Retirement Account Trusts

By Thomas D. Begley, Jr. 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 LR.A 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 bene11t 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 SSL, 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 protect.or 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.

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.2
  • The trust is irrevocable or will, by its terms, become irrevocable upon death of the IRA owner.3
  • The beneficiaries of the trust are also beneficiaries of the IRA and they are identifiable.-4
  • The trust documentation must be provided to the Plan Administrator. 5

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.

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. Rmll(:kcr. 134 S. Ct. 2242 (2016).
  • 2 Treas. Reg.§ J .40l(a)(9)-4. A-5(b)(2).
  • 3 Treas. Reg.§ I A0l(a)(9)-4. A-5(b)(2).
  • 4 Treas. Reg.§ J .40J(a)(9)-4. A-5(b)(3).
  • 5 Treas. Reg.§ J .40J(a)(9)-4. A-5(b)(3).
  • ‘6 P.L.R. 20053 7044: Harvey B. Wallace. II. Retirement Benefits Planning Update. Probate and Property. American Bar Association (May-June 2006): Wealth Preservation Update. Morris Law Group (J\far. 2007). www.law-morris.com.