The Ugly Truth About IRAs in Trusts

In Retirement by DavidLeave a Comment

Many people have been maximizing their IRA contributions for years.  Over time these can multiply to a considerable sum of money.  Frequently, people (especially people who have accumulated substantial assets) establish some sort of a trust.  There is a temptation to transfer the IRAs to the newly created trust with the other investment assets.  This is a substantial tax issue and is not recommended because transferring the IRA to the trust would trigger taxes usually including the IRA withdrawal tax.

IRAs are attractive investments because your contributions are tax-deductible if you meet the eligibility requirements. Your earnings grow tax-deferred until you begin making withdrawals, at which point you pay taxes on the earning at the income tax rate you’re subject to at the time.  The government allows IRAs to encourage people to save for retirement…not to help people hide money.

Transferring IRAs funds to a trust to avoid taxes (which could be higher or lower than your current rate) would require you to pay taxes like you had just cashed out the IRA. You may have to pay ordinary income tax plus an additional 10% federal penalty.  This does not apply when you convert a traditional IRA to a Roth IRA.  There is not a 10% penalty. With the Roth IRA, distributions of contributions are tax-free and there is not a penalty on withdrawals unless they occur before age 59½.  In that case the earnings may be subject to a 10% federal penalty tax as well as income taxes.

Many people name their trust as the beneficiary of their IRA.  This is also a mistake.  If there are two spouses, when one dies and the trust was designated as the beneficiary for the IRA, there would be no way to defer the tax on the balance in the IRA account.  The IRA would have to be immediately disbursed and the entire distribution would be taxable.

If the spouse was the designated beneficiary, that spouse could take control of the IRA.  They could either roll the balance into their own existing IRA or they could designate it as their own account and the income tax on the balance would be deferred until their death or when they begin taking the required minimum withdrawals after age 70½.

The IRS has special rules allowing a person to defer the tax on an IRA inherited from a spouse.  Those same tax advantages don’t apply to trusts.

IRA rules are very complicated and everyone has their own unique situation.  Tax planning and estate planning should be done very carefully.  Consult with your tax adviser, financial planner, or money coach about the specifics of your own unique situation.

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