A trusteed IRA offers provisions beyond a custodial plan, but is it a good strategy for clients? That answer depends on several factors, including how much control — or not — the client wants their beneficiaries to have.
Under the tax code, an IRA can be established as a trust or custodial account. With a trusteed IRA, a financial organization adds trust terms and language to the plan. Thus, the IRA itself becomes a trust, with the financial organization acting as the trustee.
lThe account is then administered under the trust provisions both before and after the IRA owner’s death. In general, this will mean greater control for the IRA owner and less for beneficiaries.
As a trusteed IRA is, in essence, a conduit trust; the trustee must pay out the annual required minimum distributions to beneficiaries. In addition to ensuring the stretch IRA for beneficiaries, some trusteed IRAs allow distributions beyond the RMDs for health, education and other support. However, because trusteed IRAs are standardized documents, there will likely be some limits on the post-death control options.
Here’s what advisers should know about this increasingly available option, so they can help clients make the most educated choice.
THE COST OF CONTROL
Clients who have large IRAs as well as other extensive assets will probably already be using trusts as part of their overall estate planning strategy. For those clients, costs are not a concern and they would likely be best-served by naming a trust as their IRA beneficiary.
For other clients, whose IRA is their largest asset by far, a trusteed IRA may make sense. A trusteed IRA will generally cost less than hiring an attorney to draft a trust. However, there will still be a set-up fee, as well as ongoing fees.
One advantage of a trusteed IRA is that, if the IRA owner becomes incapacitated, trusteed IRAs often have a provision that allows the trustee to take the RMD on their behalf.
This would not be possible with a trust or an individual named on the IRA’s beneficiary designation form. In those cases, a power of attorney would likely be needed to get the RMD paid out. A trusteed IRA eliminates this complication. The trustee can also make lifetime investment decisions, as well as pay any IRA-related fees or expenses.
ENSURING THE STRETCH FOR BENEFICIARIES
Trusteed IRAs usually include provisions limiting how much freedom a beneficiary has regarding how much they can take from the inherited IRA.
A trusteed IRA may be a good strategy for clients whose primary concern is preserving the stretch for their beneficiaries. The trusteed IRA may limit yearly distributions to the amount of the RMD, preserving the stretch IRA.
If, instead, a trust is named as the beneficiary of an IRA and the trust meets the look-through rules, the beneficiary of the trust can use the stretch and take RMDs over the life expectancy of the oldest trust beneficiary.
However, there is a risk that requirements of the look-through rules may not be met by a particular trust. An attorney drafting a trust may make an error that causes the trust to not meet these requirements, with the resulting loss of the stretch for beneficiaries. Going with a trusteed IRA mitigates this risk.
Even if a trust is drafted in such a way as to meet the requirements of the look-through rules, there can still be problems with achieving the maximum stretch if there are multiple trust beneficiaries.
The separate account rules for multiple beneficiaries do not apply to trusts. This means that all trust beneficiaries must honor the beneficiary with the shortest life expectancy.
This may not matter so much if the beneficiaries are close in age. However, if beneficiaries include a surviving spouse as well as children, this severely limits the stretch available for the children.
The work-around for this problem is to create and name sub-trusts for each beneficiary directly on the IRA beneficiary designation form. This format allows each trust beneficiary to use their own life expectancy.
Using a trusteed IRA eliminates this complication, because they are generally drafted in such a way as to ensure each beneficiary may use their own life expectancy.
When an IRA owner names a beneficiary outright, the owner will have no say in what happens to the funds after the death of the beneficiary. A beneficiary may choose their own successor beneficiary.
A trusteed IRA would give the IRA owner the ability to name successor beneficiaries. This may be helpful in second-marriage situations in which the IRA owner would like to provide for a spouse during their lifetime but then ensure that the IRA funds go to children from a prior marriage.
This could also be achieved by naming a trust as the IRA beneficiary, although at greater expense.
In many cases, after the death of the IRA owner, a surviving spouse will want to do a spousal rollover. This option is available if the spouse is named directly as the sole beneficiary on the beneficiary designation form.
Frequently, when a trust is named as the IRA beneficiary, this option becomes more complicated, and sometimes requires the time and expense of requesting a private-letter ruling from the IRS. There have been many PLRs allowing a spousal rollover when the spouse is the trustee of the trust, is the sole beneficiary and has complete control over the trust assets.
A spousal rollover would likely not be possible with a trusteed IRA, however. Clients who are looking for the ability of a surviving spouse to do a spousal rollover should strongly consider simply naming that spouse on the beneficiary designation form. They would not be well-served by either a trust as beneficiary or a trusteed IRA.
Some clients may have concerns about creditor protection of IRA assets for their heirs. For example, a parent might be concerned that, if a child is having financial trouble, creditors could access the inherited IRA funds.
There are good reasons for this concern. In Clark v. Rameker, for example, the U. S. Supreme Court ruled that inherited IRAs are not protected in bankruptcy.
A trusteed IRA would offer a higher level of protection from creditors than leaving assets outright to a beneficiary. However, the protection would be limited by the fact that the trusteed IRA would be required to pay out the RMDs each year to the beneficiary. There would be no way to protect those RMD funds.
By naming a trust as the IRA beneficiary, a higher level of protection could be achieved, because a trust could be drafted to give the trustee discretion to keep the RMDs in the trust instead of paying them out to the trust beneficiaries.
Of course, there is a downside to using a trust to protect the RMDs from creditors. RMD funds held in the trust will be taxed at trust tax rates, which quickly reach the top 39.6% income tax bracket. A Roth IRA left to a trust could eliminate this trust tax problem.
Clients who are considering trusts often want to appoint an individual, usually a family member, as a trustee. Frequently, the individual may be a co-trustee with a financial organization.
This will not work with a trusteed IRA for two reasons:
1) The trustee will be the financial organization offering the trusteed IRA.
2) The tax code does not permit an individual to be a trustee of an IRA.
MOVING INHERITED IRA ASSETS
One big downside for trusteed IRAs is the lack of ability to move the inherited IRA assets. While there is no reason that a trusteed IRA could not allow the movement of inherited IRA funds after the death of the IRA owner, these documents are generally drafted in such a way that, if not outright prohibited, it is certainly not guaranteed.
This would be something for clients to seriously consider, because these accounts will be in existence for many years. Even if the institution is sound, if beneficiaries feel they are getting poor service or would prefer different investment choices, they may not be able to vote with their feet.
Trusteed IRAs are not for everyone. Consider the alternatives of simply naming a beneficiary directly on the IRA beneficiary form or naming a trust that has been drafted specifically for the client by a knowledgeable attorney.