Naming a trust as a beneficiary: Is it a bad idea?

The pour-over will

One of the primary purposes of a trust is to avoid probate legally. Many parents set up living trusts and transfer most of their assets into the trust during their lifetime. But typically, not every minor asset is transferred into the living trust before your death, like clothes, jewelry, silverware, mementos, smaller financial accounts and more.

But you can name the trust as the “residuary beneficiary” or the sole beneficiary of the “rest residue and remainder” of your estate. This ensures that all non-designated estate assets will go directly into the trust.

But remember, property that goes from the will to the trust is subject to the rules and laws of probate in your state. Be careful of state and federal estate tax laws and plan to keep your taxable estate under those thresholds.

Special needs trust as beneficiary

Naming a special needs trust as a beneficiary of your will or certain financial accounts allows a child with disabilities to receive additional support without risking their eligibility for government benefits.

Leaving money directly to a child with disabilities is likely to interfere with their ability to receive disability benefits. A qualified estate planning attorney can help establish a special needs trust so your child can receive an inheritance from you and continue to receive needed government benefits.

Second marriages and blended families

Second marriages and blended families are a significant part of American society. But how can you ensure that your assets eventually go to your children? You can leave all your assets and financial accounts to your spouse, and they will certainly benefit. But there is no guarantee that any assets will be left to pass to your children later.

A trust allows you to control the distributions of assets and income according to your wishes. Many people with second marriages and blended families make the trust the beneficiary. The trust gives the surviving spouse an income for life and then distributes the assets to the children upon the death of your spouse.

Minors

Certain assets like IRAs and financial accounts cannot be left to minors. In these cases, naming the trust as the beneficiary allows you to ensure the financial assets will be held and then distributed to your minor children according to your wishes.

Protection from creditors and predators

Some assets, like IRAs, life insurance and annuities, have levels of creditor protection while you are alive. But that protection does not continue once the assets or proceeds are inherited. For example, inherited IRAs do not qualify under the Federal Bankruptcy Code as exempt from the creditor claims under the “retirement funds” exception. But an inherited IRA held in a properly structured trust is not an asset of the beneficiaryand has a greater level of protection from creditors.

Limiting access - saving the children from themselves

Every child is different. Some can inherit a large sum of money and make it last a lifetime while others can spend it all in a few months.

Every year the news features stories of lottery winners who inherit millions but spend themselves into poverty in just a few years. Adult children all have different lifestyles, and some have substance abuse and control issues.

By making the trust a beneficiary, you can control your children's access to the assets and regulate how much they receive per year. And you can have trust instructions for payments for their health, education and welfare.

For example, if your adult child inherits your IRA, you might believe they will only take the required minimum distributions. But they have the right to take large distributions or even withdraw the entire balance. But if a trust is the beneficiary of the IRA, your children's access is limited by the terms of the trust.

Naming a trust as a beneficiary for financial accounts is always a lively debate among estate planners, lawyers and other estate professionals.

The fundamental reasons for using a trust as a beneficiary are the same for assets as for financial accounts, like minor children beneficiaries, protection from creditors, blended families and more. But with financial accounts, there are pros and cons and complex, ever-changing tax laws.

Non-financial account assets might include cars, boats, real estate, art, memorabilia and similar items. Financial accounts will include retirement accounts, life insurance policies, bank accounts, stock accounts and other accounts held by financial institutions.

Financial accounts break into two main categories - qualified and non-qualified. The difference has to do with taxes and rules.

Non-qualified financial accounts

Investing into non-qualified accounts is done with after-tax dollars. Typically, with non-qualified accounts, you can invest as much or as little as you like and withdraw funds at any time. Stock brokerage accounts, bank accounts mutual fund accounts and annuities are considered non-qualified accounts.

Qualified financial accounts

These accounts or plans are usually retirement accounts with special tax treatment. The employees make tax-deferred contributions, and the employer can deduct the employer contribution to the plan. Examples of qualified accounts are 401(k), IRAs, Roth plans, 403(b) and 457 plans. Everything else is usually a non-qualified account.

The reasons for naming a trust as a beneficiary for non-qualified accounts are straightforward, as with other assets. You have more control over the distribution of your assets and have increased creditor protection and other typical reasons. But there are two other considerations for financial accounts.

Avoiding lump-sum payments

But one of the most common reasons for using a trust as a beneficiary is to avoid a large financial lump-sum payment going directly to your loved ones as a one-time payment.

You will designate beneficiaries when you establish your financial account, bank account or insurance policy. The financial institution sends a lump-sum payment to the designated beneficiaries upon your death, which can be sizeable. If a trust is the designated beneficiary, the proceeds will be distributed from the trust to your loved ones according to your trust instructions. Instead of a large one-time payment, you can have the distribution spread over time for their benefit.

Simpler documentation

Suppose you have several life insurance policies, brokerage accounts and bank accounts, and you name many beneficiaries on all of them. In that case, your heart is in the right place, but you may create a logistical nightmare for your loved one.

Each financial institution will often have intimidating and complex paperwork that must be completed and documented by each beneficiary. Only the trustee must submit the proper documentation if the trust is the beneficiary. Then the trust distributes these assets along with the other trust assets.

While there are several types of qualified accounts, the most common is the IRA.

An IRA is an investment account you own. You can contribute some of your earned income every year, subject to certain limits. With traditional IRAs, your contribution is typically deductible from your income, and later withdrawals are subject to income taxation.

Roth IRAs are different. The contribution is generally not tax-deductible, but withdrawals are tax-free.

Withdrawals from either type of IRA before age 59½ generally incur an early-withdrawal penalty of 10%. And at age 72, you must withdraw the minimum distributions (RMDs) each year from a traditional IRA. RMDs are based on your age and a life expectancy factor. Notably, Roth IRAs are not subject to RMDs during your life.

Because of the math of the IRS expectancy tables, if you only withdraw the RMDs, there will be assets left in the IRA at your death. And, if your IRA investments have high rates of return, your IRA might have a higher value at your death than when you started taking your RMDs.

Also, IRAs can be directly inherited without a will or trust and avoid probate. The IRA passes to the person(s) you named in the IRA beneficiary designation.

For example, you might leave your entire IRA to your spouse or possibly equal shares to your children. But you can name a trust as an IRA beneficiary, and in many cases, that might be the better option.

The IRS has rules about RMDs during the IRA owner's life. And they have more rules about inherited IRA distributions.

Historically the preferred payout method was called the “stretch IRA.” The after-death RMDs annual distributions were stretched out over the life expectancy of the new IRA beneficiary. The IRA would continue to grow tax-deferred often for many decades after the IRA owner died.

But Congress passed the SECURE Act in December 2019 and changed the rules. For most beneficiaries, the prior “stretch” rule was replaced with a 10-year rule that requires the IRA to be distributed entirely by the end of the 10th year following the year of the IRA owner's death.

With the new 10-year rule, there are no set minimum amounts per year. But by the end of the 10th year, the entire account must be distributed.

Exceptions

However, the new 10-year rule does not apply to particular beneficiaries, known as “eligible designated beneficiaries.” These include:

• The IRA owner's surviving spouse
• The owner's children while they are minors
• Certain individuals who are chronically ill or disabled
• Any person who is not more than 10 years younger than the IRA owner

The stretch IRA is still available for these beneficiaries.

The rules and laws regarding a trust inheriting an IRA account are financially important for your loved ones. And they have significant tax consequences. But these tax laws are also complex and confusing. This is definitely the time to have the advice and help from a qualified estate planning attorney.

When a trust inherits an IRA, there are RMD requirements. The IRS calculates the RMD amounts under the stretch payout, 10-year or five-year rule. The calculation depends on the attributes of the trust and the trust beneficiaries.

The trust beneficiaries are classified as non-individuals, “regular” beneficiaries or part of the new class of “eligible designated beneficiaries.”

And to qualify for the “stretch distributions,” the trust must be drafted as a “see-through” trust. The two types of see-through trusts are “conduit trusts” and “accumulations trusts.”

Conduit trusts pay out all trust distributions immediately to the trust beneficiaries. Like its name, it is a conduit for the distributions. According to IRS rules, an accumulation trust can accumulate the payments within the trust and pay them out later.

It is important to note that the RMD payout rules are different from the trust payout rules. Even if an IRA must pay out under the five-year rule to the trust, that does not mean the IRA assets will be distributed out to the trust beneficiaries within those five years. The trust will pay the beneficiaries according to the terms of the trust.

The rules are important but confusing

For example, an “eligible designated beneficiary” (EBD) of a see-through conduit trust can apply the stretch IRA rules for a longer payout term. But a non-EDB must use the 10-year distribution rule.

And under a see-through accumulation trust, both EDBs and non-EDBs must use the 10-year payout. For a non-see-through trust, the five-year rules apply, depending upon even more factors.

Every family is unique, and each has different financial and estate planning needs and goals.

Trusts are powerful and flexible estate planning tools. Whether you need a living trust, a special needs trust, a revocable trust, an irrevocable trust, a QTIP trust or other trusts depends on your financial goals and your wishes for your spouse and family.

Sometimes it makes sense to have a family living trust and contribute most of your assets during your lifetime.

But many financial accounts are different and typically not transferred during your life. For example, you must be the owner of your IRA during your lifetime.

Many financial accounts often require you to designate the beneficiary. With all the protections and controls given to you by a trust, your best option for financial and retirement accounts may be to name a trust as a beneficiary. And because of tax laws, many people name their spouse as the primary beneficiary of their retirement account and the trust as a second beneficiary. It all depends on your unique circumstances.