When an IRA Trust is a Good Estate Planning Tool
Many of my clients have accumulated substantial assets in an IRA. It is commonly, along with their real estate holdings, one of the largest assets they have in their estate. There are, however, certain issues that arise when the owner of the IRA passes away.
Most notably, the assets in an IRA do not pass through a living trust. They pass to the beneficiaries pursuant to the terms of the beneficiary designation. The beneficiary of an IRA has several options about how to receive the assets in an IRA. They can receive a lump sum payment, receive payments over five years, or decide to continue the IRA in what is called an inherited IRA.
An inherited IRA allows the beneficiary to allow for the funds in the IRA to continue to grow tax free, subject to taking an annual minimum distribution that is pegged to the beneficiary’s expected remaining life expectancy. Requiring the beneficiary to take out a minimum distribution ensures that at least some portion of the money in the IRA will be taxable every year. And pegging the amount of the distribution to the life expectancy of the beneficiary means that the minimum amount withdrawn every year will be much lower than the original owner’s minimum distribution was or would have been.
The owner of an IRA commonly is concerned that the beneficiaries of the IRA will immediately liquidate the funds in the IRA or that the beneficiaries will otherwise make imprudent decisions with respect to the funds or are too young or immature to prudently manage a large sum of money. This is an especially acute problem where the beneficiary has special needs.
This is where an IRA Trust comes into play.
An IRA Trust, which sometimes is also referred to as a designated beneficiary trust, requires its trustee to elect that the IRA continue as an inherited IRA. When minimum distributions are distributed, they’re distributed to the IRA Trust rather than directly to the individual beneficiary. As with other trusts, the trustee then distributes the proceeds to or for the benefit of the beneficiary. Further, the trustee has the discretion to take distributions from the inherited IRA above the minimum distributions, subject to the standard set forth in the IRA Trust. Commonly the standard provides that the trustee distribute funds necessary for the health, education, maintenance and support of the beneficiary. And where the beneficiary has special needs, the instructions given to the trustee will be me more specific and tailored to meet the beneficiary’s special needs.
A well-drafted IRA Trust and beneficiary designation will allow each beneficiary of the IRA Trust to receive minimum distributions that are pegged to their specific age and projected life expectancy. This feature is especially important when there are multiple beneficiaries who are at widely varying ages. For example, if the beneficiaries of the inherited IRA are siblings where the oldest sibling is 15 years older than the youngest sibling, the youngest sibling needs to withdraw a much smaller annual minimum distribution if the distribution is calculated based on his or her age, and not the age of the oldest sibling, or an average of age of all the siblings.
The IRA Trust may also provide some degree of asset protection. It is widely known that IRAs are generally protected against creditors. The U.S, Supreme Court, however, decided in 2014 that an inherited IRA is not a retirement fund that is protected from creditors. See Clark v. Rameker (holding that that, under 11 U. S. C. §522(b)(3)(C), an inherited IRA does not meet the definition of exemptions for “retirement funds.”). By designating the IRA Trust as the beneficiary of the IRA, any creditor claims would have to go through the IRA Trust, which, if properly drafted, would make such claims very difficult to enforce. Typically, the creditor would make a claim, and the trustee would decide whether or to what extent the claims of the creditor conflict with the instructions in the IRA trust. A disagreement between the trustee and the creditor may lead to litigation, but the existence of the IRA Trust provides far more protection from creditors than if the owner of the IRA gave the funds directly to the beneficiary without the IRA Trust.
IRA Trusts are especially effective when the amounts in the IRA are substantial. Some financial advisors recommend IRA Trusts when the value of the IRA exceeds $500,000. And they are always worth considering when the owner of the IRA has concerns about how a beneficiary will handle a lump-sum inheritance.
IRA Trusts are therefore an important and too often overlooked element of a comprehensive estate plan.
On a similar note, remember that if you ever transfer your 401(k) or other ERISA qualified retirement plan and roll it over to an IRA, be sure to roll it into a brand new, separate IRA that is traceable to the original ERISA qualified plan. In McMullen v. Haycock, decided in 2007, a California court ruled that, when you can trace the funds of your own IRA and show that they all came from a protected ERISA qualified retirement plan, then the assets in the IRA are also fully protected from creditors just as if those assets were in a qualified ERISA retirement plan.