From the time we started in the work world we have been advised to set aside a part of our salary in retirement savings. As I advise my children, buy less Starbucks coffee and put the weekly savings into your 401K plan.
As a result of this good advice, most people are finding that they have a significant percentage of their assets in retirement accounts, usually, an Individual Retirement Account (IRA).
One of the best things about an IRA is that a non-spouse beneficiary, after the death of the IRA owner, can “stretch” out the time period for taking distributions over their life expectancy. Think of the compounding effect as the funds in the inherited IRA continue to grow without any tax bite. That growth can be phenomenal.
The beneficiary of the IRA makes the decision as to whether to “stretch” distributions or to withdraw it in a lump sum. This may concern the owner of the IRA. They may be concerned that when the IRA beneficiary makes this decision they may be a minor, disabled, incompetent or unsophisticated in financial matters. In addition, a lump sum withdrawal subjects the money to creditor risk and marital risk.
There is a way for the owner of the IRA to take this decision out of the hands of the beneficiary; the IRA owner can make the beneficiary of the IRA a trust. The decision making is now moved from the IRA beneficiary to a Trustee. In addition, the owner can further restrict the beneficiary’s access to the funds by limiting distributions from the Trust to the discretion of the Trustee. This even goes further in that it limits the beneficiary’s access to the “stretched distribution”.
While placing a discretionary trust as the beneficiary of the inherited IRA allows the owner of the IRA to provide “post mortem control” over the beneficiary’s access to funds, it may not produce a good income tax result.
If the Trustee, using his discretion, decides to keep the IRA distribution in the Trust, i.e. not to make a distribution to the trust beneficiary, the IRA distribution is taxed at the Trust level instead of the beneficiary level. This decision may create a much larger tax.
The tax rates that apply to a trust increase much faster than the tax rates that apply to individual taxpayers. A trust is taxed at the highest rate of 39.6% once the trust’s income exceeds $12,300 (based on 2015 tax rates) while a single person bears the highest tax rate of 39.6% when their income exceeds $413,200. As an example, if the distribution from an IRA is $100,000 and the Trustee decides to not make a distribution to the beneficiary of the trust, the Trustee will incur an additional tax of approximately $16,800 on the IRA distribution.
Thus, the IRA owner who wants to control the amount of the IRA distribution available to the individual beneficiary may favor naming a discretionary trust as the IRA beneficiary. However, the tax cost of controlling access to the IRA distribution may outweigh the benefits.
If the IRA owner has valid concerns and wishes to control the amount of the IRA distribution available to the individual beneficiary, then you should consider how to mitigate the additional tax cost. One thing to consider is having the IRA owner convert the IRA to a Roth IRA. While this will be a taxable transaction, the IRA owner may be in a much lower tax bracket than the discretionary trust. In this case, all of the income taxes will be due at the time of the conversion. After the death of the IRA owner, the discretionary trust is able to withdraw the funds from the Roth IRA without incurring income tax. Therefore, if the discretionary trust does not distribute to the trust beneficiary, the trust will not be penalized by bearing the highest tax rate at a much lower income level.
Using a discretionary trust as the beneficiary of an IRA allows the providers certain advantages. However, the increased tax rates that apply to a trust may force the trustee to distribute the IRA withdrawal to the individual beneficiary. This will negate the advantages of using a discretionary trust.
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To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.