Who Pays the Tax on Inherited IRA Distributions If You Leave Your IRA to a Trust? | Ed Slott and Company, LLC

Who Pays the Tax on Inherited IRA Distributions If You Leave Your IRA to a Trust?

By Jeffrey Levine, IRA Technical Expert
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@IRAGuru4EdSlott

For a variety of reasons, you might be considering naming a trust as your IRA beneficiary. If that’s the case, then chances are that you have questions about how, exactly, that would work. One of the most common questions people have when they name a trust as their IRA beneficiary is, “Who will pay the tax on the inherited IRA distributions? The trust, or the trust beneficiaries?”

Unfortunately, there’s no easy way to answer that question because it can depend on the language in your trust and, in some cases, what actions your trustee chooses to take (or not take) after the trust inherits the IRA. And if you’re wondering why any of this even matters, here’s why. Trusts pay higher taxes at an accelerated rate compared to people.

For instance, in 2015, trusts get to the highest federal income tax bracket of 39.6% at just over $12,000 of income. Single filers don’t hit the same top 39.6% federal income tax bracket until well over $400,000 of income, and that number is even higher for married couples filing joint returns!

So clearly, the question of just who will pay the tax on your IRA when you name a trust as your beneficiary is an important one to answer. So here’s the “short” version of a long, very complicated answer.

Determining whether your trust or the trust beneficiaries will pay the tax on your inherited IRA distributions will depend on how quickly the trust pays out the money it receives from the inherited IRA. If the inherited IRA funds, like required minimum distributions, go into the trust from the inherited IRA, and then out from the trust to the trust beneficiaries, in the same accounting year, then your trust beneficiaries will pay the taxes on those distributions at their own personal rates.

How that actually happens is a bit complicated and is best left to your tax professional to sort out, but if you’re a “got to know” type of person, here’s the deal. Your trust will record the income from the inherited IRA, but it will get a corresponding deduction, known as a distributable net income (DNI) deduction, that will offset the inherited IRA income. Your trust beneficiaries will then get a k-1 from the trust and pick up the inherited IRA income on their own personal return at their own personal rate.

If on the other hand, your trust does not pay out the money it receives from the inherited IRA within the same tax year, then the inherited IRA distribution will be taxed at trust tax rates. If/when those funds are later distributed to your trust beneficiaries, they will receive the distributions free of income tax.

As the comparison in tax brackets indicated above show, it’s almost always more income-tax efficient to have inherited IRA distributions taxed to your trust beneficiaries rather than to your trust itself. On the other hand, chances are that if a trust is being designated as your IRA beneficiary, it’s being done to provide some level of post-death control. Once funds are distributed from your trust to your trust beneficiaries, that post-death control is lost, so it’s important to balance these two interests carefully.

 

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