Q: I am updating my estate plan and have a substantial IRA. Is it better to leave my IRA directly to my children or to my trust?
A: Retirement accounts are different from most other assets in your estate for two reasons.
First, they generally pass by beneficiary designation rather than under your Will or Trust, and outside of probate. If no beneficiary is named, or if all named beneficiaries have predeceased the account owner, the account may become payable to the estate and then pass according to the terms of the Will, or if there is no Will, under the laws of intestacy.
Second, most qualified accounts are funded largely with pre-tax dollars, so the income tax on the account has not yet been paid. Whoever inherits the account inherits that tax obligation along with it, and the rules governing how quickly the funds must be withdrawn—and taxed—depend on who is named as beneficiary. Both of these features shape the choice between naming children directly and naming a trust.
This is why beneficiary designations are such an important part of estate planning. Even a carefully drafted Will or Trust cannot override an IRA beneficiary designation; if the two say different things, the beneficiary designation will control.
For married couples, the surviving spouse is usually named as the primary beneficiary of an IRA. A spouse has options that are not available to most other beneficiaries, including the ability to roll the inherited IRA into his or her own IRA. This allows the account to continue growing tax-deferred and often provides the surviving spouse with the most flexibility.
Children are often named as contingent beneficiaries, meaning they inherit if the spouse has predeceased. However, the rules for children inheriting retirement accounts changed significantly with the passage of the SECURE Act in 2019.
Before the SECURE Act, many beneficiaries could “stretch” distributions from an inherited IRA over their lifetime. Today, most adult children who inherit an IRA must withdraw the entire account within ten years of the account owner’s death. The funds do not necessarily need to be withdrawn all at once, but the account must generally be fully distributed by the end of the tenth year. Because each withdrawal is taxed as ordinary income, this rule can compress decades of deferred taxes into a ten-year window—often during the child’s peak earning years, when the additional income is taxed at the highest rates.
There are exceptions for certain beneficiaries, known as “eligible designated beneficiaries.” These include a surviving spouse, a minor child, a disabled or chronically ill individual, and an individual who is not more than ten years younger than the account owner.
Minor children of the account owner receive special treatment, but only for a limited time. A minor child may be able to take distributions based on life expectancy while the child is still a minor. Once the child reaches the applicable age of majority, the ten-year rule generally begins.
A trust may be considered when the account owner does not want a beneficiary to receive the inherited IRA outright. For example, a trust may be appropriate if a beneficiary is a minor, has special needs, receives government benefits, struggles with financial management, or if the account owner wishes to provide protection from creditors or divorce.
Rather than receiving the inheritance directly, the beneficiary’s share can remain in trust and be managed by a trustee according to the instructions contained in the trust agreement.
However, naming a trust as beneficiary of a retirement account requires careful drafting. A trust does not avoid the SECURE Act rules, and if the trust is not drafted properly, it may create unintended income tax consequences or accelerate distributions.
It is also important to distinguish between naming a trust as beneficiary and transferring an IRA into a trust during lifetime. An IRA is not retitled into a trust while the account owner is living. Instead, the owner keeps the IRA in his or her own name and designates who should receive it at death.
Because retirement accounts can often represent a significant portion of a family’s wealth, but also come with tax implications and distribution guidelines that are beneficiary-dependent, beneficiary designations should be reviewed whenever an estate plan is created or updated.
The right choice depends on the account owner’s family, the income tax cost of the distribution rules, and whether the beneficiaries need the added protection or structure of a trust.
– Alma Muharemovic, Esq.
Alma Muharemovic, Esq. is an associate attorney at Burner Prudenti Law, P.C., focusing her practice on estate planning. Burner Prudenti Law, P.C. serves clients from New York City to the East End of Long Island, with offices in East Setauket, Westhampton Beach, Manhattan and East Hampton.
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