Ensuring that Inherited IRAs Benefit their Beneficiaries.

As we have discussed in previous posts, there are many forms of trusts used in the estate planning process. While many planning strategies have greater benefit to individuals with more complex financial situations today’s post addresses one form of stand-alone trust which can be very beneficial to a wide variety of clients.

An “IRA Trust,” is a stand-alone trust, separate from a Living Trust that acts as the beneficiary of IRAs or retirement benefits. The provisions of an IRA Trust satisfy all of the regulations related to the distribution of IRAs and retirement benefits, allowing clients to create a situation where their beneficiaries can take advantage of their inherited benefits over their lifetime and enjoy extra protection from creditors and other potential problems.

The beneficiaries of the IRA Trust can be the same as those of the client's Living Trust. However, the distribution terms of an IRA Trust terms are often different from the Living Trust and frequently more restrictive in order to ensure that no matter what happens to the Living Trust assets, the IRA Trust assets will be available to help support children, grandchildren and other beneficiaries. Alternately, clients can use an IRA Trust to provide for a different group of beneficiaries than their Living Trust beneficiaries. For example, the Living Trust may benefit a second spouse while the IRA Trust has children and grandchildren as beneficiaries. Finally, an IRA Trust can help beneficiaries in more difficult or complex situations, such as beneficiaries who for any number of reasons are not prepared to handle large sums of money. In these situations, the IRA Trust Trustee can provide professional management of Trust assets, allowing the IRA assets to grow tax deferred, except for required distributions, and ensure that the beneficiaries do not waste those distributions.

Just like a Living Trust, the distribution provisions of an IRA Trust dictate how the beneficiaries receive distributions. One design option for an IRA Trust is the "conduit trust", under which the trustee has no power to accumulate plan distributions in the trust and must allocate any distribution received from the IRA or retirement plan to the beneficiaries. The conduit trust lessens the trustee’s ability to control the income but still allows control over principal distributions as necessary.

Alternatively, when it is desirable or necessary to impose greater control upon the dispersal of the Required Minimum Distributions (RMDs), an "accumulation trust" allows the trustee to hold the RMDs in trust for the beneficiary’s benefit. For example, if the beneficiary of the IRA Trust is special needs child, it is important to limit income distributions in order to avoid adversely affecting the beneficiary's right to receive state or federal benefits. It is important to remember however when using an accumulation trust that the federal government taxes income received from the IRA but not distributed to beneficiaries according to the potentially higher trust income tax rates.

Whether a client wants to provide for multiple generations, ensure a lifetime of income for a beneficiary in a difficult personal or financial situation, or simply ensure that different groups of beneficiaries receive the asset that provides them the greatest value, an IRA trust is an extremely useful tool for a wide variety of situations. Due to the complexities surrounding IRA and retirement plan distributions, it is important to work with experienced estate planning attorney familiar with those regulations in order for an IRA Trust to achieve a client's goals.

Matt

Planning for the Generations

In the previous blog we mentioned that our client, Edna, contemplated leaving gifts to her grandchildren that they would not receive outright until they reached retirement age. While Edna opted against this gifting option, other clients have seen value in restricting the distribution of gifts until beneficiaries attain physical, if not mental, maturity.

Harold is in his seventies and while he is now retired, he enjoys his time because he has significant investment income in addition to his Social Security. Harold’s investment income is sufficient to allow him the luxury of only taking the minimum distributions required by law from his IRA, allowing that account to continue to grow tax-deferred. Presuming that nothing changes, Harold will have the opportunity to provide for his loved ones after his death in a variety of ways.

Harold outlived two wives but was close with his own children, Isaac and Janice, as well as his stepchildren, Karen and Luke. While he wants to treat all four children equally, he recognizes that Luke has issues managing money, as evidenced by a recent bankruptcy. Additionally, Harold wants to provide for his grandchildren, but sees that each of them is at a different point in their lives and therefore it might not be appropriate to make gifts to them in the same manner. This sort of complex family situation is ideal for a Living Trust, because the Grantor (Harold) can divide assets as he sees fit and the successor Trustee has the responsibility of dispersing assets in the manner Harold chose.

In this case, Harold chose to divide the majority of his assets into four equal shares for the benefit of Isaac, Janice, Karen, and Luke. While the value of each of these shares is to be equal, the terms of distribution are not. Isaac, Janice, and Karen are to receive their shares over the course of five years, with the Trustee having the discretion to make distributions for their health, maintenance, or support if circumstances warrant. Luke’s share, in light of his ongoing bankruptcy, is to be held in trust with the Trustee having the authority to make distributions for Luke’s benefit, but not to distribute funds directly to Luke.

This difference in distribution terms will help to protect any inheritance Luke receives from garnishment by his bankruptcy proceeding, while still allowing Luke to benefit from the funds. Harold has provided that upon reaching age 65, Luke may receive whatever remains of his Trust outright. This additional restriction, lasting long beyond the current bankruptcy, helps ensure that as Luke gets older there will be  funds available for him in retirement. Due to the value of Harold’s trust, it is likely that there will be funds remaining at this time and Harold hopes that by 65 Luke will have the maturity to handle his own affairs.

To address Harold’s desire to provide for his grandchildren we established a separate “IRA Trust” that does not contain any assets during Harold’s lifetime, but the IRA Trust is named, in very specific fashion, as the beneficiary of Harold’s sizable IRA. The IRA specifically names sub-trusts created under the terms of the IRA Trust, each for the benefit of a particular grandchild, as a beneficiary. This designation, along with other terms that allow the IRA trust to comply with the law and regulations, allows the IRA Trust to serve as the beneficiary of the shares of Harold’s IRA while still using the separate ages of Harold’s grandchildren as the measuring ages for making the minimum distributions required under the law. As a result, each of Harold’s grandchildren, ranging in age from 30 to 12, will be treated slightly differently but all of them will benefit more from Harold’s IRA than if the IRA Trust did not exist.

First, the IRA Trust allows the Trustee to manage the assets and comply with laws, leaving the beneficiaries free to enjoy the boon from their grandfather. The IRA Trust also prevents a beneficiary from electing to take a large distribution from their inherited IRA without fully appreciating the consequences of that action. Finally, because the IRA Trust allows each beneficiary’s age to act as the measuring age for their required minimum distributions, the younger beneficiaries do not need to withdraw more funds in a year than necessary. This benefits the younger grandchildren by allowing more funds to grow tax deferred until age 65 when Harold has decided that his grandchildren will gain complete access to the funds.

Clearly, this level of complexity is not necessary for all clients but many clients like the idea of using particular assets to benefit certain beneficiaries and often there is a benefit to doing so in order to gain either tax savings or increased growth potential. The complexity of Harold’s plan is something that people should not attempt without consulting financial planners and attorneys experienced in complex estate planning as even simple errors in implementation may be very costly when it comes time to execute the plan.

Matt and Al

Adding Additional Protections for Inherited IRAs

     Last year the Supreme Court of the United States unanimously held that Inherited IRAs do not qualify for protection during a bankruptcy. Stating that the term "retirement funds" refers to money set aside for time when a person is no longer working, the Court stated that three characteristics disqualify the funds held in an Inherited IRA from the status of "retirement funds.” 

1. The owner of an inherited IRA cannot add additional funds to the account. 
2. Holders of Inherited IRAs must take distributions from those accounts without regard to the number of years until the account owner reaches retirement. 
3. The owner of an Inherited IRA may make penalty-free withdrawals from the account, up to the entire balance of the account, at any time without triggering the 10% withdrawal penalty found in the Internal Revenue Code.

     This important for any client who expects their retirement accounts to make up a large part of their estate, because this decision means that those inherited retirement assets do not enjoy the usual protection from creditors and will be at risk if one of their beneficiaries files for bankruptcy after receiving their inheritance. Presumably, those assets will also be at risk if a beneficiary divorces a spouse.  Thankfully, we already have a tool that addresses this concern and provides protection for beneficiaries. A standalone IRA Trust named as the beneficiary of a client's IRA can make distributions to the beneficiaries of the IRA Trust without exposing the inherited IRA to creditors. I

     Normally only an individual can be a "designated beneficiary" under an IRA, but if a Living Trust meets certain requirements it is considered a "see-through" trust and the Internal Revenue Code and Regulations treat the beneficiaries of the trust as the "designated beneficiaries" of the IRA. This allows those beneficiaries to stretch their distributions to receive the minimum required distributions over the life expectancy of the oldest beneficiary. In the event that it would be more advantageous for each beneficiary to take distributions over their own life span, it is possible to create specific sub trusts for each beneficiary under the IRA Trust to stretch distributions over the individual beneficiaries' lifespans. 

     For years, we have been using standalone IRA Trusts to assist clients who wished to place different restrictions on the distribution of their retirement and nonretirement assets or to protect beneficiaries from misusing the benefits of an inherited IRA by taking large lump sum distributions, or as protection against possible creditors or loss of assets in a divorce action. With this recent decision from the Supreme Court, a standalone IRA trust provides clients with the peace of mind that in the event one of their loved ones becomes one of the nearly 1,000,000 people who file for bankruptcy in the United States each year, their inherited IRA assets will remain protected.

     The law and regulations governing "inherited IRAs" and the use of IRA Trusts is expansive and complex. Before a client begins designating a trust as the beneficiary of a retirement account they should consult with a legal expert in that area. Additionally at the death of the account owner, it is important to seek additional advice as to the best way to retitle accounts or distribute the assets. If you or your clients have specific questions regarding this or any other planning matter please do not hesitate to contact us and we will be happy to provide you with an understanding of the consequences of any actions.

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

Estate Planning for a Second Marriage

     Recently a colleague asked for information about the use of trusts in estate planning following a divorce and remarriage. Since we have not addressed this topic yet, a post on the subject seemed appropriate. It is important for client to consider estate planning issues following a divorce and remarriage to avoid inadvertently disinheriting either the new spouse or children of the first marriage. Clients (husband and wife) in their first marriage usually have common goals, such as providing for the surviving spouse during their lifetime and leaving any remaining assets to their children equally. This makes estate planning relatively simple, because a living trust holds the assets to limit tax liability, avoid probate, and ensure the assets pass to the surviving spouse for use during the spouse's lifetime and then on to the couple's children.

     Clients in second marriages, whether because of divorce or death, usually have a more complex situation with which to deal. In those circumstances there are concerns regarding the surviving spouse, children from the first marriage, the surviving spouse's children, and possibly children from the second marriage. Clients wish to ensure the surviving spouse has sufficient assets during lifetime, while also ensuring that the assets they brought into the marriage eventually pass to their children.

     A frequent concern of clients in their second marriage is ensuring that both their second spouse and their children receive gifts following the client's death. A common technique used to achieve this goal provides the surviving spouse with a regular stream of income from the trust assets, while reserving distributions of principal for the client’s children following the death of the surviving spouse. When using this technique, it is also common to provide the trustee with the discretion to make distributions of principal to the surviving spouse, under a limited set of circumstances, to ensure that the surviving spouse has sufficient assets to live on following the first spouse's death. It is important in these circumstances that the trustee understand that part of their responsibility is to balance the best interests of both the spouse and children from the first marriage in making distributions. It is a good idea for the client to discuss these issues with the named trustee.

     Alternatively, some clients opt to address this issue by distributing different assets to their surviving spouse and their children. For example, a trust might provide that the client’s children receive immediate distributions from the trust assets equal to the payout from a life insurance policy. The client may also provide that the children are beneficiaries of the client’s IRA or other retirement accounts. The trust then provides that the client's surviving spouse receive all income from the remaining trust assets, and gives the trustee broad discretion to make distributions of principal for the surviving spouse's needs. Any trust assets that remain following the death of the second spouse are distributed to the client’s children. This technique ensures that that the client’s children receive an immediate gift as well as the potential for additional assets should any remain after ensuring that the surviving spouse has sufficient assets during the their lifetime.

     A well-drafted trust is required to make use of these techniques because you need an entity maintain the trust assets instead of passing those assets directly to the surviving spouse. During a first marriage, a common technique for probate avoidance is to own property jointly with rights of survivorship. This allows the surviving spouse to remain the sole owner of the property following the first spouse's death without the property passing through probate. If this same technique is used following a second marriage, the surviving spouse becomes the sole owner of the property or bank account and then is free to do with that property whatever he or she chooses. This means that property the client intended for children to inherit following the second spouse's death could pass directly to the second spouse's children or family and completely disinherit the client's children from the first marriage.

     There is not always controversy about who inherits which assets. In many second marriages, spouses and their children from first marriages live in perfect harmony. Even in these circumstances, the spouses may wish to ensure that particular assets, such as vacation homes or collectibles, that each has brought into their second marriage are eventually inherited by their own children. With proper planning, it is possible to maintain these separate assets for both spouses’ use while ensuring that after the second death the assets will go to each spouse’s children, while assets earned jointly during the marriage are split equally amongst all the children.

     It is clear that the circumstances that exist when contemplating estate planning for a second marriage involve a level of complexity that generally does not exist when planning during a first marriage. These circumstances can become even more complex if either spouse’s children has special needs, dependency issues, creditor problems, or if there are significant personal conflicts between children and second spouses.  You may actually have a case where the new spouse has his or her own issues, which need to be addressed. An example of this occurs if the new spouse has an unpaid federal income tax liability and the spouse transfers a residence originally owned individually to the other spouse as joint tenants. Now the IRS can attach a lien to the residence. It is important to speak with an experienced attorney to ensure that the estate plan meets the goals of both spouses and is implemented with a minimum of conflict.

Other IRA Issues with Estate Planning

On Tuesday, I discussed funding retirement benefits to a Living Trust and some of the issues that may come about because of the funding. In response to that post I received a few comments and questions on related issues and thought it a good idea to expand on the topic in today's post.

The first comment talked about the opportunity of using a direct IRA beneficiary trust as well, to mandate a "stretch-out" of distributions and protect non-spouse beneficiaries from creditor claims. We discussed the IRA Trust in our post on November 20, 2012, but it is worthwhile discussing it again.  

The “IRA Trust”, is a stand-alone trust, separate from a Living Trust that acts as the beneficiary of IRAs or retirement other 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 their inherited benefits over their lifetime. Using the IRA Trust allows the client to design a special trust specifically for the IRA assets and perhaps even for different beneficiaries then for the majority of the estate under the client's Living Trust. 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 this spending in mismanagement of money. Additionally, if an IRA trust provides for more than one beneficiary, if the IRA beneficiary designation form specifies the percentage of the account that will go to a specific sub trust for each of the beneficiaries, each beneficiary can then use their own life expectancy in calculating the RMDs for a particular year.
     A second comment asked how one meets the "see-through" trust requirements when one of the trust beneficiaries is a charity or other non-individual beneficiary. When a client names non-individual trust beneficiaries, those beneficiaries can be "removed" as a beneficiary for the purposes of determining the “see through” status of the trust. To “remove” the non-individual beneficiary the trustee must either make a distribution of the amount allocated to that beneficiary or arrange for the beneficiary to disclaim their interest. The deadline for this “removal” is September 30 of the calendar year following the calendar year of the account owner's death (the "Beneficiary Finalization Date"). If this is accomplished, the regulations exempt the non-individual trust beneficiaries for purposes of determining individual beneficiaries.
One might ask why anyone would disclaim his or her interest in a Living Trust. In some cases an older beneficiary will disclaim their interest in the IRA assets of the trust, because it will allow the younger beneficiaries (perhaps grandchildren in their 20s) to extend the IRA distributions over the lifetime of the oldest life expectancy of that group. This is important because unless you eliminate the elder beneficiary, all of the beneficiaries must use the oldest beneficiary's life expectancy in calculating the RMDs. Alternatively, a charitable beneficiary may disclaim an interest in IRA assets in exchange for a larger immediate gift that it can invest or put to use immediately.

On a final note, if there are sufficient assets in addition to the IRA to protect loved ones, and the client is charitably inclined, client may want to consider designating one or more charities as the beneficiary of the IRA. This will satisfy their charitable inclinations will save significant income taxes because the IRA will not be subject to income tax when paid to the charity. This can save a large amount of tax, especially where the estate is taxable for estate tax purposes and then the IRA is taxed for income tax purposes as it is distributed to individual beneficiaries. Naming a charity as the IRA beneficiary excludes it from taxation for federal estate tax purposes and income tax purposes.

Again, it is important that a client discusses their desires with experience counsel prior to designating beneficiaries in order to protection of beneficiaries and minimize taxation of the account.

The Benefits of an IRA Trust

As we have discussed in previous posts, there are many forms of trusts used in the estate planning process. A special type of trust, known as an “IRA Trust,” is a stand-alone trust, separate from a Living Trust that acts as the beneficiary of IRAs or 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 their inherited benefits over their lifetime.

While there is nothing barring a Living Trust from being the beneficiary of an IRA, due to the regulations that govern the distribution of retirement benefits it may be difficult if not impossible to take advantage of the most beneficial distribution rules or provide for a lifetime distribution of benefits using only a standard Living Trust. For example, if the Living Trust beneficiaries include charities the Living Trust will not qualify as an "individual beneficiary" and thus the non-charitable beneficiaries will not benefit from the ability to “stretch out” the IRA benefits. In addition, if the Living Trust benefits elderly relatives, the shorter life expectancy of those relatives limits the ability to stretch out distributions and delay or defer income taxation for younger beneficiaries because the regulations base MRD on the life expectancy of the oldest beneficiary. The provisions of an IRA Trust avoid these problems and ensure that the IRA Trust’s beneficiaries enjoy the greatest benefit from their inherited asset.

The beneficiaries of the IRA Trust can be the same as those of the client's Living Trust. However, the distribution terms of an IRA Trust terms are often different from the Living Trust and frequently more restrictive in order to ensure that no matter what happens to the Living Trust assets, the IRA Trust assets will be available to help support children, grandchildren and other beneficiaries. Alternately, an IRA Trust can divide assets between different groups of beneficiaries. For example, the Living Trust may benefit a second spouse while the IRA Trust has children and grandchildren as beneficiaries. Finally, an IRA Trust can help beneficiaries in more difficult or complex situations, such as beneficiaries who are:

1. Spendthrifts and unable to handle money
2. Children with addictions
3. Children with creditor issues
4. Children with bad marriages
5. Special care needs children, including those who qualify for government benefits
6. A surviving spouse who is  unable to say no when children ask for money

In these situations, the IRA Trust Trustee can provide professional management of Trust assets, allowing the IRA assets to grow tax deferred, except for required distributions, and ensure that the beneficiaries do not waste those distributions.

If there are multiple beneficiaries, IRA Trusts are drafted and coordinated with the beneficiary designation of the IRA to allow each of the beneficiaries to use their own life expectancy in determining the minimum required distributions. For example, the beneficiary designation after the death of the client should read as follows: “50% to the sub trust for the benefit of Jane Doe under the John Doe IRA Trust.” With proper drafting, an IRA trust can provide not only for children, but grandchildren and beyond, allowing multiple generations to take advantage of the IRA benefits. In those circumstances, the IRA Trust is often known as a "Dynasty Trust" because it can provide for multiple generations.

Just like a Living Trust, the distribution provisions of an IRA Trust dictate how the beneficiaries receive distributions. One design option for an IRA Trust is the "conduit trust", under which the trustee has no power to accumulate plan distributions in the trust and must allocate any distribution received from the IRA or retirement plan to the beneficiaries. The conduit trust lessens the trustee’s ability to control the income but still allows control over principal distributions as necessary.

Alternatively, when it is desirable or necessary to impose greater control upon the dispersal of the RMD, an "accumulation trust" allows the trustee to hold the RMD in trust for the beneficiary’s benefit. For example, if the beneficiary of the IRA Trust is special needs child, it is important to limit income distributions in order to avoid adversely affecting the beneficiary's right to receive state or federal benefits. It is important to remember however when using an accumulation trust that the federal government taxes income received from the IRA but not distributed to beneficiaries according to the potentially higher trust income tax rates.

Whether a client wants to provide for multiple generations, ensure a lifetime of income for a beneficiary in a difficult personal or financial situation, or simply ensure that different groups of beneficiaries receive the asset that provides them the greatest value, an IRA trust is an extremely useful tool for a wide variety of situations. Due to the complexities surrounding IRA and retirement plan distributions, it is important to work with experienced estate planning attorney familiar with those regulations in order for an IRA Trust to achieve a client's goals.