owner creates a trust. This trust is named as the beneficiary of the IRA, so if there is a remaining account balance when the account owner dies, these funds will pass to the trust instead of a direct heir.
The trust then has its own eligible designated beneficiary (or beneficiaries), who will receive distributions from any assets held in the trust, such as an IRA. These beneficiaries can be the account owner’s children, grandchildren, siblings, friends, or anyone else they may want to indirectly pass their assets to following their death.
When establishing the trust, the original owner is also able to set their own terms of the trust, or the rules and limitations that might be placed on the beneficiaries of the trust once the assets have changed hands.
Pros and cons of putting an IRA in a trust
But just because a trust can be helpful in many circumstances, the question of should an IRA be included in a trust still remains. Or, in some cases, are there good reasons to reconsider this strategy? Here are some of the pros and cons of naming a trust as an IRA beneficiary.
Potential advantages of putting an IRA into a trust
If an investor leaves behind a balance in their IRA account when they pass away, bequeathing that IRA and its investments to a trust can be beneficial in the following circumstances.
- If the owner wishes to pass assets to a child or someone with special needs. Naming a trust as the actual beneficiary can enable this account to provide for a minor or disabled person without ownership and management complications.
- If the owner wants to control how and when their beneficiaries receive funds. Owners can set specific terms for the trust to prevent the beneficiaries from spending inherited funds all at once.
- If the owner wants to pass assets to a first family, or non-related individuals. While an estate may automatically pass to a surviving spouse or heirs (like children), account owners may also want to provide for others. Naming a trust as an IRA beneficiary allows owners to pass assets to children from a previous marriage, siblings, and/or other important individuals, regardless of where the rest of the estate goes.
- If the owner wants to name successive heirs. Typically, once an asset is passed to an heir, it’s up to that heir to decide where (and to whom) it will go next. But if the account owner names successive beneficiaries when creating the trust, they can dictate who the assets pass to in the future. This allows them to name their surviving spouse as a first heir and their grandchildren as successive heirs, for instance.
- IRA funds held in a trust can be better protected. If an IRA passes into a trust, the account is generally well-protected from potential creditors or other threats to its value, such as divorce or bankruptcy. For instance, many retirement accounts (including IRAs) are fair game during a divorce, and can be divided between spouses through what’s called a transfers incident to divorce. However, if one of those spouses is the beneficiary of IRA funds held in a trust, those funds are typically excluded from marital property calculations.
- The trust can be responsible for any taxes due on disbursements. If the trust is the IRA’s beneficiary, any taxes due on elective or required disbursements that are taken by the trust can potentially be the responsibility of the trust, rather than the beneficiaries. If, for example, the trust is set up to hold those funds until a beneficiary reaches a certain age in the future, the trust will take distributions, hold the money, and pay the taxes owed.
Of course, trusts aren’t right for every investor—they could be more complex than the investor needs, especially if the circumstances above don’t apply.
The bottom line
When opting to save in an individual retirement account (IRA), most individuals are looking ahead to the years and decades to come. The funds they set aside today are intended for their own retirement years—but some investors will leave behind a balance after they pass away.
Passing an IRA on to beneficiaries after one’s death can sometimes be an involved process, especially if there are minors involved or a complex family structure. This is where a trust can help: Using a trust can be one way to control who will benefit from those funds and when they will receive them.