Orange County Blog

Trusts are extremely flexible, useful estate planning tools that have been used for decades to accomplish a myriad of purposes.  A traditional and widely-used practice is to employ trusts to Control distributions to beneficiaries and to Protect the beneficiaries from creditors, lawsuits, taxes, and from themselves.  Why not use a trust to distribute qualified plan money for the same reasons?

New IRS rules now permit an individual to create an IRA Beneficiary Trust to insure that your beneficiaries (those who will receive the IRA's after your death) “stretch-out” their taxable, required minimum IRA distributions over a much longer period of time. And, if they do it right, the IRAs can continue to compound for many years income-tax free -- and may literally grow to be worth millions of dollars! In 2005, the IRS issued a private letter ruling 200537044 (the “PLR”) that approved this new type of revocable trust created solely to be the beneficiary of an IRA account. As a result of this PLR, it is now possible to create a stand-alone trust that allows each beneficiary to take “stretched-out” distributions based on his/her individual RMDs.

IRA Beneficiary Trusts insure that their beneficiaries will stretch-out payments from the IRA after they inherit their shares of the account so that the funds will grow inside the account without being taxed. This type of trust has also been referred to as an IRA trust, an IRA inheritance trust, a stand-alone IRA trust, an IRA stretch trust or an IRA protection trust.

If children and grandchildren who inherit IRA funds keep the funds in the IRA over their lives and only take the required minimum distributions each year (the “stretch-out”), the amount of money that can be earned, accumulated and paid to the beneficiaries can be staggering. To illustrate how this compounding can work, I have calculated how much money a beneficiary can receive from a parent's $100,000 IRA account; I have used two different ages (10 and 35) for the beneficiary and have assumed that the account averages an annualized 8% return:

This wealth accumulation strategy only works if the beneficiaries retain the inherited funds inside the IRA account. If a beneficiary takes all of the funds out of the IRA account at the time of the owner's death (called a “blow-out” because it blows the stretch-out), this wealth accumulation technique will be lost. One of the reasons to create an IRA Beneficiary Trust is because it can insure the stretch-out and can prevent a blow-out. This blow-out happens more often than you may think. The beneficiaries may not be aware of the tax rules and their distribution choices, so they may immediately withdraw the IRA's at the first opportunity (or worse yet, do a prohibited rollover!). Or the beneficiary, influenced by his or her spouse, may just decide to withdraw the IRA's to foolishly spend it. If the “stretch-out” isn’t done properly by the beneficiaries and income taxes are paid up front shortly after the IRA's are inherited, your family may lose hundreds of thousands of dollars (or more). 

Even if you assume that your beneficiaries will do the right thing (that is, keep the funds in the IRA account for their lives to maximize the income tax “stretch-out” of the IRA's), the IRA's may still be seriously exposed to one or more of the following threats that can arise years after you are gone:

• The beneficiary’s spouse may snatch half (or more) of the inherited IRA's in a divorce. The divorce rate is over 50% and a big pile of inherited money may become a divorce incentive for the ex-spouse. Even though inherited property is separate property, the beneficiary's ex-spouse's divorce lawyer will probably go after the IRA funds because the IRA account is frequently the largest asset and the lawyer knows there is a good chance the spouse who inherited the IRA will give a large portion or all of the IRA account just to end the divorce and to be rid of the ex-spouse.

   

• The beneficiary's poor spending habits, creditors and lawsuits may grab all of an inherited IRA's.

   

• The beneficiary could lose his or her needs-based government benefits (if he or she ever requires them), such as supplemental income (SSI) or long-term nursing care.

   

• And even if the beneficiary never encounters any of these problems, he or she may get walloped with a huge estate tax when he or she passes the IRA's down to the next generation.

One of the big advantages to the IRA Beneficiary Trust is the option to give a "Special Trustee" the right to elect out of the "conduit trust" (i.e., where the MRD must be paid to the beneficiary on an annual basis) to a fully discretionary "accumulation trust" (i.e., where the trustee can hold the beneficiary's MRD inside the trust). This election must be made, if at all, by September 30 of the year following the client's death. Making this election may result in a shorter “stretch-out” because the age of the oldest “possible beneficiary” must be used (the Special Trustee is also given the power to limit such possible beneficiaries to minimize this issue); however, having this option to elect between the different forms of trusts provides the flexibility to consider all factors known at the time of death and up to the election deadline (e.g., creditor problems, disability, etc.) the benefits of which may greatly out-weigh the increase in the income tax costs.

I have been directly trained by the lawyer that conceived this strategy and obtained the PLR.  Since 2006, I have drafted dozens of IRA Beneficiary Trusts. I understand all of the nuances involved in the proper establishment and implementation of this plan.  I recommend that all clients and their advisors consider naming a properly-drafted IRA Beneficiary Trust as the beneficiary of qualified retirement plans that are valued over $300,000.