The Major Asset You Should Never Place In A Living Trust

Putting your hard-earned lifetime assets in a living trust could be a good way to avoid the headaches that accompany the probate process. A legal probate is not only time-consuming, but it can also be a costly affair for your beneficiaries. A living trust, on the other hand, bypasses the hassles of a probate and also provides privacy (which makes a trust different from a will). However, while certain assets benefit from trust protection, others don't. Your retirement accounts (whether you use a 401k, Roth IRA, or 403b) are assets that should not be placed in a living trust, since transferring them would entail a withdrawal, and you would likely end up paying income tax.

Retirement accounts are investment accounts that are either employer-sponsored, such as the 401k, or are individual accounts, like the traditional or Roth IRA. The purpose of these accounts is to allow the working population to either defer taxes or grow their money tax-free and build long-term financial security. Per Fidelity, around 70 million Americans have a 401k account. Meanwhile, almost 60 million households had IRAs by mid-2024, according to the Investment Company Institute. Considering the significance of these assets for a majority of the population, it is understandable that the owners would want their heirs to access their benefits easily after they pass away. Nonetheless, transferring these assets directly to a living trust is a costly error that you should always avoid.

There are several reasons why placing your retirement accounts in a living trust could be a huge mistake. First, moving your retirement account to your trust is equivalent to liquidating the asset, which is seen as a taxable event by the IRS. If you move the entire account to the trust, you will have to pay income tax on the entire account balance for the year, according to Ferguson Cohen LLP. You'd also end up in a higher tax bracket as a result,   

Next, your retirement account comes with certain tax benefits and protections, which differ depending on the account type. Transferring your account to a trust could annul these benefits. This means that you and your beneficiaries won't be able to enjoy the tax-deferred status of a traditional IRA or the tax-free growth of a Roth IRA account if the funds are moved to a revocable living trust. On top of this, if you're below the age of 59½ years, you will likely have to pay a 10% penalty for early withdrawal from your retirement account. With potential consequences like these, the move is a mistake you should never make before retirement.

Instead of transferring your retirement account to a living trust and paying a large sum in taxes, you can name beneficiaries to the account. Retirement accounts allow you to name your spouse, children, or even a trust as primary and contingent beneficiaries. Appointing beneficiaries to your retirement accounts helps you avoid paying income tax on the transfer and lets you distribute assets according to your terms after your death. Going this route also maintains the tax-advantaged status of your accounts.

But if you can make your spouse or children beneficiaries, does it ever make sense to designate the trust instead? Sometimes it does. For instance, in the event of your and your spouse's death, you may not want to burden young children with a large amount of money all at once. This is where designating a trust to manage your funds for a period of time can be the right way to go. A trust can also holds funds if the beneficiary is still a minor, in which case they cannot inherit the money. 

That said, naming the trust as the beneficiary could also subject the assets to required minimum distribution (RMD) payouts, according to the life expectancy of the oldest beneficiary. This can be a major problem if you have multiple children. Considering the complications involved with appointing beneficiaries to retirement accounts, it's always best to consult a qualified attorney for effective estate planning.