Retirement Plan Trusts
Retirement Plan Inheritance Tax Problem
If you have very large balances in your individual retirement accounts (IRA’s) and employer-sponsored retirement plans such as profit-sharing plans, 401(k) plans, 403(b) plans, 457(b) plans or defined benefit plans there could be huge tax consequences if your heirs decide to take a lump sum distribution of their inheritance. If you leave your plan(s) to your spouse, he/she has the option of rolling the balance over into his/her own IRA. This is not an option for non-spouse beneficiaries such as your children.
Generally, once you turn 70 1/2, you are required by law to take Required Minimum Distributions (RMD’s) from your retirement accounts each year. Since the money you paid into your traditional retirement accounts was tax-exempt and enjoyed tax-deferred growth, all RMD pay-outs would now be taxed at your income tax rates. Upon your death, a non-spouse beneficiary has the option to stretch out RMD’s using his/her own life expectancy or take a lump-sum distribution. If your non-spouse beneficiary is significantly younger than you (such as your child), the RMD’s would be much lower because it would be based on their life expectancy rather than yours. Since the RMD’s are lower, this would leave a higher balance in your IRAs resulting in longer tax-deferred compounding inside the IRA. (see attached table)
So What’s The Problem?
If your children and grandchildren keep the inherited IRA funds in the IRA over their lives and only take the required minimum distributions each year, the amount of money that can be earned, accumulated, and paid to the beneficiaries can be staggering. But what if they don’t? What if you have an IRA worth $400,000 and you leave it to your 25 year old son. He decides to cash it out to buy a new car and drive to Las Vegas to “let it ride”. Besides an immediate tax hit of 35% ($140,000), the future value of that account (hundreds of thousands of dollars) would also be lost.
If you have over $150,000 in all of your retirement plans, an IRA Beneficiary Trust (also known as a Standalone IRA trust, IRA Stretch Trust or IRA Protection Trust) can be a useful method to ensure the stretch-out of RMD’s. The IRS would recognize it as a “designated beneficiary”, ensuring that RMD’s would be stretched-out over the beneficiary’s lifetime. If a trust does not qualify for designated beneficiary status, tax laws require immediate distribution and taxation of the entire balance in the IRA account. Simply naming your revocable living trust will not work because of many technical IRS rules.
The major advantage of an IRA Beneficiary Trust is the ability to minimize tax effects and allow maximum growth. However, even if stretching out RMD’s is not a priority, besides preserving that option, there are several other benefits of setting up this type of trust for your heirs:
provides protection against divorce by keeping assets as separate property
provides protection against creditors and lawsuits
provides protection against undue influence to withdraw funds prematurely
provides protection against the beneficiary’s own poor spending habits
ensures that IRA funds will go to certain beneficiaries instead of leaving it all to your spouse who may pass it on to a future spouse or leave it to children from another marriage
may prevent disqualification from needs-based government benefits, such as disability income or Medicaid
Types of IRA Beneficiary Trusts
It is important to note that not all trusts which qualify for “designated beneficiary” status are created equal. There a several types to choose from depending on how simple or complicated your needs are:
A “conduit trust” is the least complicated trust because it merely serves as a pass-through vehicle for the RMD’s. The trustee must withdraw at least the RMD each year from the retirement plan and immediately distribute the funds to the beneficiary. An advantage of this is the beneficiary does not have to remember to take out the RMD each year, the trustee does. This avoids the potential risk of a 50% excise tax on any distributions not taken.
Although this trust allows the beneficiary to “stretch-out” the benefits over their own lifetime, it does not allow accumulation of the funds in the trust. Because this feature is not allowed, many benefits such as creditor protection and spendthrift protection are lost. This type of trust is useful for beneficiaries who do not need asset protection and clients who wish to name both individual and charitable beneficiaries. If a revocable living trust is named as beneficiary of the retirement plan and the trust has both individual and charitable beneficiaries, it would not qualify as a “designated beneficiary” without conduit trust provisions (because a charity is not an individual and does not have a “life expectancy”). This trust allows the primary beneficiary’s life expectancy to be used to calculate RMD’s and any successor beneficiaries (in this case, charities) to exist without detriment to the “designated beneficiary” status.
An “accumulation trust” allows a trustee to accumulate income in the trust after receiving it from the IRA instead of distributing it immediately. Because of this discretionary power, the beneficiary is shielded from creditors, lawsuit judgments or just poor spending habits. This type of trust makes qualifying for “designated beneficiary” status much more difficult because all beneficiaries, both primary and residuary, must be taken into account when calculating RMD’s. If there’s a chance that non-individual beneficiaries or older beneficiaries may take, the trust risks disqualification or loss of income tax benefits of the stretch-out. Usually, an accumulation trust has an income beneficiary for life and if all trust assets are not distributed, successor beneficiaries step in to receive benefits. Under the RMD rules, the age of the oldest beneficiary must be taken into account in order to calculate the RMD. If you name your child as primary beneficiary and have any residuary beneficiaries who are much older, much of the “stretch-out” benefits are lost because the lower life expectancy will make the RMD’s much higher.
Also, if the beneficiary is given too great of a “power of appointment” over the trust or there is a remote chance that the trust contains a charitable or un-identifiable beneficiary, the trust will not qualify as a “see-through” trust and the entire balance of the trust will have to be withdrawn within 5 years.
A “toggle trust”, which is a hybrid of a conduit trust and accumulation trust, is a more flexible solution because it allows the choice of which trust to use to be made at the last minute. This trust allows a “Trust Protector” to make that decision based on the needs of the beneficiaries at the time of the IRA owner’s death. So if the beneficiaries are responsible adults with no creditor problems, the Trust Protector will choose the conduit trust for that beneficiary. If not, the Trust Protector may choose the accumulation trust option for maximum creditor protection. The beauty of this type of trust is that it can be drafted to create a sub-trust for each child and the decision to use either a conduit trust or accumulation trust can be individually executed for each trust. However, the decision can only be made once, and it must be made within 9 months of the IRA beneficiaries death.
Proviso Law Group provides attorney services in the areas of Business Law, Estate Planning, Wills, Trusts, Probate and Trust Administration. We are located in Manhattan Beach, California near Hermosa Beach, Redondo Beach, El Segundo, Torrance, Hawthorne, Culver City, Los Angeles, Orange County, Gardena, Lawndale, South Bay.