April 1, 2012

Using a Conduit IRA Trust

Tax deferral is the main benefit of an IRA, as the income earned on IRA assets is not taxed until it is withdrawn. The longer the money stays in the IRA, the longer the growth will compound on a tax deferred basis. Beginning in the year after the year of death an IRA owner, the designated IRA beneficiaries can take minimum required distributions (the MRD) from their inherited IRA’s based upon calculations of their own life expectancies, rather than calculations based upon the life expectancy of the IRA owner/decedent. This has the effect of stretching the payout from an IRA over a longer time period and allows the beneficiary to realize the growth that can occur with compounding income. The beneficiaries always have the ability in any given year to take more from their IRA than the MRD.

With a little proactive planning, you can take steps to protect your IRA so that your heirs get the maximum benefit from it. Using a trust can prevent your beneficiaries from cashing out the IRA immediately; it can keep the assets in the family in the case of divorce; and it can also protect the inherited IRA from creditor claims and bankruptcy. IRAs are normally exempt from creditor claims, but this is not true for inherited IRAs. This puts the IRA at risk if your beneficiaries have significant debt.

One method of protecting your IRA is setting up a conduit trust. With a conduit trust, your beneficiaries are entitled to the MRD from the IRA, but are not able to withdraw more than the required amount. The MRD is still calculated over the beneficiary’s lifetime, so there is still the benefit of stretching out the life of the IRA. A conduit trust is a flow-through entity and does not accumulate income, as each year’s MRD is distributed to the beneficiary and therefore it is not taxed at the trust level.

The IRS has set the following requirements under Treasury Regulation Sec. 1.401(a)(9)-4 for a trust to be used as an IRA beneficiary:

  1. The trust must be valid under state law
  2. The trust must be irrevocable at death
  3. The trust beneficiaries must be identifiable in the trust document
  4. All beneficiaries must be individuals
  5. Documentation must be provided to the custodian of the IRA by October 31 of the year following the IRA owner’s death

Each conduit trust should have only one beneficiary, it should be created before death, and designated as a direct beneficiary on the IRA designation form. It is important to note that the conduit trust for an IRA is normally a separate trust document from a Revocable Living Trust document.

The conduit trust is just one option for protecting your IRA. Each individual’s situation is unique and may require a different approach. Please contact RINA to discuss what options are available to protect your assets in a way that your objectives are met.