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My wife and I are both over 65 and are doing some estate planning. Can I transfer funds from a traditional IRA to a trust without immediately being taxed? What would be the tax consequences of making the trust the beneficiary of my IRA?
The reader's best bet would be the second strategy -- making the trust the beneficiary of his individual retirement account, says Natalie Choate, an estate-planning lawyer at Nutter McClennan & Fish LLP in Boston.
Still, there is a caveat we will get to in a moment.
To take the questions in order: Transferring funds from an IRA to a trust would "invariably cause immediate taxation," because the transfer would be considered an IRA distribution, Ms. Choate says.
Note: Investors might encounter a technique espoused by some estate-planning experts, which in theory would allow for a transfer without triggering taxes. But the Internal Revenue Service has never specifically "blessed" the technique, Ms. Choate says. So, "most estate-planning lawyers would say you shouldn't try it without getting a ruling from the IRS, which would be quite expensive."
Instead -- and here we turn to the second question -- the reader could name the trust as a beneficiary of his IRA. It is a popular estate-planning move for people who want to use a trust to avoid estate taxes or protect beneficiaries, such as children who are too young to manage the money themselves, or adult children with special needs, Ms. Choate says.
You would need to make sure that the trust is written to follow strict IRS guidelines known by estate planners as "see-through" or "conduit" trust rules. Also, the income-tax rates that trusts pay are generally higher than income taxes paid by individuals. But your heirs can avoid paying the high trust rate if the trustee can pass all the IRA distributions out to the individual trust beneficiaries. "So, you need to be sure, if you name a trust as beneficiary, that the trustee has the latitude to do this, and the IRA distributions won't get trapped inside the trust," Ms. Choate says.
There are drawbacks to leaving an IRA in a trust for your spouse, as opposed to other beneficiaries. A trust would have to draw down the IRA in installments every year over the life expectancy of the oldest trust beneficiary. In contrast, if you name your spouse outright as beneficiary, instead of using a trust, he (or she) can roll your IRA into his or her own IRA -- and possibly defer distributions and taxes for many more years, Ms. Choate says.
So, you may want to combine the strategies so that your IRA goes to your spouse upon your death, and then to a trust on behalf of your other heirs upon your spouse's death.