Retirement assets take a lifetime to build. For many of our clients, savings and investments represent one of their most considerable assets.
However, many people won’t spend all their retirement assets. Sometimes, their motivation is creating an enduring legacy for their children and grandchildren. They are also concerned, and understandably so, about how their retirement assets will be distributed after they die, how their beneficiaries will use them, and the tax burden this financial legacy places on their heirs.
For individuals and couples in this position, a retirement trust may be the right solution.
What is a Retirement Trust, and How Does it Work?
Consider the following scenario: Jeff has worked hard to build his $1.8 million Individual Retirement Account (IRA). While he plans on using his IRA to fund his retirement, he also understands that he could die before he spends down his account.
Jeff wants his three children to split the remainder of the IRA after his passing. The simplest option, although not always the most effective one, is naming his children as beneficiaries on the account.
Jeff’s concern is that his oldest son is in a rocky marriage, his younger son has credit problems and is known to spend money frivolously, and his young daughter is just 14 years old. He shudders at the thought of handing each a lump sum of money with no guardrails or oversight in place.
As a solution, Jeff could consider a retirement trust. This fiduciary relationship is also referred to as an individual or standalone retirement trust and sometimes casually called a retirement plan trust.
A retirement trust can be created and assigned as the beneficiary of Jeff’s IRA. Jeff would act as the grantor — the person or organization that creates a trust, as Investopedia explains in more detail. He would name someone as the trustee, the person who manages the trust per Jeff’s instructions. Finally, he would then name his three children as beneficiaries to the trust and establish the terms of the trust — the rules the trustee will follow for distributing the funds.
When Jeff dies, the trust is funded with his remaining IRA funds. Crucially, each child’s share will be held in the trust to be distributed according to its terms.
So, how does Jeff’s retirement trust arrangement address his concerns?
For his oldest son, the trust may protect his inheritance from an ex-spouse. For his younger son, it can protect his inheritance from creditors or bankruptcy. And for his young daughter, the trust will hold on to her inheritance until she is an adult.
If any of his children are ever in need of government assistance, the structure of the trust helps to protect them from income limits for government benefits. For all three, Jeff can dictate the amount and timing of distributions.
By spreading their distributions over time, his children will not suffer a significant tax burden. Jeff can also add a disability provision, so his accounts are maintained in the event of an illness or long-term incapacitation. Problem solved.
Comparing Retirement Trust Alternatives
The retirement trust has several advantages over its alternatives. Why should you consider this alternative instead of simply naming beneficiaries on your IRA or using an inherited IRA?
When setting up IRAs, most people forgo any planning and only list designated beneficiaries on their account. It’s simple and, when you die, the funds in your account automatically pass to your beneficiaries. Your heirs then have the option to stretch their required minimum distributions (RMD) over their lifetime or simply cash out and pay taxes currently.
You might prefer the first option because it can maximize your beneficiaries’ inheritance. However, they might choose the second option, which would put a severe dent in the inheritance and its chances of making it to the next generation.
Who Can Benefit from an Individual Retirement Trust?
Because retirement trusts offer a unique structure, they can be somewhat complicated to set up. It works best for those who have amassed significant retirement assets and have specific concerns about their future distribution. If you have any of the following specific concerns, a retirement trust may be worth considering:
- Protecting assets from creditors: With an IRA or inherited IRA, once the assets are passed to beneficiaries, they lose their protection against creditors. Funds inside a retirement trust are protected from creditors.
- Spendthrift heirs: If you’re concerned with how the funds will be used, you can include limitations on their distribution. For example, you can have any amount that exceeds the required minimum distribution (RMD) set aside to be subject to the trustee’s discretion. This degree of control simply isn’t possible with other methods of passing along a retirement account to your heirs.
- Control of distributions for blended families: With a retirement trust, you can select a variety of beneficiaries with varying percentages. Additionally, beneficiary designations are irrevocable, giving you extensive control over the distribution of assets long after your passing.
Foundational and Frequently Asked Questions About Retirement Trusts
Can You Put Retirement Accounts in a Trust?
Yes, you can name a trust as the beneficiary of a retirement account. As you can tell from the example above, retirement accounts can be placed into a trust. That includes traditional and Roth IRAs, 401 (k) plans, and 403 (b) plans, and other retirement accounts.
What is a Standalone Retirement Trust?
A standalone retirement trust (SRT) is simply another name for a retirement trust. An SRT is not structured or managed differently than a retirement trust.
How is an IRA Left to a Trust Taxed?
The University of Illinois’ Tax School explains that when a retirement trust accumulates funds but does not immediately disburse them, the trust itself must pay taxes on those funds. This would happen if the beneficiaries do not meet standards set by the trust, such as a minimum age requirement. The benefit is that beneficiaries receive after-tax funds in this situation.
If the retirement trust instead distributes the income to beneficiaries without delay, the funds are taxed based on the beneficiary’s tax rate.
In cases where a trust is named as the beneficiary of Roth retirement accounts, like a Roth IRA, the money has already been taxed. That means disbursements are tax-free moving forward.
What Happens When an IRA Goes to a Trust?
An IRA going to a trust (to be more specific, naming a trust as the beneficiary of your IRA) provides more control over how the funds are shared with your heirs. By leaving clear instructions and naming a trustee you can count on, it helps you better define and manage your legacy.
How to Know if a Retirement Trust is Right for You
Retirement assets like IRAs can include large sums of money for both you and your heirs. Always review the potential benefits and drawbacks of any financial decision before moving forward. Remember that consulting with a fiduciary financial advisor can help you make a more informed decision, as well as a decision that’s in your own best interests.
That said, if you have considerable retirement assets and share some of the concerns outlined above, you may be a good candidate for a retirement trust.
The bottom line is a retirement trust can help you enjoy the tax benefits of an IRA while establishing a comprehensive asset management plan for your heirs. The trust enables you to build and customize your legacy with long-term control over distribution options. With a single document, you can combine your IRA with a trust to streamline your legacy’s administration and simplify the process.
But it may not be that straightforward. To determine if a retirement trust is right for you, you would need to meet with your financial advisor, who can help you assess your circumstances, needs, and priorities in considering your options.
If you think you may be in a situation that could benefit from retirement trust, we invite you to meet with a Dechtman Wealth Management advisor for a no-obligation consultation.
