Nancy recently set up her living trust and instructed me to rename her IRA into the trust. It seemed like a pretty straight-forward request. But had I done what she asked it would have cost her a pile of moolah. I explained the situation and she quickly changed her mind.
The mistake my client was just about to make wasn’t her fault. It’s something that could easily happen to anyone. Since most banks and custodians don’t provide feedback on retirement accounts, I thought you might like to understand this a little more so you don’t make a similar error.
What Happens When You Move Your IRA Into Your Trust
You already know that when you withdraw money out of your IRA you have to pay income tax. Well, when you move money from an IRA into a trust, you’ve basically withdrawn all the money. It doesn’t matter if you spend the bread or not. Every single dollar will be taxed as income if you do this.
So, if you have $100,000 in an IRA and rename it to your trust you just “made” $100,000 and you’ll have to pay tax on it friend. For most of us, this completely defeats the purpose of having retirement accounts. Aye Carumba!
How You Should Use Your Trust When It Comes To Retirement Accounts
Trusts do play a role with retirement accounts. Once in a while an attorney will instruct a client to name their trust as beneficiary of the retirement account. This can make sense sometimes but even this maneuver has its drawbacks. Here’s why.
In many cases, if you die and your trust is the beneficiary of your retirement accounts, the money will have to be paid out either immediately or within 5 years. But if you name your spouse as beneficiary, they can roll your IRA into their own IRA and depending on their age, continue to grow the money tax deferred.
If you name other people beneficiary (like your children) they can roll your IRA into a Beneficiary IRA and continue to grow most of that money tax deferred as well. But again, when you name a trust as beneficiary your trust beneficiaries might lose that tax deferral potential.
I say “might” because it depends on how the trust is written. If your attorney creates a special beneficiary trust or writes your family trust using special language, they may be able to continue the tax deferral bonanza. These are known as “see-through” and “conduit” rules. But even if they do a good job there are limitations. In a best case situation if you name a trust as beneficiary, the mandatory withdrawals are based on the age of the oldest trust beneficiary rather than each individual trust beneficiary. It sounds complicated but it isn’t really.
The Take Away
You don’t need to become a world-class lawyer to know what to do. Just keep in mind the following three rules:
- Never place your IRA into a trust unless specifically told to do so by a tax or legal professional. If this happens, get it in writing from your tax or legal advisor.
- If a tax or legal professional tells you to do this, ask her why and make sure you understand the pros and cons completely.
- Sometimes it can make sense to name a trust as beneficiary of your IRA. This is far different from the trust owning the account. Still, if someone suggest you do this, ask them if the trade-offs are worth it.
Have you named your trust beneficiary of your retirement accounts? What was your motivation?