Thinking About Naming a Trust as a Beneficiary?

Know the nuances to ensure that your plan aligns with your financial goals.

A critical part of estate planning is deciding how to distribute your retirement assets, such as IRAs or 401(k)s. One option is to name a trust as the beneficiary of these accounts, which can offer benefits in terms of control and protection. However, this decision also comes with potential tax implications and administrative complexities.

It's important to weigh the pros and cons carefully before proceeding.

Benefits of Naming a Trust as Beneficiary

There are several reasons why you may want to consider naming a trust as the beneficiary of your retirement account, but the most common motivations often revolve around exercising control over how the assets are distributed and protecting them from external risks.

Control Over Asset Distribution: If your beneficiaries are minors, have special needs, or lack financial responsibility, naming a trust allows you to set specific conditions for how the assets are distributed. For instance, you can dictate that funds only be released when a beneficiary reaches a certain age or limit withdrawals to a certain amount each year.

Protection From Creditors or Divorce: Trusts can help shield assets from creditors, lawsuits, or divorce proceedings. By naming a trust as the beneficiary, you can provide an extra layer of protection against these risks, ensuring that your retirement savings are passed down intact.

Multi-Generational Wealth Preservation: A trust allows you to stagger distributions over many years, helping to preserve assets for future generations. This can be especially beneficial for maintaining long-term financial stability for children or grandchildren.

Managing Complex Family Dynamics: For those with complicated family situations – such as children from different marriages or estranged family members – a trust ensures assets are distributed according to your wishes. Trusts can help prevent conflicts and avoid assets being distributed according to default state laws.

Centralizing Asset Management: If you have a large estate with multiple assets, naming a trust as the beneficiary can help consolidate management under one entity. This simplifies the administrative burden and ensures that a trustee, rather than individual beneficiaries, handles financial matters in a cohesive manner.

Disadvantages of Choosing a Trust

While there are clear benefits to naming a trust, there are also significant drawbacks, particularly around taxes and administrative challenges.

Higher Tax Rates: Trusts reach the top federal income tax bracket – 37% – at a relatively low threshold of $15,200. In contrast, individuals typically need a much higher income to hit that same rate. This can result in a larger tax burden on your retirement savings, potentially reducing the amount passed on to your beneficiaries.

Less Flexibility: Trusts are legal entities with specific instructions, which may make them less adaptable to changing circumstances. For example, if you want to alter the trust or change beneficiaries, it can be a complex legal process, particularly if it’s an irrevocable trust.

Risk of Trustee Mismanagement: Trusts require a trustee to oversee the distribution of funds and handle other administrative tasks. While you may trust the person named as the trustee, there is always the possibility of mismanagement, especially if the trustee lacks experience or faces conflicting interests.

Administrative Complexities: Unlike naming a person as a beneficiary, naming a trust can complicate how the assets are withdrawn and taxed. Trusts must comply with various rules, which may require professional guidance from attorneys or financial advisors.

The Impact of the SECURE Act of 2019

The SECURE Act, which was passed in 2019, introduced new rules for inherited retirement accounts that significantly affect how trusts as beneficiaries are treated. One of the major changes is the elimination of the "stretch" IRA option, which allowed distributions to be spread over the beneficiary's life expectancy.

The 10-Year Rule

Under the SECURE Act, most beneficiaries – including trusts – must withdraw the entire balance of the inherited retirement account within 10 years. This accelerated distribution can result in higher tax burdens, particularly for trusts.

Loss of the “Stretch” Rule

Previously, a trust could stretch distributions over the life expectancy of the beneficiary, but the SECURE Act now limits this period to 10 years. Trustees must decide whether to spread withdrawals over the decade or take smaller required minimum distributions (RMDs) annually and withdraw the remainder in the 10th year. Either way, there's a significant risk of hitting higher tax brackets.

The 5-Year Rule

In some cases, the 5-year rule may apply instead of the 10-year rule. This can occur when the trust does not meet the requirements to be considered a "see- through" trust or if non-designated beneficiaries, like a charity, are named.

Tax Strategies to Mitigate the Burden

Trustees can distribute income to the trust's beneficiaries, allowing them to report it on their personal tax returns, potentially at lower tax rates. However, this approach requires the trust to be structured in a way that permits these distributions. Trustees must be empowered to issue a Schedule K- 1 (Form 1041) to the beneficiaries, shifting the tax burden to them.

Should You Name a Trust as Beneficiary?

There is no one-size-fits-all answer to whether you should name a trust as the beneficiary of your IRA or

401(k). It ultimately depends on your priorities. If your primary concern is maintaining control over how assets are distributed and you are willing to accept the potential tax and administrative complications, a trust could be a good fit. On the other hand, if you want to maximize the financial legacy you leave behind, it may be more beneficial to name individual beneficiaries.

For most people, naming a spouse as the primary beneficiary makes the most sense, as they are not subject to the SECURE Act's 10-year rule or mandatory RMDs. A spouse can also roll over inherited IRAs or 401(k)s into their own accounts, avoiding immediate tax consequences. Before making a final decision, it’s wise to consult with an estate attorney or financial advisor who can guide you through the nuances and help ensure that your plan aligns with your financial goals.

"Thinking About Naming a Trust as Beneficiary?" FMex 2024.