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An Example of Why a Trust for an IRA Can Make Sense

By Harry S. Margolis

About a dozen years ago a woman unexpectedly passed away. She was unmarried and had no children. She had named her nephew, John, as the beneficiary of her IRA. John was five years old at the time of his aunt’s death when the IRA held approximately $1.2 million.

Today with the increase in the stock market, the IRA is holding approximately $3 million. John is 17 years old and doesn’t know about the IRA. He’ll soon be 18 and have access to the funds. According to his parents, John’s a good kid, but not so responsible at this point in his life. They don’t know how he’ll respond when he learns about the funds.

What About the Sister?

In addition, John’s mother was pregnant at the time of her sister’s death. John’s now 12-year-old sister, Deborah, is not a beneficiary of the IRA. The parents don’t know if John will be willing to share his IRA with Deborah and, even if he is, it could get complicated.

Any withdrawal from the IRA is taxable, so splitting the IRA in half would be very expensive with most of the proceeds being taxed in the highest bracket. Since the aunt died before passage of the SECURE act, John can take annual withdrawals based on his life expectancy. He could do that, each year splitting half the proceeds after taxes with Deborah. That might work for a while, but will John still want to be doing that when he’s 40 and potentially married and supporting his own children?

Another approach would be for John to accelerate this process, withdrawing more than the minimum each year making sure not to push himself into too high a bracket and setting aside half the proceeds for Deborah. This could take more than a decade and raises the issue of how to determine half since the values of both funds will fluctuate over time and Deborah’s share will be tax free (other than future capital gains) while John’s will be subject to tax.

How to Avoid this Dilemma

This all would have been easier if the aunt had made her IRA payable to a trust. A trust could have accomplished the following:

  • Accounted for future nieces and nephews.
  • Delayed the age when beneficiaries would be able to control their accounts.
  • Protected the IRA from creditors of the beneficiaries.
  • Protected the IRA in the event a beneficiary were divorced.

Anyone can become incapacitated or need the protections described above, which can argue for all IRAs being payable to trust, but this is especially the case when naming a minor as beneficiary.

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