By Sarah Stewart Legal Group
Trusts are estate planning documents that direct how your assets will pass after your death. If the trust is properly funded, you heirs will be able to avoid probate when you die. Trusts can save your loved ones a lot of heart ache in the long run and allow your assets to pass smoothly from one generation to the next. Though, overall, a trust is a sound decision for your estate planning, no matter who you are, there are tax consequences of using a trust with a Traditional IRA.
People fund their Traditional IRAs with pre-tax dollars. This means deposits made into the IRA are tax-deferred. Tax-deferred means the IRS will take income taxes out of the disbursements when they are made. The IRS will require Trust beneficiaries to take withdrawals once the account holder dies and taxes will be calculated accordingly.
Tax calculations for trusts that are beneficiaries of Traditional IRAs can become rather complicated. If there is only one beneficiary, the withdrawal amount the heir is required to take will be based on the beneficiary’s life expectancy. Income taxes are generally based on the beneficiary’s tax rate.
If there is more than one beneficiary, mandatory distributions will be calculated by the oldest beneficiary’s life expectancy. This can force younger beneficiaries to take larger amounts, and pay more taxes than originally expected.
If a business, charity, or another non-person entity is named as a trust beneficiary, the IRA must be closed and distributed. IRA disbursements are considered taxable income. This can lead to a large tax bill for beneficiaries, depending on the size of the IRA. Tax rates will usually be calculated using the trust’s tax rate, which may also be much higher than the beneficiaries’. In 2017, the income tax rate for trusts was 39.6% after $12,400 in income.
If you have a ROTH IRA you will not have the same issues. ROTH IRA savings are made with post-tax dollars. This means you pay taxes on the money before you put it into the IRA. So, ROTH IRA distributions are not taxed like Traditional IRAs.
If you have significant assets held in a Traditional IRA, you need to consider the pros and cons of naming a trust as a beneficiary of the IRA. Even if you use a trust for your estate plan, you can always name separate beneficiaries for your Traditional IRA assets and avoid the trust tax rate. This may or may not be the best option for your situation. Be sure to consult attorneys, tax advisors, and financial planners for your own estate planning purposes.