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A recent Supreme Court decision has rekindled the debate about whether it is better to inherit IRA assets in a trust than to receive them outright. In the wake of that case, which I wrote about here, some advisers are encouraging clients to set up new trusts for the purpose. These trusts generate fees for: the lawyers who write the documents; professional trustees who run the trust after someone passes away; and investment advisers who manage the trust assets. They can also make estate planning with IRAs much more complicated. Therefore, it's important to understand what you – and your heirs – would be getting into.
First some IRA basics. Money in IRA accounts (or employer sponsored retirement plans, such as 401(k)s and 403(b)s) will not normally be covered by a will. Instead, an IRA inheritance is given out according to beneficiary designation forms that you fill out when you open the accounts or later amend. So if you want your IRA to be held by a trust after you pass away, you must name that trust as the beneficiary of your IRA.
The Court’s June decision in Clark v. Rameker gives advisors an excuse to bring up the strategy. In a nutshell, the Court found that Heidi Heffron-Clark, who inherited an IRA from her mother in 2001 and filed for bankruptcy nine years later, could not shield the account from her creditors. (For the court’s reasoning, see my post, “Supreme Court Finds Inherited IRAs Not Protected In Bankruptcy.”)
Reacting to the decision, Forbes contributor Jay Adkisson, an asset protection lawyer, predicted that it “will probably cause a mini-boom in estate planning, and cause folks with anything like significant amounts in their IRAs to create trusts for their heirs instead of on death leaving those heirs the IRA accounts outright.”
But Clark is actually a case that will affect very few people. After all, how many folks with unspent inherited IRAs will go bankrupt? So before you become part of the “mini-boom in estate planning,” ponder the pros, cons and pitfalls of making a trust the beneficiary of your IRA. Here are issues to consider.
What other purposes does the trust serve? Even if you don’t expect an heir to file for bankruptcy, a trust can protect the IRA assets from other creditors – the most common one is a divorcing spouse. You might also consider a trust if you want to control the cash flow to heirs you regard as spendthrifts.
If the intended beneficiaries are minors, you can’t leave property to them outright, so you have a choice between naming a custodian for the child who will inherit the IRA, or creating a trust for the benefit of minors, that will in turn be a beneficiary of the IRA. With a trust you can limit their access to the money, which would otherwise come under their control when they reach the age of majority (18 in most states). Depending on the size of the IRA and how much money you want them to have at a young age, this is an option to consider.
How does a trust affect the stretch-out? This is a reference to a financial strategy, available to an IRA owner or beneficiary, which extends the tax advantages of an IRA. Generally, IRA inheritors must withdraw a minimum amount each year, starting on Dec. 31 of the year after they inherit the account. The rules for spouses are more lenient, as explained here.
If they choose to, heirs can stretch out these minimum required distributions over their own expected life spans. Stretching out the IRA in this way gives the funds extra years and potentially decades of income-tax-deferred growth in a traditional IRA or tax-free growth in a Roth IRA.
When the trust meets certain requirements set by federal regulations (more about that later), the IRS will “look through” the trust and treat its beneficiary as if he or she were directly named the IRA’s beneficiary. This enables the trust to take advantage favorable minimum-distribution rules that apply to individual beneficiaries. In trusts with multiple beneficiaries, the required yearly withdrawal will be based on the life expectancy, under IRS tables, of the oldest beneficiary.
If the trust doesn’t qualify as a look-through, or see-through, trust, it will still get the money. However, it may be required to take the payout within as little as five years if the account owner hadn’t reached the required beginning date for taking IRA withdrawals (April 1 of the year after the account owner reaches 70 ½) before he or she died.
A different payout period applies if the owner died on or after this date. In that case, a trust without designated-beneficiary status can calculate withdrawals according to the account owner’s remaining life expectancy, as if he or she were alive. This would probably mean a more rapid payout than if the trust could use the life expectancy of its oldest beneficiary to calculate withdrawals.
To qualify for look-through treatment, the trust must meet four criteria outlined in 26 Code of Federal Regulations Section Sec. 1.401(a)(9)-4. The requirement that has proved most troublesome is one dictating that beneficiaries be identifiable as of the date of the IRA owner’s death. The goal is to know who is the oldest beneficiary so withdrawals can be based on his or her life expectancy. As a practical matter, though, if it’s possible that the oldest beneficiary might not be identifiable in certain situations, the trust could flunk the test and the IRA would be treated as if there were no beneficiary.
For example, powers of appointment, a popular device that permits beneficiaries to decide who will receive certain trust property, could cause a trust to violate the rule, because older beneficiaries could conceivably be added to the trust. For the same reason, “spray” powers, authorizing the trustees to give out principal among a class of beneficiaries when appropriate, could also cause a trust to flunk this test if the trust permits older beneficiaries to be added to the trust later.
Equally problematic is the fact that the regulations define an identifiable beneficiary as a human. Trusts with a beneficiary that, however remote, is not a person, won’t qualify for look-through treatment. That’s true whether the beneficiary is a charity or the estate of the IRA owner. Many trusts name a charity or the estate as the contingent beneficiary that will receive the funds if all the human beneficiaries have died.
Should the trust just name one beneficiary, or more than one? A trust with just one beneficiary could use that person’s life expectancy in figuring withdrawals. In a trust with multiple beneficiaries, the trust would take withdrawals based on the life expectancy of the oldest beneficiary. When naming multiple beneficiaries, though, there is a risk of the stretch-out being significantly shorter than the IRA owner would have liked. This could happen if there’s one beneficiary – even a contingent beneficiary – who is significantly older than the others.
Is there a downside of naming a trust for your spouse as the IRA beneficiary? Yes, says Ed Morrow, a senior wealth specialist at Key Private Bank in Dayton, OH, since you lose the major income tax benefits of leaving an IRA to a spouse outright. Normally, the spouse (assume it’s the wife) can roll over the IRA into his or her own and defer distributions until reaching age 70 ½. Another advantage of doing the rollover is that, when calculating her required minimum distributions, she can use the IRS uniform life expectancy table that applies to IRA owners, rather than the so-called “single life expectancy” table that applies to inheritors; using this table results in smaller required distributions each year. Rolling the IRA over into her own also entitles her to convert it to a Roth, which can add tremendous value to the IRA. This option is not available to nonspouse inheritors.
Do you need a special trust for the purpose? People who have set up other trusts in their estate plan, such as a bypass trust, dynasty trust, or living trust, might be tempted to simply name those trusts as IRA beneficiaries, rather than creating a new one for the purpose. Pitfalls abound. These garden-variety trusts may contain boilerplate language that’s fine in other contexts but detrimental when an IRA is concerned. (See the heading above, “How does a trust affect the stretch-out?”)
The same goes for the qualified terminable interest property trust, or QTIP. This trust is designed to qualify for the unlimited marital deduction when the first spouse dies. It must require the trustee to pay all income to the surviving spouse for life (the trustee can also make distributions of principal) and not permit distributions to anyone other than the spouse while he or she is alive. After that, the assets can go to whomever you specify in the trust.
As explained above, the main disadvantage of naming a trust for the spouse as an IRA beneficiary is that spouses lose the generous treatment they get under the Internal Revenue Code when they inherit IRAs directly. Another drawback, assuming the children are the ultimate beneficiaries of the trust, is that the trust cannot use their life expectancies in figuring the minimum distribution that it must withdraw from the IRA each year. Instead, this calculation must be based on the age of the oldest beneficiary, who will generally be the spouse.
What’s the difference between an accumulation trust and a conduit trust? With a conduit trust, as its name suggests, the IRA distribution simply passes through the trust and gets paid out immediately to the beneficiary. In contrast, an “accumulation” trust permits assets to build up in the trust over time rather than requiring them to be distributed immediately. Each has its uses.
A conduit trust might appeal to doting grandparents who want the grandchildren to have some extra money without ever being able to completely cash out the IRA. Although the trustee may have discretion to distribute more than the minimum, the trust largely forces the grandchildren to use the life expectancy payout.
Although some advisers are reluctant to set up conduit trusts for a minor who doesn’t really need the money, the payouts, based on the kid’s life expectancy, will usually be so small that it doesn’t make much difference, especially if the funds are going to a custodian anyway.
Also note that conduit trusts are generally not appropriate if you want to provide for a family member with special needs. The purpose of a trust in this case is to prevent these individuals from owning assets directly because it could disqualify them for public assistance.
Bruce Steiner, a lawyer with Kleinberg, Kaplan, Wolff & Cohen in New York, says he doesn’t like conduit trusts because all the money is forced out of the trust, making it vulnerable to claims of “predators and creditors.” But from an income tax perspective these trusts do have one advantage, he notes: Since the IRA distribution gets paid out immediately, the beneficiary, rather than the trust, pays tax on the withdrawal. In contrast, with an accumulation trust, the trust pays the tax. And trusts reach the top tax bracket when their earnings exceed $12,150; individual taxpayers, on the other hand, don’t reach that rate until they have income over $406,750 ($457,600 for married couples filing jointly).
In effect, then, there is an income tax cost for the asset protection you achieve by making a trust the beneficiary of an IRA . But you do have the flexibility of deciding, on a year-by-year basis, whether to keep the required minimum distribution for that year in the trust, or pay it out to beneficiaries. Another way around the problem is to convert the IRA to a Roth while you are alive. Since beneficiaries don’t have to pay income tax on distributions from a Roth IRA, this eliminates the potential tax problems.
What are the other costs associated with such a trust? Asset protection doesn’t usually come cheap, especially not in this context. Most consumers – and many professionals – don’t understand the subtleties of this area of the law. If you want to make a trust the beneficiary of your IRA, consult an advisor who is fluent in both the language of trusts and the intricacies of using them to hold IRA assets. Ask this professional to examine trusts already in place (or one created by your will or living trust) to see whether it meets the federal criteria, or set up a new one specifically designed to inherit the IRA. For the former, you might be able to pay by the hour; for the latter, it will cost you between $1,500 and $5,000 to create the new document, depending on the size and location of the law firm.
When you pass along IRA assets this way, you also pass along additional costs to your heirs. These include the fees of professional trustees and investment managers, if you choose to leave them in charge. Plus it will cost $500 to $1,500 yearly to have the trust tax return prepared. It’s hard to justify all these expenses unless the value of the IRA assets is at least $500,000. Many corporate trustees (if that’s what you contemplate) won’t even take on a trust unless it’s worth at least that much.
Whether you decide to use an existing trust, or create a standalone trust for the purpose, make sure you name it on the beneficiary-designation form. Otherwise, it will not be considered the beneficiary of your IRA. Forgetting this crucial last step is a common oversight. (For more about IRA oversights, see "When Bad Things Happen To Good People With IRAs.")
Archive of Forbes Articles By Deborah Jacobs
Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide, now available in the third edition.
