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RETIREMENT PLAN TRUSTS – Begley Report

by: Begley Law Group

By:  Thomas D. Begley, Jr., Esquire, CELA

INTRODUCTION

The United States Supreme Court in a 9-0 unanimous ruling held that an inherited IRA is not protected in bankruptcy under federal law.[1]  Heidi Heffron-Clark inherited an IRA from her mother in 2001 and filed for bankruptcy nine years later.  The court held that the IRA was not shielded from her creditors, because the funds were not earmarked exclusively for retirement.  The Supreme Court indicated that creditor protection does not apply to inherited IRAs for a number of reasons:

  • Beneficiaries cannot add money to an inherited IRA like IRA owners can to their accounts;
  • Beneficiaries of inherited IRAs must generally begin to make Required Minimum Distributions (RMDs) in the year after they inherit the accounts regardless of how far away they are from retirement;
  • Beneficiaries can take total distributions of their inherited accounts at any time and use the funds for any purpose without a penalty.  IRA owners must generally wait until age 59-1/2 before they can take penalty-free distributions.

The court held that inherited IRAs do not contain funds dedicated exclusively for use by individuals during retirement.  As a result, the favorable bankruptcy protection afforded to retirement funds under the Federal Bankruptcy Code does not apply.

The court did not rule on whether a Spousal Rollover IRA is protected from creditors.  Like other IRA owners, if the money is rolled into their own IRA, they may have to pay a 10% early-withdrawal penalty if money is taken before age 59-1/2.  If the money is not rolled over into the Spousal Rollover account, then it would appear that the assets will not be protected in bankruptcy.

A way to safeguard IRA and other retirement account assets from creditors is to name a trust as beneficiary of the retirement account.

TRUST AS BENEFICIARY

The best practice is to name a standalone retirement trust as beneficiary for IRAs and other tax-deferred retirement accounts.  Naming a beneficiary outright has several disadvantages:

  • The money could be available to the beneficiary’s creditors, spouse, or ex-spouse.
  • A young adult or even older beneficiary may be tempted to take out larger distributions or even cash out the entire account.
  • If the beneficiary is a spouse, the spouse would be able to name new beneficiaries.
  • If the beneficiary has special needs, the IRA could cause a loss of government benefits.
  • If the beneficiary becomes incapacitated, a guardian would have to be appointed for the beneficiary.
  • If the beneficiary is a minor, distributions will need to be paid to a guardian; if no guardian has been appointed, one will have to be appointed by a court.

♦ IRA Trust Advantages

  • Creditors. Naming a trust as beneficiary provides more control. A trust can be drafted to protect the assets from a beneficiary’s creditors.
  • Squandering. If retirement account monies are left directly to heirs, the funds may be squandered by the heirs defeating any benefit of the long-term tax deferral.
  • Divorce. If the heir is divorced, the retirement account funds may be subject to claims of the non-heir spouse.
  • Benefit of Beneficiary. If a parent names a child as beneficiary of the parent’s retirement account and subsequently the child dies, that child may name the child’s spouse as beneficiary and the child’s spouse may remarry naming the new spouse as beneficiary.  The retirement account would no longer remain in the bloodline.
  • Special Needs. If the beneficiary has special needs, the trust can be drafted to protect the beneficiary’s entitlement to government programs such as SSI, Medicaid or any other means-tested public benefits.  
  • Incapacity. Finally, no guardianship proceeding is needed upon the beneficiary’s incapacity.  

♦ Separate Trust. A separate trust designed specifically to control the retirement account is recommended.  It is best that the trust not be part of a revocable living trust or any other trust.  A “standalone retirement trust” is preferred.

♦ Professional Trustee. When an IRA is paid to a standalone retirement trust or any other trust, it is important to consider a professional trustee.  The rules regarding inherited retirement accounts are complex and family member trustees are often unfamiliar with them.  This could cause a loss of important tax benefits.  Most family members do not understand the rules regarding required minimum distributions (RMDs), conduit trusts or accumulation trusts.  This could cause loss of important tax benefits.  If the retirement account is $500,000 or more, it usually makes more sense to name a professional trustee.  The professional trustee understands the tax rules and has investment expertise.

A family member could be named as trust protector.  A trust protector has the right to monitor the performance of the professional trustee and to remove and replace the trustee with another professional trustee, if the trust protector is not satisfied with the performance of the trustee.

♦ Income Tax Rates. To the extent that distributions are retained by the trust, the separate rate schedule for trusts and estates is applied.[2]  These rates are significantly higher than the tax rates for individuals.

If the IRA distribution is distributed by the trust to trust beneficiaries, the trust receives an income tax deduction.  To the extent that the trust beneficiary receives distributions, they are taxed at the beneficiary’s rate rather than the trust rate.[3]  

♦ Trust as Designated Beneficiary. A trust may qualify as a designated beneficiary.  This is important in order to preserve the ability to stretch the required payments from the IRA out over the lifetime of the beneficiary.  In order for a trust to qualify, there is a four-pronged test:

  • The trust must be valid under state law or would be but for the fact that there is no corpus.[4]
  • The trust is irrevocable or will, by its terms, become irrevocable upon death of the IRA owner.[5]
  • The beneficiaries of the trust are also beneficiaries of the IRA and they are identifiable.[6]
  • The trust documentation must be provided to the Plan Administrator.[7]

♦ Trust Beneficiaries as Designated Beneficiaries. If a trust is the beneficiary of an IRA, separate account treatment for benefits is prohibited even if the trust terminates immediately upon the participant’s death and is divided into separate shares or sub trusts.[8]  If separate account treatment is an important goal, the separate accounts must be created in the beneficiary designation form and the separate accounts must be left directly to the different beneficiaries.  If the trust is designated as beneficiary, the required distributions will be based on the life expectancy of the oldest beneficiary of the trust.

In order for benefits payable to a trust to be treated as separate accounts, there are two requirements:

  1. There must be actual separate trusts that are created at or before Participant’s death (benefits payable to a single trust cannot be treated as “separate accounts” under any circumstance), and
  2. Benefits must be divided, at the Plan level, into separate accounts payable to those separate trusts by the December 31 deadline.  This means that the division of the IRA into separate accounts must also be made in the beneficiary designation form rather than simply naming a trust that is divided into sub-trusts.[9]

An IRA trust can be drafted as either a conduit trust or an accumulation trust.

♦ Conduit Trust. Under a conduit trust the trustee must immediately distribute any IRA or plan benefits received by the trust (whether as a required minimum distribution or otherwise) to the trust beneficiaries. RMD payments are determined by the single life expectancy of the trust’s conduit beneficiary, but trust distributions may be sprayed to other beneficiaries younger than the conduit beneficiary as well.[10]

The trust distributions will be measured by the life expectancy of the initial beneficiary, so if that beneficiary dies any older beneficiaries will still receive the payout based on the life of the initial beneficiary. Following the conduit beneficiary’s death, the trustee may accumulate plan benefits.

Pros:    All income is distributed to beneficiary and tax paid at beneficiary’s rates.

Cons:   The amount distributed as RMD is subject to beneficiary’s creditors.

♦ Accumulation Trust. A trust named as a beneficiary of an IRA can be designed as an accumulation trust. Under an accumulation trust the trustee can retain IRA distributions rather than pay them out as received. The problem is that where an accumulation trust is used, the shortest life expectancy of all of the possible beneficiaries is used to determine RMD. An accumulation trust should be used when the beneficiary is a special needs trust.

Pros:    IRA protected from beneficiary’s creditors.

Cons:   May pay tax at trust’s rate if not distributed to beneficiaries.

In short, the benefit of the lower tax rate on distributions to the beneficiary must be weighed against the disadvantage of the loss of creditor protection on those distributions.  To a certain extent, this will vary from beneficiary to beneficiary.  If the child is a spendthrift or likely to be subject to claims of creditors, then perhaps an accumulation trust should be considered.  Otherwise, it probably makes more sense to make the distribution and pay the lower taxes. 

♦ Trust Protector. Under an IRA trust a trust protector can be appointed. The trust protector must be unrelated by blood to the trust beneficiary but may have a personal relationship, such as financial advisor, attorney, CPA, or friend. The trust protector can change a conduit trust to an accumulation trust.   This gives the trustee the discretion to accumulate funds.[11]

 Spousal Planning. Planning for retirement assets for a surviving spouse is greatly assisted by portability.[12] Under this provision, the first spouse to die can leave his or her unused federal estate tax exemption to the surviving spouse. This is known as the “deceased spousal unused exclusion amount” or “DSUEA.”  There are three advantages to portability:

  • Estate Tax Savings.  There can be considerable estate tax savings in situations where the poorer spouse dies first.
  • Outright Gifts.  The new law permits outright gifts to a surviving spouse while avoiding payment of taxes without utilization of a credit shelter trust.
  • Step Up.  Assets, other than retirement plans, included in the estate of the first spouse to die and then again in the estate of the second spouse to die receive a step up in basis on each death.

While credit shelter trusts offer a number of advantages for non-retirement assets, it is usually a disaster for retirement assets. This is for several reasons:

  • Shrinkage. The amount of assets in the retirement plan of the first spouse to die that are left to a credit shelter trust may have declined significantly between the date of death of the first spouse and the surviving spouse.  This is because of required minimum distributions and the tax on those distributions.  The tax will be larger, because the distributions made to the trust will be required to be larger than if the retirement plan had been rolled over into a spousal IRA.
  • Conduit Trust. If the trust was a conduit trust, then all unspent after-tax proceeds will be included in the surviving spouse’s taxable estate, which contravenes the purpose of the credit shelter trust.  Prior to portability, there was a tradeoff between the positive income tax outcome of a spousal rollover and the negative estate tax outcome.  Portability solves that problem for most married couples.

CONCLUSION

As Americans rely less on the availability of work-related pensions for their retirement, more of their wealth is found in the tax-deferred retirement accounts that they have funded over the years. As the estate tax exemption grows and becomes less of a concern for most Americans, it becomes increasingly important to understand and plan for minimization of the income taxes that are ultimately payable with respect to these tax-deferred accounts while at the same time maximizing family wealth transfer goals. The standalone IRA Trust is sufficiently flexible that it allows most people to balance their tax and family goals well, offering opportunities for creditor and other beneficiary protections, protection for special needs beneficiaries and spousal planning as well as the possibility of professional management to assist in investing and minimizing income taxes for the beneficiaries.


[1] Clark v. Rameker, 134 S. Ct. 2242 (2016).

[2] I.R.C. § 1(e).

[3] I.R.C. § 678; I.R.C. § 672(f).

[4] Treas. Reg. § 1.401(a)(9)-4, A-5(b)(2).

[5] Treas. Reg. § 1.401(a)(9)-4, A-5(b)(2).

[6] Treas. Reg. § 1.401(a)(9)-4, A-5(b)(3).

[7] Treas. Reg. § 1.401(a)(9)-4, A-5(b)(4).

[8] WPLR 2003-17041, 2003-17043 and 2003-17044.

[9] P.L.R. 2004-32027 and 2004-32029.

[10] P.L.R. 200227059.

[11] P.L.R. 200537044; Harvey B. Wallace, II, Retirement Benefits Planning Update, Probate and Property, American Bar Association (May-June 2006); Wealth Preservation Update, Morris Law Group (Mar. 2007), www.law-morris.com.

[12] I.R.C. § 2001(b)(1).