IRA Trusts as a Tool for Protecting Beneficiaries from Themselves

We all have clients who recognize their children's limitations and want to protect those children against their own shortcomings. These shortcomings may take the form of a drug or alcohol dependency, a gambling problem, or a spending problem. I once counseled a client who had two children who spent more than they made, often requiring my client to bail them out of financial trouble, as to how she could protect her children against themselves after she passed away. In addition, she wanted a portion of her estate held for the benefit of her grandson.

While this client had a number of assets, she had a particularly large IRA account. Because of her goals and the existence of this IRA account, I suggested the client set up an "IRA Trust".  An IRA Trust is a stand-alone trust, separate from a Living Trust, which acts as the beneficiary of IRAs or other retirement benefits. The provisions of an IRA Trust satisfy all of the regulations related to the distribution of IRAs and retirement benefits, allowing the beneficiaries to take advantage of stretching distributions of their inherited benefits over their lifetime, delaying taxation. Except for the required minimum distributions (RMDs), the IRA assets can continue to grow tax-deferred and protect beneficiaries against their own bad habits of misspending and mismanagement of money.

The IRA beneficiary designation specified that at the client’s death three separate sub-trusts would each be the beneficiary of one-third (1/3) of the IRA. This specific allocation allowed the Trustee to use each beneficiary's separate life expectancy to calculate the required minimum distributions, rather than the life expectancy of the oldest beneficiary of the trust. There was eight years difference in the daughters' ages, which allowed the younger daughter to take a smaller required distribution every year. This strategy was particularly beneficial to the grandson, who was only 13 at the time his grandmother passed away. This allowed the trustee to calculate his required distributions using 70 additional years of life expectancy, resulting in very small taxable distributions, thereby deferring tax.

We also designed the IRA Trust with different sub-trust provisions for each beneficiary. One daughter only would receive the greater of income earned by her sub-trust or the required minimum distribution. This restriction was always in force and that daughter could not accelerate any distributions. The second daughter, who was somewhat more responsible with her finances, also received the greater of income earned by her sub-trust or the required minimum distribution, but after three years was entitled to take up to 10% of the value of her sub-trust each year if she chose to request it. Finally, the share for the grandson was set up to provide for income and principal as needed, but if not used, remained in the trust for later use, such as education, purchasing a home, or starting a business.

Our client did express one final concern that her daughters would be unhappy with the limitations placed on them, but was comforted by the fact that by the time the children were aware of the restrictions she would not be in a position of having to listen to their complaints.

 Our client was somewhat less restrictive with distributions to her daughters from her Living Trust because she knew that even if the daughters spent those assets quickly, the terms of the IRA Trust still protected her daughters and grandson from completely running out of assets. The client was also able to make charitable distributions from her Living Trust without worrying that charitable beneficiaries would negate the "stretch out" of IRA distributions over the other beneficiaries' lifetime.

Clients are often reluctant to place restrictions on their children even if it is for their own good. It is often the difficult obligation of advisors to begin the discussion about ways to protect the beneficiaries from their own shortcomings and let the client eventually find comfort with specific strategies for protecting them. As with all estate planning strategies, careful consideration should be given not only to the relevant tax provisions, but also to understanding a client's true desires. 

Alan Ferrara and Matt Ferrara