When we draft estate plans for parents of minor children, those plans typically include a trust fund for their children. This trust fund generally is structured so that a trustee selected by the parents (typically, a trusted family member) will manage those funds for the child until the child is old enough to do so themselves (perhaps at age 25-30).
When the parents’ assets include significant traditional IRAs or other pre-tax retirement accounts that would be included in this type of trust, the parents will also want to consider using a conduit trust to minimize taxes on IRA accounts that would be held by the trust. This article explains that option.
Understanding IRA Accounts
A good place to start on this topic is with some background on IRAs. In this article, for simplicity’s sake we’ll call these pre-tax accounts IRAs. The same rules apply all pre-tax retirement accounts, which include 401k plans, 403(b) plans, and SIMPLE IRAs. Roth IRAs follow different rules and are outside the scope of this article.
IRAs are funded with pre-tax money, meaning that the account owner has never paid any income tax on the funds in the account. Instead, the owner will pay the taxes when the owner withdraws the funds during their retirement.
If the owner of the IRA dies with a balance in the IRA, the deferred income taxes must be paid by the beneficiary who receives the account. Generally speaking, the beneficiary will want to further defer the taxes as much as possible. The longer the taxes are deferred, the more opportunity there is for the account to grow pre-tax, and the more likely beneficiary can pay the taxes at a lower bracket. From the IRA perspective, however, the longer the taxes are deferred, the longer the IRS must wait to collect.
For that reason, the IRS has created a set of rules governing tax deferral in this situation. The rules are different for different types of beneficiaries, with surviving spouses receiving the most generous tax treatment, and trusts (in most cases) receiving the least generous treatment.
What all this means for parents of young children is that they have three options: (1) leave the IRA directly to the child; (2) leave the IRA to a simple trust for the child; and (3) leave the IRA to a more complex conduit trust for the child. Each of these has its own benefits, drawbacks, and rules on how the IRAs will be taxed.
IRAs Left Directly to Minors
The first way to leave IRAs to minor children is to name the child as a direct beneficiary on the IRA account. In that case, IRS regulations state that in years when the child is under age 21, the child must take a small required minimum distribution (RMD) from the account each year and pay taxes on it. When the child reaches age 21, the RMDs stop. The child must then withdraw all funds and pay the taxes on the withdrawals during the 10-year period following their 21st birthday. (In other words, all taxes must be paid no later than the year the child reaches age 31.)
This is an excellent result from a tax perspective, since a 10-year-old child has 21 years of tax deferral and will pay all taxes at an individual (not trust) rate. However, it is not a good option from an estate planning perspective, since a guardian must be appointed through a court process to manage the funds while the child is a minor, and the child will have full control of the funds at age 18. Given a choice between tax savings and an 18-year-old receiving a check for $500K, most parents will choose the former.
IRAs Left to a Simple Trust
The second way to leave IRA funds to a child is to use a simple trust called an accumulation trust. In an accumulation trust, the trustee has full control over the trust funds during the term of the trust (again, typically until the child reaches age 25 or 30).
In an accumulation trust, IRS rules state that taxes on all IRA funds received by the trust must be paid no longer than five years following the death of the IRA owner. However, even receiving five years of tax deferral requires adding complex beneficiary designations to the plan. As a result, in most simple trust plans all taxes will be paid in full within two tax years of the death of the decedent.
The difference between the taxes being deferred and paid by the individual and paid immediately by the trust can be substantial. A young person not earning much income might have a marginal rate of 12% while a minor, perhaps increasing to 22% or 24% in their 20s. Trust tax rates start low but reach the 37% bracket starting with trust income over $13,450 (in 2022). (For comparison purposes, for a single individual the 37% bracket in 2022 started with income in excess of $539,900.)
To understand this, consider a $500K IRA left to a simple trust for a child. Most of the IRA is taxed at 37%, meaning the total federal taxes are in the range of $185K. If the child paid the taxes, they might pay an average rate of 20%, or about $100K in taxes. This obviously is a less than ideal result from a tax perspective.
IRAs Left to a Conduit Trust
The final option is to set up a more complex trust for the child called a conduit trust. A conduit trust allows for a longer payout period, but the trust must include specific rules on how the IRA funds in the trust will be handled.
Under IRS rules, if a conduit trust receives IRA funds while the child is under age 21, the trust document must require the trustee to distribute all RMDs and other IRA withdrawals to the beneficiary when the funds are withdrawn. If this rule is followed, the IRS will ignore the trust and treat the child as the owner of the IRA funds for tax purposes. (Hence the term conduit—the funds flow straight from the IRA to the beneficiary, as through a pipe.)
This is a good result from a tax perspective, since it allows most taxes to be deferred over a much longer period. It also allows all of the taxes to be paid by the beneficiary at the beneficiary’s rate. The downside is that the IRA funds must be fully distributed to the child at age 31, and the trustee must make small RMD payments to the beneficiary each year the beneficiary is under 21.
To understand this, again consider our example of a parent who dies when their child is 10 years old and leaves a $500K IRA. If the IRA is left to a conduit trust, during the time that the child is under 21, an RMD of approximately $7,500/yr must be paid to the beneficiary. All taxes will be paid over the 21-year period ending when the child turns 31. If we assume the child’s marginal rate is 20%, the total tax due will be $100K, the same as if the IRA were paid to the individual.
In this example, the conduit trust has saved $85K in taxes for the child compared to an accumulation trust. In real life, the savings will be more than $85K, since this basic calculation does not account for the value of tax deferral or tax savings on the appreciation in the account.
Quirks and Tradeoffs
At first blush, this all seems to indicate that all young families with significant IRA assets should have a conduit trust plan. But there are some tradeoffs. First, simple trusts are easier to draft for us, which translates into a lower cost plan. Second, they are easier to designate on beneficiary forms for IRAs, life insurance, and so on, which makes finishing the plan easier for our clients. Third, if parents have more children after they complete a conduit trust plan, they must update all beneficiary forms, which is not necessary with an accumulation trust. Finally, all IRA funds in conduit trusts must be distributed to the child at age 31, while some parents prefer a trust that runs until age 35 (we don’t necessarily recommend this, but we have had parents who prefer this later age).
Our Rule of Thumb
We didn’t write these rules, and our clients are looking to us to simplify this choice for them. Having run the numbers with different assumptions and worked with many families in this situation, we can offer a relatively simple way to think about this.
First, we think parents with IRA funds under $75K per child can safely ignore all of this and just do a simple trust. The tax savings in that case are minimal anyway, and a conduit trust adds unnecessary cost and complexity.
Second, for families with IRA funds between $75K and $200K per child, we think either type of trust can be a good option, and the choice is a judgment call for the parents. There will be some tax savings with a conduit trust, but there is also more cost and complexity, particularly if the parents plan on having more children. If the parents want to do everything they can to maximize the funds available to their children in the unlikely event that something happens to them or expect their IRAs to grow substantially, the conduit trust will be the right option, but a simple plan can be just fine too.
For families with over $200K per child in IRA funds, the conduit trust will usually be the right option. At that point the tax savings are substantial, and spending a few extra dollars to create the plan and a little more time to update beneficiary forms properly is worth it. Families with this level of wealth in IRAs tend to be a bit older and done having children, which also means the beneficiary forms will only need to be done once.
Keeping Tax Savings in Perspective
Saving taxes on IRAs is a good thing (what can be more American than saving taxes!) but it is not the most important thing parents of young children can do. The most important thing parents can do is basic estate and trust planning—naming good guardians and setting up a trust fund to avoid an 18-year-old receiving a large check on their birthday. Do that, and you are ahead of 80 percent of the other parents at your kids’ soccer games.
The second most important thing is to invest in a simple term life insurance policy. These policies are generally very affordable and widely available. In the grand scheme of things, having an extra $50-100K in a trust fund by saving taxes on an IRA is unlikely to appreciably change a child’s life if they lose a parent while they are young. Having an extra $500K from a life insurance policy might.
The third most important thing is structuring the plan to include a conduit trust to minimize taxes on the IRAs when applicable. It can be worth doing, but the first two items are much more important.
Have more questions about a conduit trust? We’re sure you do. Contact our office for a free consultation.