Estate planning for retirement plan assets and naming a trust as a beneficiary

Individual retirement accounts (IRAs) and other retirement plan accounts are also useful vehicles often used to grow assets free from current income tax and to transfer those assets to the next generation. IRAs were introduced in the 1970s, and since that time have become an increasingly popular structure for accumulating wealth. These tax-advantaged accounts now collectively hold over USD 11 trillion in assets, which is more than a third of all retirement assets in the US.

As the significance of IRAs has grown, it has become more common to name trusts as IRA beneficiaries, thus combining the tax-advantaged growth of an IRA with all of the advantages that trusts have to offer.

An IRA is a retirement vehicle generally set up as an investment account. Each year, you can contribute income that you earn, subject to certain limits. For traditional IRAs, this contribution may be deductible from your income, and then later withdrawals are subject to income taxation. For Roth IRAs, the contribution is not tax deductible, and later withdrawals are tax-free. If you withdraw assets from either type of IRA before age 59½, you generally will incur an early-withdrawal penalty of 10%.

Under current law, when you reach age 72, you must start taking required minimum distributions (RMD) each year from a traditional IRA. The RMDs are based on your age and a life expectancy factor listed in tables published by the IRS. Roth IRAs are not subject to RMDs during your lifetime.

The IRA, with its remaining assets, passes to whomever you have named in the IRA beneficiary designation. The most common designations are to individuals – for example, all to a spouse or in equal shares to children. However, a trust also can be named as an IRA beneficiary, and in many instances, a trust is a better option than naming an individual. 

Reasons to name a trust

When a trust is named as the beneficiary of an IRA, the trust inherits the IRA when the IRA owner dies. The IRA then is maintained as a separate account that is an asset of the trust.

So, what are some possible reasons to consider naming a trust as an IRA beneficiary instead of an individual?

One of the most common reasons is that the intended beneficiary is a minor who is legally unable to own the IRA, and it would be better to have the account controlled by a trustee, than a guardian who may have to be appointed by a court.

Or the IRA owner wants to support an individual with special needs who will lose access to government benefits if he or she gains access to those assets upon reaching the age of majority.

Another common reason to provide IRAs benefits through a trust is that an IRA owner may wish for RMDs to benefit their second spouse during the spouse’s lifetime, and then have the remainder of the IRA pass to their children from a prior marriage. If the IRA owner leaves the IRA outright to their spouse, they can be certain that their spouse will benefit, but they cannot guarantee that their children will receive the balance. If the IRA owner instead leaves the IRA to a properly structured trust, their goal of having the property benefit both sets of beneficiaries can be carried out.

A final reason to name a trust is to provide additional creditor protection to the beneficiary inheriting the account. A person’s own IRA has some level of protection from creditors, but this does not always carry through to the inherited IRA. The US Supreme Court ruled that inherited IRAs do not qualify under the Federal Bankruptcy Code as exempt from the claims of creditors as “retirement funds”. An inherited IRA held instead in a properly structured trust will not be an asset of the beneficiary and will have some protection from creditors. 

Pulling back on the stretch IRA

Just as there are rules about RMDs during the IRA owner’s life, there also are rules about distributing an inherited IRA after the owner dies. The preferred payout has long been the stretch IRA, where the post-death RMDs are stretched out, with annual distributions, over the life expectancy of the new IRA beneficiary. In this case, the IRA could continue to grow, tax-deferred, often for many decades after the owner’s death. But for many clients, this is not an option any longer as a result of the SECURE Act.

The SECURE Act, passed in December 2019, has significantly reduced the ability to create a stretch IRA and other defined contribution plans. However, the IRS did not touch the minimum distribution rules, and instead of a complete overhaul of the rules, the IRS created what I like to think of as a modification to the existing rules.

The prior stretch rule has been replaced, for most beneficiaries, with a 10-year rule that requires the IRA to be distributed out completely by the end of the tenth year following the year of the IRA owner’s death. The 10-year rule does not require annual distributions, so long as the full amount is distributed by the end of the tenth year.

The new 10-year rule does not apply to the following beneficiaries (known as “eligible designated beneficiaries”) and for them, the stretch IRA is still available:

• The IRA owner’s surviving spouse; 
• The owner’s children while they are minors,
• Certain individuals who are chronically ill or disabled (SSI definition generally), and 
• Any person who is not more than 10 years younger than the IRA owner. 

One note under the minor’s child exception to the rule is that the exception to the rule only applies for the minor child of the plan participant. So, if a grandmother leaves her IRA to her minor grandchild, the exception does not apply and the 10-year rule kicks in. Furthermore, the life expectancy payout only lasts until the minor attains the age of majority; then it flips to a 10-year payout. 

RMD rules for trusts inheriting IRAs

Conduit vs. accumulation trusts

Over the years, conduit and accumulation trusts have both been used to defer income tax payments by stretching distributions over a beneficiary's life expectancy. However, this tax benefit of deferral can only take place if each trust qualifies as a see-through trust under the Internal Revenue Code. One of the primary differences between the two trusts is whether the beneficiary or the trust would be responsible for the income taxes payable on the distribution.

What is a conduit trust?

A conduit trust is trust (often referred to as a “see-through” trust because we look through the trust to the identifiable trust beneficiaries) where all distributions paid out of the IRA to the trust must be immediately distributed to the individual trust beneficiary, who is the sole beneficiary of the trust. Trustees are required by the terms of the trust to pass out, to an individual beneficiary, all payments received from the IRA during the lifetime of the beneficiary.

Pre-SECURE Act, the trust would look to the life expectancy of each specific beneficiary and ensure the beneficiary's share of any RMD paid to the trust is distributed to that beneficiary. What would typically take place is that the distributions would continue for the beneficiary's lifetime in a way that would attempt to stretch the payments sufficient enough to defer as much income taxation as possible. 

The way conduit trusts work – with assets passing out of the inherited IRA, into the trust, and then out to the beneficiary – has not changed post-SECURE Act. However, the impact of the SECURE Act is such that now most inherited IRA assets will need to be distributed to the beneficiary within a 10-year time frame. If the trust is a non-see-through trust, the time frame is 5 years.

As a hypothetical example, let's consider a spouse who has adult children from a previous marriage and would like to leave his USD 1 million IRA to them while also providing for his second wife. He can leave his IRA to a conduit trust for the benefit of his spouse, and name his children as remainder beneficiaries of the trust. The IRA would make distributions to the surviving spouse based on her life expectancy, and upon her death the assets would pass to his children with the requirement that they be distributed from the IRA within 10 years.

Note that post-SECURE, if there are no conduit provisions set up for the spouse, the children could potentially inherit an asset that is worth much less as the taxation on the IRA would be accelerated over 10 taxable years as compared to the pre-SECURE stretch provisions. 

What is an accumulation trust?

An accumulation trust is also a see-through trust where the trustee can accumulate retirement plan distributions in the trust during the beneficiary’s lifetimes (no required payouts). So long as there is an identifiable  individual trust beneficiary who will ultimately receive the retirement plan distributions, the trust will qualify as a designated beneficiary. But along the way, if a retirement plan distribution through the trust is made to a charity or an estate, this will disqualify the trust as a designated beneficiary. The determination of whether the accumulation provisions apply requires one to determine all the possible beneficiaries (both current and remainder) who might ever be entitled to a distribution.

An accumulation trust is also a see-through trust where the trustee can accumulate retirement plan distributions in the trust during the beneficiary’s lifetimes (no required payouts). So long as there is an identifiable  individual trust beneficiary who will ultimately receive the retirement plan distributions, the trust will qualify as a designated beneficiary. But along the way, if a retirement plan distribution through the trust is made to a charity or an estate, this will disqualify the trust as a designated beneficiary. The determination of whether the accumulation provisions apply requires one to determine all the possible beneficiaries (both current and remainder) who might ever be entitled to a distribution.

Accumulation trusts differ from conduit trusts in that these trusts provide the trustee with discretion in determining whether to pay out or retain any distributions taken from the inherited IRA. This flexibility allows for assets to remain in trust protected from potential creditors. It also alleviates the IRA owner's concern of having beneficiaries receive assets either too soon or in too large an amount because all distributions are in the control of the trustee. 

Planning pitfalls

The change in the rules requiring distributions from an IRA be withdrawn within 10 years could lead to differing interpretations of the 10-year period. It could be interpreted to mean the trustee must wait until the end of the 10-year period to withdraw funds from the IRA, then make one large distribution at the end of 10 years. Or it could mean taking more out in the beginning years to front load the payments. Without guidance in the trust itself, there could be a definite disconnect between a person’s intentions in setting up the trust and how the trust will be administered for the trust beneficiaries.

With these accelerated distributions come accelerated tax burdens. So, unless there is proactive planning, the new law could mean that beneficiaries could ultimately end up receiving less money than they would have before the law changed.

In many cases, trusts named as beneficiaries of retirement accounts may need to be amended to resolve this conflict. In the meantime, it could be a good idea to remove trusts as beneficiaries immediately and add them back in again after the necessary revisions have been made to the trust documents.

For people who have not reviewed their estate plans for many years, it is advisable to take a look at plans that were designed prior to SECURE. The following are candidates that will be most affected and might need attention:

1. People whose estate plans were designated around a stretch IRA (e.g. for grandchildren) – the best deal they can get is the 10-year payout.
   
   
2. People who set up conduit trusts as conduit trusts might not work as intended as in the tenth year; or prior thereto, the entire trust will need to be distributed out of the IRA plan.
   
   
3. Finally, plans for spouses mean that while benefits can still be left to a spouse in lifetime trust, when the spouse dies, the 10-year rule will usually come into play.  

Trusts can be an important tool for reaching one’s estate planning goals. However, if there is a desire to leave retirement plan assets in trust, it is crucial to consider the ramifications to avoid pitfalls that can occur.

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