In 2005 a Private Letter ruling was issued by the IRA approving a specially designed "IRA Trust" that offers maximum protection and flexibility while allowing the beneficiaries to "stretch" their shares of the IRA over their life expectancies. The IRA Trust can also be used for employer provided retirement plans, such as 401(k)s, 403(b)s, 457 Plans, etc.
Having spent a great deal of time studying the IRA distribution rules and the advantages of using an IRA Trust, I am now recommending them to just about every client whose retirement account balance exceeds $200,000.
Individual Retirement Accounts (“IRAs”) were not originally designed to be wealth transfer vehicles. But effective January 1, 2003, the IRS issued final Regulations with respect to Internal Revenue Code 401(a)(9), the code section which creates IRAs. These Regulations govern the calculation of required minimum distributions (“RMD”) from IRAs.
These Regulations dramatically change the way that we now plan IRA beneficiaries from tax, financial and estate planning viewpoints. The key aspect of these Regulations is that they now permit a non-spouse beneficiary to “stretch” the taxable required minimum distributions over his or her actuarial lifetime. The ability to compound the IRA investments, tax free, over a much longer period of time makes IRAs now one of the most valuable assets when passing wealth down from generation to generation. A $200,000 IRA, inherited by a 50-year-old, could be worth $1.5 million or more over his and his children’s lifetimes! In other words, obtaining maximum income tax stretch is now a prime planning objective.
This income tax stretch can be obtained either by naming individuals as beneficiaries or by naming a trust as a beneficiary. However, naming individuals as beneficiaries may create a
host of other problems:
• The individual beneficiary may at any time decide to take out more than the required
minimum distributions (“RMDs”) because he is not aware of the tax rules and the choices he has, or he gets bad advice, or he simply wants to spend the money (or his spouse or another party influences him to spend it), and thereby cause the taxation to occur much earlier, lose years of tax-free compounding, and essentially blow the stretch;
• The original account owner does not control who will eventually inherit the IRA assets
after the primary beneficiary;
• The beneficiary may have poor money management skills, be a spendthrift or too young or disabled to manage money;
• The IRA is exposed to the beneficiary’s spouse in a divorce;
• A beneficiary receiving government benefits could lose them;
• Lawsuits against the beneficiary and his creditors could grab the IRA; and
• Even if none of the above occurs, what could represent a substantial sum when the beneficiary dies may then be subject to estate taxes when it goes down the next generation.
All of these problems may be dealt with naming, instead, a trust as a beneficiary. Unfortunately, under the IRS Regulations, a trust named as a beneficiary must jump through a number of hoops in order for the RMDs to obtain maximum stretchout over the lifetime of the beneficiaries of the trust. A Living Trust typically cannot meet all of these requirements and, therefore, a separate trust, called the IRA Trust, is instead established as the IRA beneficiary. The IRA Trust is specially designed to not only meet the IRS requirements for a “Designated Beneficiary Trust,” in order to obtain maximum income tax stretchout, but it also provides protection against all of the seven problems recited above that may occur when an individual is named beneficiary.
What Sets The IRA Trust Apart From Other Designated Beneficiary Trusts?
The IRA Trust offers some unique post-mortem flexibility, which permits the trust to adapt to
the conditions existing at the time of the IRA owner’s/grantor’s death. If the beneficiary’s share
of the IRA Trust is a “Conduit,” trust, meaning that all of the IRA distributions flow over into the trust and then are immediately distributed out to the beneficiary, the beneficiary’s life expectancy can be used for stretch purposes. On the other hand, there are a number of estate planning reasons why we would prefer an “Accumulation” trust instead, where the IRA distributions that flow into the trust are distributed to the beneficiary only in the discretion of the trustee. Unfortunately, an Accumulation trust may cause the maximum stretch to be lost unless a whole number of requirements are met; if any monies accumulated in that trust could ever, at any time in the future, pass to someone older than the primary beneficiary, that older person’s shorter life expectancy must be used and there are even situations where no life expectancy can be used and the IRA will have to be distributed for and all the tax paid in five years. Since a discretionary trust is often designed for estate planning purposes to benefit individuals other than just the primary beneficiary, such as that beneficiary’s issues or others subject to the beneficiary’s power of appointment, and we want to take advantage of generation skipping for estate tax purposes, it may be very difficult for the estate planner, at the time of drafting the trust, to determine where to cut off future beneficiaries in order to balance the desire for stretch with the desire to fulfill the grantor’s dispositive intent. Also, it is difficult to determine at the outset whether or not a beneficiary’s trust would best be a Conduit or Accumulation trust, not knowing the circumstances of the beneficiary that will exist at the time of death, and the amount of protective features that will be appropriate for that beneficiary.
One of the unique features of the IRA Trust is a “toggle switch” which the Trust Protector can use, following the grantor’s death, to convert between a Conduit and Accumulation Trust, as is appropriate given the circumstances of the beneficiary and their need for protection. The Trust Protector, armed with this toggle switch, can also determine, for any beneficiary who will have an Accumulation trust, which secondary or contingent beneficiaries should be kept in or removed
in a way that best balances the primary beneficiary’s desire for stretch and fulfills the grantor’s
dispositive intent when that primary beneficiary passes away.