Historically, most individual retirement accounts are structured as a “custodial” account, but the Internal Revenue Code permits IRAs to be structured as trust accounts as well.
The benefit of using a “trusteed IRA” is that the account is literally controlled by a trust document, which both ensures continuity in the form of a trustee that manages the account, and can restrict beneficiaries’ future access to the money after the original IRA owner dies (either to protect them from themselves, or to protect their IRA inheritance from potential creditors).
The caveat, however, is that a trusteed IRA really doesn’t provide any benefits that can’t already be accomplished with a (separate) trust as beneficiary. And in fact, having a standalone trust drafted to be the beneficiary of a retirement account can provide even more flexibility, or more robust spendthrift and asset protection for future beneficiaries.
Nonetheless, the ranks of trusteed IRA providers have been growing in recent years, in part because the trusteed IRA is highly appealing from the perspective of the IRA provider – because, as the trustee of the IRA itself, it’s very difficult for future beneficiaries to ever fire the trustee or transfer the account to another provider, allowing the trusteed IRA provider a greater likelihood of retaining the assets than a traditional custodial IRA provider. In addition, it’s notable that while drafting a separate trust as beneficiary of a retirement account has a non-trivial one-time upfront cost, it may still be less than paying ongoing fees for the trustee to manage and administer the trust for what could be decades into the future.
The trusteed IRA may still be appealing in situations where the IRA owner wants to outsource investment management for beneficiaries, is comfortable with the “risk” that beneficiaries may have trouble changing providers anyway, and simply cannot find a competent attorney who can draft a proper conduit or accumulation trust to serve as the IRA beneficiary instead. Yet ultimately, for those who do have access to competent legal counsel as part of the estate planning process, a well-drafted trust as IRA beneficiary can accomplish everything a trusteed IRA provides, and potentially more estate planning strategies as well!
What Is A Trusteed IRA?
A trusteed IRA is a form of Individual Retirement Account where the Financial Institution holding the IRA operates it as a trust (for which the Institution serves as trustee), rather than simply as a custodial account that the Institution holds. In fact, by default an IRA is meant to be structured as a trust account under IRC Section 408(a), although a custodial account may be treated as a trust account (and satisfy the IRA requirements) under IRC Section 408(h).
In practice, this means that a trusteed IRA is literally controlled by a trust document, that the IRA owner signs and agrees to in opening the account (and may help to design and structure up front), for which the Financial Institution will serve as trustee, albeit subject to following directions that the IRA owner provides. With a custodial IRA, though, the Financial Institution merely holds the assets on behalf of the IRA owner, who retains full legal control of the account. This distinction – between whether the IRA is literally controlled by the IRA owner (with the Financial Institution serving as custodian), or whether the IRA is controlled by a trust document (where the Financial Institution is trustee and takes direction from the IRA owner) – may seem like a minor nuance, but it has important differences.
From a tax perspective, though, the rules governing IRAs are exactly the same regardless of whether the account is organized as a custodial IRA or a trusteed IRA (or as an Individual Retirement Annuity, or “IRA Annuity”, under IRC Section 408(b)). In all cases, the standard IRA tax rules apply, including the ability to deduct IRA contributions when the requirements are met, the taxability of distributions when received, the potential for early withdrawal penalties prior to age 59 ½, and the obligation to take Required Minimum Distributions after age 70 ½.
Administratively, however, the operation of a trusteed IRA, and the role of the trust document that controls it, has important differences from a custodial IRA, both during the life of the IRA owner, and especially after death.
Differences Between A Trusteed IRA And A Custodial IRA
Differences During The Life Of The IRA Owner
As noted earlier, with a custodial IRA, the role of the Financial Institution is literally just to hold and have custody of the IRA assets. Legal control over the account remains fully vested in the IRA account owner. Which means not only does he/she have the right to make all decisions, but it means the IRA custodian can only act upon his/her directions, or someone with legal authority to act in the owner’s stead, such as a legally appointed guardian or an attorney-in-fact under a Power of Attorney in the event that the IRA owner is incapacitated.
By contrast, with a trusteed IRA, the Financial Institution itself serves as the trustee, and simply takes direction from the IRA owner about how the account should be handled. Which is important, because that means if the IRA account owner is incapacitated, the trustee has the authority to continue to manage and oversee the IRA, including making prudent investment decisions, executing required minimum distributions, etc.
Thus, in practice, control of a custodial IRA is effectively frozen when the IRA owner becomes incapacitated, until and unless a guardian is appointed or a Power of Attorney document is provided by an attorney-in-fact to act in his/her stead. With a trusteed IRA, though, continuity of control and management remains, even if the IRA owner is incapacitated, thanks to the continuing role of the trustee themselves.
Differences After The Death Of The IRA Owner
More substantively, though, are the differences between custodial and trusteed IRAs after death.
In the case of a custodial IRA, after the death of the (original) IRA owner, the retirement account is bequeathed to (and becomes the property of) the named IRA beneficiary, giving him/her (or “it” in the case of an estate, trust, or charity as beneficiary) full control over the account. Under the so-called “stretch IRA” rules, the beneficiary has the option to leave the money in the account and take only the annual post-death Required Minimum Distribution, or can choose to some or all of the money more quickly. It’s the beneficiary’s choice, because the beneficiary controls the account after the death of the original owner; the Financial Institution simply serves as the custodian to hold the account, and follow the directions of the beneficiary.
On the other hand, with a trusteed IRA, after the death of the original IRA owner, the account will pay out according to the terms of the trust document that controls the IRA, as executed by the trustee. Control does not transfer to the beneficiaries (unless the trust document stipulates that it should).
Accordingly, a trusteed IRA might stipulate that beneficiaries are limited in their post-death distributions, such as being able to only take the post-death RMDs every year (which are mandated), but no more. Control of the remaining IRA assets (beyond just the RMD amounts) might not be released at all, or only at certain ages (e.g., half at age 35, the remainder at age 45), or additional distributions might be allowed for the beneficiary’s support needs but only at the discretion of the trustee.
Benefits Of A Trusteed IRA Over A Traditional Custodial IRA
While the ability to expedite management of an IRA during the life of the owner if he/she becomes incapacitated may be appealing, in practice the most popular benefit of the trusteed IRA is the ability to restrict the beneficiary from fully accessing (and liquidating) the inherited retirement account.
Notably, the ability to restrict beneficiaries from liquidating the inherited retirement account is helpful not merely to reduce the risk that they merely irresponsibly spend down the account to quickly, but also to “ensure” that the beneficiaries maximize the tax benefits of stretching the IRA out over their life expectancies (by being required to take no more than the minimum amount required under the post-death RMD rules).
Furthermore, using a trusteed IRA to restrict the beneficiary’s ability to access the money provides an asset protection benefit – as the beneficiary cannot liquidate the account for themselves, a judge cannot compel them to liquidate the account for credits, which is important given the Clark v. Rameker Supreme Court decision that does not otherwise provide asset protection to an inherited IRA (the way that an individual’s own IRAs are protected). Though of course, any RMDs already distributed could/would still be subject to creditors.
A trusteed IRA that limits a spouse’s access to the inherited IRA may also be able to exclude the value of the IRA from the surviving spouse’s estate (effectively replicating the benefits of a Bypass Trust, where only the amounts actually distributed are in the survivor’s estate). And the trusteed IRA can stipulate both the initial beneficiary of the retirement account, and successor beneficiaries, allowing the original IRA owner to ensure that the remaining value of the account goes where desired (e.g., in blended family situations, to children from a first marriage, and not whoever the second surviving spouse chooses, by structuring the trusteed IRA to qualify as a QTIP trust).
Of course, the reality is that all of these outcomes could also be achieved simply by using a trust as the beneficiary of the retirement account – which similarly puts a “barrier” between the beneficiary and the inherited retirement account (not to mention the beneficiary’s potential creditors and the inherited IRA). Or by using an IRA annuity with a restricted beneficiary payout to limit the beneficiary’s access to the inherited account. However, using a trust entails the cost of drafting such trust documents (and an experienced attorney who has the knowledge and expertise to do so, given the complexity of the trust-as-IRA-beneficiary rules), and holding an annuity inside of an IRA has an additional cost (the expense ratio of the annuity, for guarantees that may not otherwise be needed if the sole purpose is to restrict the beneficiary after death).
In addition, using a trusteed IRA greatly simplifies tax reporting for beneficiaries – at least compared to a trust-as-beneficiary alternative, as the beneficiary of the trusteed IRA simply receives the standard Form 1099-R reporting for distributions as they occur. While with a trust as beneficiary, it’s necessary to send the Form 1099-R to the trust, which in turn files an annual Form 1041 for trust income tax reporting, and then must distribute a Form K-1 to any beneficiary to report his/her share of RMD income if/when the RMDs are passed through to that beneficiary.
Trusteed IRA Providers And Costs
In order to use a trusteed IRA, it’s necessary for the IRA provider to actually offer a trusteed IRA option, in a world where most IRAs are still held in custodial form. And the distinction matters – a lot – from the perspective of the IRA provider, both because the firm must create the templated trust document to manage the trusteed IRA, and be ready to follow what the trust document stipulates, but also because once the IRA custodian also serves as a trustee, it must comply with the standard rules that apply to trust companies. Accordingly, all of the providers of trusteed IRAs are either trust companies or bank trust departments, or financial services providers that have a trust company subsidiary to serve as the trusteed IRA provider.
Accordingly, the available trusteed IRA providers today are a miscellaneous smattering of traditional private bank and trust companies for high-net-worth clientele (e.g., U.S. Trust, US Bank, Key Bank, and Northern Trust), direct-to-consumer platforms that make trusteed IRAs available (e.g., USAA), financial advisor platforms (e.g., Merrill Lynch, Edward Jones, MassMutual, and LPL), and even an advisory firm that created its own subsidiary (Manning and Napier via Exeter Trust).
Because trusteed IRAs are functionally “trusts” that are managed by a corporate trustee, the cost for a trusteed IRA is the cost for having a corporate trustee of a professionally managed trust. For most trust companies, this simply entails an AUM fee for a percentage of trust assets every year (typically 1% to 1.5%, potentially higher for small trusts, and tiering down to lower graduated breakpoints for larger trusts). Some trusteed IRA providers also assess a separate trustee fee (e.g., Edward Jones charges a $1,200/year flat fee for trustee services on top of its AUM fee), while others simply include an all-in AUM fee for investment management and trust services. Most providers have a minimum as well – given the base overhead cost to the trust company to administer a trust in the first place – although minimums vary widely from one provider to another, with Edward Jones charging a minimum fee of $6,000 (which equates to a $320,000 trusteed IRA), Manning and Napier recommending at least $1.5 million in the trusteed IRA, and U.S. Bank suggesting that its Heritage IRA solution is best for IRAs with at least $2M in assets.
Notably, some trust providers offer a lower AUM fee option for just trustee services as the trust administrator, and allow an independent financial advisor to be the investment manager of the trust – for instance, LPL’s Private Trust Company charges “just” 65bps on the first $1M with a $4,200 minimum fee, scaling down for larger trusteed IRA accounts – although in practice most trusteed IRA providers operate with employee advisors or trust officers and include the investment manager services bundled into the trusteed IRA (and as a result the trusteed IRA cost is a single bundled fee).
Caveats And Pitfalls Of Using A Trusteed IRA
While the trusteed IRA provides substantial estate planning opportunities for a sizable IRA, from limiting access to spendthrift beneficiaries, “forcing” them to maximize the value of a stretch IRA, providing creditor protection, and helping to control the ultimate disposition of IRA assets to successor beneficiaries after the death of the primary beneficiary (e.g., blended family situations), it’s crucial to recognize that there’s nothing unique to what a trusteed IRA can do, compared to what a trust-as-beneficiary can accomplish as well.
Flexibility Of A Trust-As-Beneficiary Vs A Trusteed IRA
In fact, using a trust as beneficiary of the IRA actually allows for even more flexibility to control the disposition of an IRA than “just” using a trusteed IRA, even while allowing (or requiring) the IRA to “see through” the trust and be stretched over the life expectancy of the beneficiary. The reason is that a trusteed IRA is effectively like a “conduit trust” beneficiary of an IRA – one where all RMDs are automatically passed through to the underlying beneficiaries. But a trust as beneficiary of an IRA can also be structured as an “accumulation trust”, where all of the IRA – including not just the value of the IRA account, but also all of the post-death RMDs – can be accumulated within, and controlled by, the accumulation trust. In other words, with a trusteed IRA (or a conduit trust), the beneficiary cannot be limited from accessing the RMDs as they occur – which also means the beneficiary will gain total control of the inherited IRA by his/her life expectancy when all the RMDs must be paid out – while an accumulation trust as the beneficiary of the inherited IRA can limit access to the RMDs as well.
And the ability to restrict access to both the IRA itself, and the RMDs, is very important for many estate planning strategies. For instance, if the goal is to minimize estate tax exposure for the surviving spouse, who has sizable assets of his/her own, pushing inherited IRA RMDs into the surviving spouse’s estate just compounds the estate tax problem, while using an accumulation trust as a bypass trust allows the entire IRA to be sheltered (including its RMDs). Similarly, an accumulation trust ensures that an irresponsible beneficiary can’t be wasteful with any of the money – including what could be sizable annual RMDs. And the truth is that for creditor protection purposes, a known-and-required-to-be-distributed series of RMDs from a trusteed IRA is still an asset that a creditor place a claim against and attempt to garnish, while an accumulation-trust-as-beneficiary that has no requirement to distribute secures even more robust asset protection benefits.
Restrictions On Transfer Of A Trusteed IRA After Death
In addition, the trusteed IRA often puts additional restrictions on the retirement account after death that may be unappealing for some beneficiaries. For instance, many trusteed IRAs prevent the beneficiaries from changing financial institutions – effectively “writing themselves in” as permanent trustees and investment managers, unable to be fired even if the beneficiaries are unhappy with the trustee’s future (administrative or investment management) services. Some trusteed IRA providers will “allow” the trusteed IRA to be transferred, but notably this would only be permissible if the receiving institution agrees to adhere to all the trust provisions of the original trust – which may or may not be feasible for the new institution, if its systems aren’t built to handle the way the prior provider’s trusteed IRA was structured. And if an independent financial advisor is involved, there’s a risk that the trust company fires/terminates the independent advisor after the death of the original owner and turns the trusteed IRA into a house account or assigns it to its existing trust department (which, again the beneficiaries cannot stop if they don’t have control of the trusteed IRA and cannot change the trusteed IRA provider once they inherit the account).
By contrast, using a trust as beneficiary of the inherited retirement account separates the trust itself from the (custodial) IRA provider. This ensures that the trustee independently determines what financial advisors or investment managers are associated with the account, and creates a better checks-and-balances system (to the extent the trustee is now separate from investment manager, and can independently fire a poor-performing manager). Furthermore, use of a standalone trust-as-beneficiary allows for a family member to be a trustee (or co-trustee) to help determine when discretionary distributions to beneficiaries should be made – which isn’t possible for a trusteed IRA, as the trustee must be a financial institution under IRC Section 408(a) and cannot be an individual (whether a family member or any other third-party professional trustee outside of a bank or trust company itself).
Post-Death Stretch Complications Of Trusteed IRAs
It’s also notable that the trusteed IRA actually can create some minor-but-non-trivial tax complications as well, when it comes to determining the post-death stretch period for an inherited IRA.
For instance, under Treasury Regulation 1.401(a)(9)-4, Q&A-5(c), when a single trust has multiple beneficiaries – whether as a trusteed IRA, or a trust-as-beneficiary-of-IRA – all beneficiaries must take post-death RMDs based on the oldest beneficiary with the least favorable life expectancy. If the IRA beneficiary designation itself names multiple trusts as beneficiary, then each trust beneficiary can use the separate account rules of Treasury Regulation 1.401(a)(9)-8 to use their own life expectancies. But this requires the IRA beneficiary designation – of the custodial IRA or trusteed IRA – to be clear about naming separate trusts from the start. (A surmountable hurdle for trusteed IRAs, but a complication that must specifically be addressed before death.)
Similarly, if a trusteed IRA is bequeathed to a surviving spouse, the restrictions that limit the spouse from accessing the account will also prevent the spouse from completing a spousal rollover to his/her own account, and instead for the spouse into the less favorable RMD rules as a beneficiary instead. Notably, the same result would occur with a trust-as-beneficiary for the spouse – in other words, this is not a caveat of the trusteed IRA in particular, but of using any kind of trust structure for the inherited IRA. Nonetheless, it is important to recognize the less favorable tax treatment involved in the trade-off of placing more restrictions on a spousal beneficiary.
Why The Trusteed IRA Usually Isn’t Worth The Risk (And Cost)
Ultimately, a trusteed IRA I really just another way to structure using a conduit trust as the beneficiary of an IRA – to automatically pass through annual RMDs, but restrict the beneficiary’s access to the remainder of the account. With the caveat that a (separate) trust as beneficiary of an IRA can be structured in any manner the IRA owner desires (while he/she is still alive), while the trusteed IRA will be limited to the available options offered from the provider.
The good news of the trusteed IRA is that it may be simpler and easier to set up, as while it is functionally equivalent to a conduit trust as beneficiary, getting a conduit trust established requires an attorney who understands the trust-as-beneficiary-of-IRA rules well enough to draft it properly. Which isn’t always the case. And may involve a non-trivial cost for the attorney to create the trust. Yet for many/most trusteed IRAs, it’s as “simple” as just filling out a slightly-longer-than-usual beneficiary designation form with some additional choices about how future beneficiaries may be restricted.
On the other hand, given that trusteed IRAs typically require the use of the trust company’s managed account services, and may charge additional trustee administration fees as well, the trusteed IRA will often still end out being far more expensive than having a separate trust drafted, especially in situations where the IRA owner and/or beneficiaries didn’t need the trusteed IRA provider actually serving as the investment manager as well (or where a financial advisor separate from the trusteed IRA provider is expected to be managing the account). And ironically, the fact that investment minimums (or outright fee minimums) are so common for trusteed IRAs means it’s unlikely to be cheaper than just drafting a separate trust for a small account (where the minimum trusteed IRA fee comes to bear), nor is the trusteed IRA likely to be cheaper for a large account (where the trust drafting fee is much smaller than paying ongoing trust management fees on a sizable asset base).
And in the extreme, there’s the risk that if beneficiaries in the future aren’t happy with the trusteed IRA provider, there may be no effective way to change providers after the death of the original IRA owner. Accordingly, it is perhaps no surprise that a growing number of IRA custodians are rolling out trusteed IRA alternatives – it’s a path to virtually “guaranteeing” that they will retain control of the retirement account after the death of the original IRA, without little or no ability to ever be fired in the future.
In practice, the trusteed IRA might still be appealing for those who simply cannot find a competent third-party attorney who can draft a proper beneficiary trust for an IRA, and who don’t mind delegating investment management to the trusteed IRA provider (or can find a trusteed IRA provider that is willing to work with a financial advisor, or allow the beneficiaries to more directly influence investment decisions), and are willing to accept a nearly “permanent” trustee (with the associated costs, and “risk” of being unable to fire the trustee later). Though because there is no standardization in the trust language for trusteed IRAs, it may still be necessary to involve an estate planning attorney, just to thoroughly review the trusteed IRA trust documents and ensure that the restrictions of the trusteed IRA fit the estate plan (and are properly understood).
But in the end, for IRA owners who are so concerned about the final disposition of their IRA assets in the first place, arguably it’s still best to seek out a competent estate planning attorney, for what in the long run will likely be a less expense and more flexible solution of drafting a separate trust to serve as the beneficiary of the IRA – which is especially vital in estate planning situations like robust asset protection or sheltering estate taxes, where it’s crucial to use an accumulation trust that does not automatically pass through RMDs to the beneficiary in the first place!
So what do you think? Have you ever used a trusteed IRA for estate planning? Or do you prefer to use a (separate) trust as beneficiary instead? Please share your thoughts in the comments below!