If you have reservations about giving your heirs unfettered access to an inherited individual retirement account, an IRA trust could give you peace of mind.
While such trusts once were rarely used, a 2014 ruling from the nation's highest court has spurred more financial advisors to recommend to some clients that they name an IRA trust as the beneficiary of their nest egg instead of naming particular individuals.
"I think anyone with a sizable IRA should use one if they're concerned about their heir's ability to handle the money or if the heir has debt problems," said Leon LaBrecque, CEO and managing partner at LJPR Financial Advisors.
In simple terms, an IRA trust prevents an heir from receiving money outright from the IRA upon the account owner's death.
Without a trust, heirs can treat an inherited IRA as a piggy bank to whatever degree they want, as long as they take required minimum distributions as mandated by the Internal Revenue Service.
Unfortunately, creditors also can get a crack at the funds, thanks to the Supreme Court's decision in Clark v. Rameker. Before that 2014 ruling, inherited IRAs were treated as protected assets in bankruptcy. Now they are fair game. (A handful of states have laws that specifically protect inherited IRAs from creditors, but most do not.)
"I use the IRA trust to protect the kids from the money and the money from the kids," said LeBrecque, who is both a certified financial planner and an attorney.
It's important to note that although workplace retirement plans such as 401(k) plans operate under different laws from IRAs — and rules governing the transfer of 401(k) funds upon an account owner's death differ among plans — an IRA trust can be the beneficiary on both types of accounts, including their Roth counterparts.
But before even considering an IRA trust, it's key to remember that the beneficiaries named on financial accounts — IRAs and the like, insurance policies, brokerage accounts, etc. — supersede anything dictated in your will. In other words, if your will calls for your IRA to go to your new wife but the listed beneficiary on the account is your ex-wife, guess who unfortunately gets the money.
CFP Jason Lina, lead advisor at Resource Planning Group, said that two basic considerations help determine whether an IRA trust makes sense for his clients. First is account size.
"When you get to a half-million dollars and above, it's about asset protection," Lina said, offering lawsuits, divorce and bankruptcy as examples of potential threats to inherited IRAs.
When an IRA trust is named as the beneficiary, the trust becomes the owner of the account's assets. And although the trust in turn has the heir as its beneficiary, that ownership differentiation is key.
Basically, when the IRA trust is set up, a trustee is named. That person — often a professional — is charged with distributing assets from the IRA to the beneficiary (the heir). But having the trust as a protective layer between the assets and the heir means that as long as the trust documents are properly written, the heir's control of the money, and therefore ownership, is nonexistent.
The second consideration, Lina said, is the particular life situations or personalities of the heirs.
For example, he said, if a minor is the beneficiary of an inherited IRA, once the child reaches 18 or 21 (depending on the state), a young adult with no money-management experience or a penchant for reckless spending could suddenly be single-handedly in charge of massive amounts of money.
"They could liquidate an entire IRA," Lina said. "That has negative tax implications and negative long-term financial effects."
Under federal law, even if the heir's intentions were to move the money to, say, a brokerage account soon after withdrawing the money, the IRS has no mercy with inherited IRAs and will treat the withdrawal as a taxable distribution. Additionally, unwise spending can rob heirs of a secure future.
Sometimes heirs are experienced adults but face other challenges that cause parents to limit their access to IRA money.
CFP Christopher Lamia became aware of such a case when an older married couple, clients of his, confided in him that their adult daughter was struggling with substance abuse.
Lamia realized that, from a financial planning standpoint, the information called for a change to their estate plan.
"It was a heartbreaking story, but I realized it meant it could become a really, really bad situation because the daughter could inherit an awful lot of money and blow it all at once," said Lamia, president of Lamia Financial Group.
The clients, accompanied by Lamia, met with an attorney who created an IRA trust to ensure that the daughter can be protected from her own current proclivity for poor judgment. Additionally, the trust's documents direct the trustee to ensure that any trust money given to the daughter will be applied in a positive way to help her during recovery.
Two basic types of IRA trusts exist. The first is called a conduit trust, which involves distributions basically bouncing from the IRA to the trust to the beneficiary, and the money getting taxed at the beneficiary's rate.
The second is called an accumulation trust, which receives distributions from the IRA but holds on to the money for distribution to the beneficiary at a later date. In that case, the distribution is taxed at the trust's income-tax rate, which tops out at 39.6 percent.
There also are costs involved in creating and maintaining a trust, which needs to be weighed against the benefits of protecting the assets, advisors say.
"Not everyone should have an IRA trust," said LaBrecque of LJPR. "But if you have a large IRA and have concerns, look into it."
— By Sarah O'Brien, special to CNBC.com
More From CNBC