Take-Away: An IRA Trust is a form instrument that is used by a large stock brokerage company to take title to a customer’s IRA which assures that only required minimum distributions (RMDs) are paid out to the IRA Trust beneficiaries (a conduit type of trust.) Some advantaged do exist if an IRA Trust is considered by a client.

Background: The Tax Code permits an IRA to come in two different forms: a custodial account or an IRA Trust. Specifically, the Tax Code defines an IRA as a “trust for the exclusive benefit of an individual or his beneficiaries.” IRC 408(a) A trust cannot technically own an IRA. Only an individual can own an IRA. But a trust can be named as the beneficiary of an IRA.

An IRA can also be set up within a financial institution in the form of a trust during the IRA owner’s lifetime. [Note that the IRA owner cannot just take a distribution from their IRA and transfer those assets into a trust; that would result in the immediate income taxation of the IRA distribution to the owner (the assets, after withdrawal, would no longer be IRA assets when they are deposited into the trust.)]

With the IRA Trust the financial organization’s document is more than just an IRA custodial account agreement. The IRA Trust adds trust terms and trust language, with a limited menu of distribution options for the owner to select from. In short, the IRA becomes a trust with the financial organization acting as the trustee. The trustee administers the IRA Trust both while the IRA owner is still alive (it is a revocable grantor trust), and after the IRA owner’s death (when the owner’s trust becomes irrevocable.)

The IRA Trust is almost always structured as a conduit trust, which pays required minimum distributions to the designated trust beneficiaries each year.

It comes as no surprise, either, that the IRA Trust also usually prohibits the transfer of the IRA Trust assets to a different financial organization, (hence my description of it as  a convenient ‘marketing tool’ used to lock-in continuing business long after the IRA owner’s death.)

Practical Observation:

Often IRA Trusts are promoted because the financial institution has pretty much paid for the preparation of the trust with its use of a form IRA Trust instrument with its limited distribution options. For clients who do not want to pay an attorney to prepare a Trust instrument, then the IRA Trust  may have some appeal. But if the client is fairly wealthy, or the client has accumulated substantial sums in their IRA, there is a pretty good chance that they already have a Trust instrument in place as part of their estate plan to hold and distribute  their other wealth, so cost savings may not be all that big  of a motivation to them. If all the client owns is a large IRA, and few other assets (which might pass by TOD, POD, or ladybird deed) then maybe a IRA Trust may be something for the client to adopt to distribute their retirement assets after their death.

Pro’s and Con’s:

    Advantages of using an IRA Trust include:

  • It ensures that the required minimum distributions (RMDs) are taken while the IRA owner is alive and it ensures that RMDs will be taken/distributed after the IRA owner’s death; with a custodial IRA there must also be an agent  who can act under a Durable Power of Attorney  to take RMDs (and avoid the 50% penalty for the owner’s failure to take them) and to manage the IRA owner’s account should the owner later become disabled;
  • No trust tax returns are filed by itafter the owner’s death, if the sole asset in the Trust is an IRA, which must distributed to trust beneficiaries (a ‘wash’ of the taxable IRA income distributed out to the beneficiaries with a reporting 1099-R;)
  • It will always comply with the IRS’s technical see-through rules, which eliminates some of the risks that a separately drafted Trust might trigger by not complying with those technical rules;
  • It is cheap because all the IRA owner does is sign the financial institution’s form, but there will still be a fee to set the IRA Trust up and ongoing fees of some magnitude charged by the trustee; and
  • Generally the IRS’s separate account rules do not apply to trust instruments, which is why conventional planning compels naming each sub-trust to be created under the governing Trust as the beneficiary of a portion or fraction of the deceased settlor’s IRA account, i.e. the division of the settlor’s IRA occurs in the beneficiary designation form, not the in trust instrument; most IRA Trusts are initially set-up to satisfy this separate account rule so that each beneficiary may use his/her own life expectancy for their required minimum distributions.

    Disadvantages of the IRA Trust include:

  • Only a corporate trustee is permitted under an IRA Trust; usually no individuals can act as co-trustee;
  • An accumulation trust is usually not available for an IRA Trust; it is just a ‘hard-wired’ conduit trust, which may prove to be inflexible for some of the IRA owner’s beneficiaries and their changing needs;
  • If strictly a conduit distribution or stretch IRA is contemplated by the IRA Trust, then in rare occasions when the trust beneficiary may need more than just their RMD distribution for the calendar year, the IRA Trust may prove to be too inflexible to permit the trustee to meet that beneficiary’s needs;
  • The IRA Trust assets cannot be moved by a vote of the beneficiaries to a different financial institution; the beneficiaries will not be able to vote with their feet;
  • Sometimes when a trust is the designated beneficiary of the deceased settlor’s IRA, it is possible to claim a marital deduction for the IRA assets that are allocated to the decedent’s surviving spouse under that trust, e.g. through disclaimers of other trust beneficiaries, etc; a spousal rollover of a portion (or all) the decedent’s IRA will be less likely an outcome to save taxes if an IRA Trust is used; and
  • Since an IRA Trust is almost always set-up as a conduit trust to exploit the stretch RMD rules, it provides little creditor protection to the extent that a creditor can seize each annual RMD distribution to the trust beneficiary; a specifically drafted Trust instrument that receives the IRA can contain provisions to switch from a conduit to an accumulation trust if the beneficiary encounters creditor problems or other provisions that might be used to frustrate creditors, e.g.  ‘pay to or for the benefit of the beneficiary…).

Summary: There are a limited number of situations where an IRA Trust might be the best solution for an IRA owner. But if that owner already has a Trust as part of their estate plan, it is probably much better to use that existing estate planning Trust to receive and distribute their IRA assets, in conjunction with all of their other wealth that is held in the Trust. More flexibility can be achieved through a carefully drafted Trust instrument that tailored to the client’s needs and desires for his or her beneficiaries, which is not the case with pretty much a ‘pre-printed’ form IRA Trust instrument. Nor is it economical for the client or his or her heirs to maintain two separate trusts, one to distribute IRA assets and the other to hold and distribute the balance of their wealth. One also has to wonder about the long-term efficacy of IRA Trusts if Congress does finally act to limit stretch IRAs which it started to do with the Senate Finance Committee’s bill last year to shorten all RMD periods to 5 years from the IRA owner’s death. Cost vs inflexibility is the decision that most IRA owners will have to balance when looking at an IRA Trust.