Leaving an IRA directly to heirs is fraught with pitfalls: the heirs may exhaust the funds quickly to the detriment of any long-term tax deferral benefits, the money may be vulnerable to divorce settlements or creditors, and any withdrawn money will lose the inherent protections of the IRA.

Trusts offer a safer option for passing on your IRA to heirs. Just like any assets held in trust, an inherited IRA left to a trust will limit exposure to both creditors and unchecked spending, thus providing greater assurance that long term tax deferral will be achieved. Furthermore, leaving an IRA to a trust with a responsible trustee can increase the likelihood that, along as there’s no imperative need for cash, your heirs’ tax deferral benefits will be maximized.

Will your heirs resent this setup? Those who wish to spend more than you had in mind may be dissatisfied. But an heir who spends recklessly might have a change of heart about trusts once the money is gone. A trustee can be granted the power to draw from the IRA, if necessary, but the trustee can also be given the ability to pay out as little as possible, from this trust. As a result, a $250,000 inheritance can, over time, ultimately pay $1 million, $2 million, or more to the heirs.

The Trouble with Trusts

As nothing in life is perfect, you should be aware that leaving an IRA to a trust has its disadvantages as well. The IRS interprets the minimum required distribution (MRD) rules strictly for trust beneficiaries, which can result in reduced tax deferral.

Example: You leave your IRA to a trust, naming your sister Karen as the trustee. Karen will have the discretion as to how much she distributes to your son Peter, who is the primary trust beneficiary.

This arrangement serves to protect the assets. Karen can take minimum distributions from the IRA and hold the funds in trust, if she wants to keep Peter from depleting the money too quickly or losing the money to creditors or divorce.

Trap: The IRS considers the above example an “accumulation trust.” With such trusts, the shortest life expectancy of all the possible trust beneficiaries will be used to determine MRDs.

Suppose that the IRA passes to the trust when Peter is 48, with a 36-year life expectancy on the IRS table. If his Aunt Belle, 65 years old with a 21-year life expectancy, is the oldest of the secondary beneficiaries, money must be withdrawn from the IRA on a 21-year schedule. The result is that taking money from the IRA over 21 rather than 36 years will curtail tax deferral and reduce potential wealth building.

Alternative: A “conduit” trust in lieu of an accumulation trust may be preferable in certain cases in order to ensure long-term tax deferral.

How it works: A conduit trust has a single individual as a primary beneficiary. The trustee is required to take at least the MRD amount from an inherited IRA each year, and pass that amount through to the trust beneficiary.

Advantage: With a conduit trust, the primary beneficiary’s life expectancy can be used to extend the MRD schedule.

Disadvantage: Distributions cannot be accumulated in the trust as they must be passed through to the trust beneficiary, risking the money being spent or lost to creditors even though the IRA principal may still be protected.

Summary: Until recently, leaving an IRA to a trust meant choosing between the maximum protection of an accumulation trust or the maximum tax deferral of conduit trust.

Introducing the IRA Trust

The IRS issued Private Letter Ruling 200537044 in 2006, approving an “IRA Trust.” A Private Letter Ruling is an IRS document that approves or rejects a specific request, such as the use of a trust designed in a certain way, for a particular taxpayer.

Using this new strategy, a benefactor begins by creating either an accumulation trust or conduit trust that will inherit his or her IRA. This trust should be a one-purpose trust. Following death, an independent party can “toggle” from one of these types of trust to the other, depending on the beneficiary’s needs. At the death of the owner of the IRA, this IRA Trust will divide into smaller “subtrusts,” one for each intended beneficiary.

Example: You intend to divide your IRA among your four children. At your death, the IRA Trust (which becomes irrevocable at your death) will divide into one trust for your daughter Rachel, one for your son Matthew, one for your son Charles, and one for your daughter Sabrina.

If you have full confidence in your children’s ability to handle their inherited IRAs, each of the subtrusts can be structured as conduit trusts for maximum tax deferral and potential protection of principal. At any point during your lifetime, you can alter the plan if you decide that one or more of your children needs the protection of an accumulation trust.

What happens after your death has now been clarified by Letter Ruling 200537044, which approves an arrangement in which each subtrust can have a “trust protector.” The person who serves as trust protector must be unrelated by blood to the trust beneficiary, but may have a personal relationship to him or her, such as a personal financial adviser, attorney, CPA or friend.

If worrisome circumstances arise, such as a beneficiary has matrimonial or creditor problems, the trust protector can change a conduit trust to an accumulation trust by voiding the provision that requires the immediate payout of IRA distributions to the primary trust beneficiary. As a result, the trustee will gain the discretion to accumulate funds, and more significant asset protection is afforded the beneficiary.

This ruling has the benefit of working both ways. If an accumulation trust had been setup for a beneficiary with current financial problems that have since been resolved, the trust protector may switch it to a conduit trust by requiring the full payout of MRDs.

It is important to note, however, that such a post-death toggle can be done only once, regardless of the direction the switch is made. According to the Private Letter Ruling, the one switch can be made within nine months of the IRA owner’s death. The decision can, however, be made on a beneficiary-by-beneficiary basis so that some beneficiaries have conduit trusts and some beneficiaries have accumulation trusts.

While this is an exciting and intriguing development in the world of retirement planning, one should proceed with caution. The IRA Trust has been approved in a Private Letter Ruling, which technically applies only to the taxpayer making the request. For more information about incorporating IRA Trusts into your retirement plan, please send an email to Morris Law Group at Info@Law-Morris.com or call 561-750-3850.