If you don’t need all the money in an IRA after you retire, there can be big tax advantages in carefully leaving it to your children or other heirs. If it’s done right, the heirs can take out only the minimum required distribution each year, and the assets in the IRA can continue to grow tax-deferred for decades – and in some cases, for generations to come.
The problem with this planning technique is that it requires your heirs to be patient money managers. In the real world, many heirs withdraw the funds from an inherited IRA quickly, which destroys the tax advantages.
The traditional solution is to leave your IRA to a trust, in which a trustee can decide how to invest the IRA, when to make withdrawals from the IRA, and what distributions to make to your heirs.
Trusts have other advantages, such as that they can benefit a surviving spouse during his or her lifetime, and later benefit children from an earlier marriage. They can also shelter IRA assets from estate tax if your spouse is from another country and doesn’t have a large estate tax exemption.
Recently, though, some financial institutions have been pitching a new product called a “trusteed IRA.” The new product is similar to a trust, in that a trustee is appointed who will manage the IRA assets and limit future distributions to heirs.
The main advantage of a trusteed IRA is that the tax rates for trusts have risen recently, and at least for the near future, a trust might pay higher taxes than the beneficiary of a trusteed IRA.
However, trusteed IRAs also have a very big drawback, which is that you can’t pick the trustee and you don’t have any flexibility for special circumstances.
With a trusteed IRA, your assets will be managed by a money manager who works for the financial institution and likely has no familiarity with your family or your preferences. Plus, the trustee has no ability to bend the rules if the circumstances require. If your heirs ever need extra distributions to pay for education, health problems, starting a business, or any other contingency, they’ll be out of luck – whereas with a trust, you can pick a trustee who understands your heirs’ needs, and you can write the trust to give the trustee power to help them when appropriate.
Either way, it’s important to talk to an estate planner about how to choose the beneficiaries of an IRA. While the tax advantages can be huge, the rules are complex and technical and it’s very easy to make a mistake.