If you have the wrong kind of trust, naming it as the beneficiary of your retirement account could cost your kids a lot in extra taxes. How? It happened because you’ve just forced your heirs to report the entire amount as income.
When you inherit a retirement account, several things change immediately. The first is that the account will look at the new owner to re-calculate the measuring life on the account. If they can see a person, they’ll use that person’s age. This is called the “stretch out rule”. But, if they just see an entity like most trusts that have no age, there is no stretch out, and the beneficiary will be forced to close out the IRA account and take the income tax hit. If you have an ordinary trust, naming it as the beneficiary kills the possibility of a stretch-out.
The second big change when you inherit a retirement account is that there is no longer any early access penalty. You could withdraw the entire amount, or something less, and the only consequence is that you will owe income tax on the distribution. This is why the US Supreme Court in Clark v. Ramiker decided that creditor protection laws do not protect inherited retirement accounts.
What about the right kind of trust?
The right kind of trust is specifically designed to handle retirement accounts, and meet the four requirements of a see-through trust outlined by the IRS. A retirement trust allows you to preserve the stretch out for your beneficiaries, and put into place the plan and asset protection a trust can create.
Using this kind of trust, you can:
- Help keep the IRA in the family, by avoiding having a child name his or her spouse as a beneficiary, and seeing the money go to that new spouse’s children
- Protect the asset in case of a divorce
- Manage the account for beneficiaries who are young children, elderly or disabled
- Give direction and security for a beneficiary with poor money management skills
Unless you have the right kind of trust, don’t send your retirement funds there. But do consider the benefits to your children of using the right kind of trust for your retirement funds.