What if You Leave Your IRA in Trust?
By Jennifer Rowe, Esq., Trust Administrator
If you plan to leave your retirement account in trust for your children or other beneficiaries, the SECURE Act presents some new wrinkles. Just as if you left the plan to individuals, in most cases the ten-year distribution rule now applies (there are exceptions for disabled or chronically ill beneficiaries, minor children, your surviving spouse, and beneficiaries less than ten years younger than you). But what if you don’t want your children to receive the entire IRA amount in ten years? Your trust can provide that the trustee should take out the IRA distributions over ten years as required, pay the tax, and continue to hold the distributed amount in trust for your children and the beneficiaries who follow them, for their lifetimes or until the age you select. Just as you planned, the trust can provide protection from your beneficiaries’ creditors, possible divorce, and unchecked spending, and continue to carry out whatever estate tax measures you may have chosen to include.
However . . . the income tax impact of the ten-year rule is more severe if the IRA’s income is trapped in a trust instead of passing into the hands of an individual beneficiary. That’s because a trust pays income tax at the top rate, currently 37%, on virtually all its income, while an individual pays that top rate only on income exceeding a bit more than $500,000. So unless your children have income sufficient to put them in the top tax bracket, holding the IRA distributions in trust is going to cost even more in income tax than giving them the entire IRA within ten years. What to do? We have some ideas. There are provisions you can add to your trust that will shift the responsibility to pay income tax from the trust to the individual beneficiaries, without actually paying out all the income.
“How is this a good thing?” your children are now asking as they read over your shoulder. “I have to pay the tax on income I didn’t even receive?” Keep in mind that the trust will be able to distribute to those taxpaying children sufficient funds to cover the additional tax they’ll owe, and most important, remember that as long as the children are paying tax at the 12%, 22%, or 24% rate, they’re paying less than the trust would pay on the same amount of income. That’s an overall savings that preserves more in trust for the future benefit of your children, and perhaps their children also. “OK, I’m in,” your child may now be saying. “I’ll work together with the trustee to minimize the joint tax burden paid by the trust and me, which will leave more for me later on.”
If this is your situation, talk with us and with your attorney about including language in your trust that lets your trustee choose to give a beneficiary the power to withdraw the taxable income from the trust each year. Under this provision, whether or not your child withdraws the income, the income will be taxed to the child at the child’s rate. Any portion of the taxable income that your child does not withdraw remains in trust after the power to withdraw lapses, which will happen on a predetermined schedule or at the end of the year. Of course, if your child repeatedly uses the withdrawal power to take all the year’s taxable income out of the trust, no trust protection is gained, and in that case the trustee can decide in any given year not to offer the withdrawal power. Giving the trustee that discretion means you can add some flexibility to your trust and use the withdrawal power to limit taxes . . . whenever it makes sense.