Naming a trust as beneficiary of a retirement account

Naming a trust rather than an individual as beneficiary of a retirement account is a legitimate technique with specific requirements. Getting it wrong produces a substantially worse tax outcome.

Why anyone does it

Retirement accounts left directly to an individual are theirs outright, immediately.

A trust allows control over what happens next.

Young beneficiaries. Preventing a substantial sum passing outright to a beneficiary in their twenties.

Beneficiaries who cannot manage money, or who have creditor problems, or addiction issues.

Blended families. Providing for a surviving spouse during their lifetime while ensuring the remainder goes to children from a previous relationship.

This is one of the more common and more important uses.

Beneficiaries with disabilities receiving means-tested benefits, where an outright inheritance can disqualify them.

Creditor protection, since inherited retirement accounts have been held in some circumstances not to enjoy the same protection as the original owner's.

The technical requirements

Retirement account distribution rules are based on the beneficiary. A trust is not a person, so specific requirements must be met for the trust's beneficiaries to be considered.

The requirements have generally included that the trust be valid under state law, that it be irrevocable on the owner's death, that its beneficiaries be identifiable from the document, and that documentation be provided to the plan administrator by a specified deadline.

A trust meeting these conditions is commonly described as a see-through or look-through trust.

A trust failing them may be treated as having no designated beneficiary, which generally produces a much faster required distribution and a correspondingly worse tax outcome.

The two structures

Conduit trusts require that any distribution received from the retirement account be passed immediately to the beneficiary.

Simpler to draft and to qualify, and it provides limited protection, since the money reaches the beneficiary anyway.

Accumulation trusts permit distributions to be retained inside the trust.

These provide much stronger protection and are more complex, because all potential beneficiaries — including remainder beneficiaries who might receive assets in the future — may need to be considered.

Retained income inside a trust is also taxed at trust rates, which reach the top bracket at a very low income level, so the tax cost of accumulation is significant.

What recent legislation changed

Substantially, and it made many older trust arrangements obsolete.

Where most non-spouse beneficiaries must now empty an inherited account within a limited number of years, a conduit trust drafted under the previous rules may now be required to distribute the entire balance to the beneficiary at the end of that period.

Which defeats the purpose of the trust entirely — the protection was meant to last decades and now expires quickly.

Anyone whose estate plan names a trust as beneficiary of a retirement account, drafted before these changes, should have it reviewed.

This is one of the more common unaddressed problems in existing estate plans.

The special needs case

Where the analysis differs.

A beneficiary with a disability receiving means-tested benefits can be disqualified by an outright inheritance.

A properly drafted special needs trust holds assets for their benefit without those assets counting for eligibility purposes.

Certain categories of beneficiary, including disabled and chronically ill individuals, may also be entitled to more favourable distribution treatment than the general rule.

This combination makes trust planning particularly valuable here, and particularly technical.

The alternatives worth considering

Because a trust is not always the answer.

Roth conversion during life. Converting before death means heirs inherit a Roth account, and while distribution timing rules still apply, the withdrawals are generally tax free.

For someone concerned about heirs facing a compressed distribution period in high brackets, this can be more effective than trust drafting.

Leaving retirement accounts to charity and other assets to individuals, since charities pay no income tax on such distributions.

Naming individuals directly where the concerns about control do not apply, which is simpler and cheaper.

The practical point

This is not a do-it-yourself area.

The interaction between trust drafting, distribution rules and tax treatment is technical, the rules have changed recently, and errors surface only after the account owner has died.

Where a trust is used, the drafting should be done by an attorney who works in this area specifically, and the arrangement should be reviewed periodically against current law.

General information only, not legal or tax advice. Rules governing inherited retirement accounts have changed and continue to be clarified — consult a qualified estate attorney.