IRA Beneficiary Trusts - Frequently Asked Questions (and Answers!)

SUPREME COURT DECISION IMPACTS IRA BENEFICIARIES

Q:    Is my financial advisor correct that the Supreme Court just changed the way an IRA will be treated when my account is inherited?

A: Yes. On June 12, 2014, the U.S. Supreme Court unanimously decided that funds held in inherited IRAs will not be protected as “retirement funds” - meaning that an inherited IRA will now clearly be more readily available to satisfy the claims of creditors.  The Clark case related to a daughter who inherited a $300,000 IRA but ended up in bankruptcy after her small-town pizza shop failed.

Q: Okay, but what if my child doesn’t file bankruptcy but has creditors trying to collect money?

A: The Clark ruling reasoned that IRAs inherited by someone other than a spouse cannot be properly considered retirement funds, because beneficiaries cannot invest additional money or delay distributions until retirement (like their own account).  A judge in a non-bankruptcy collection case could potentially use similar logic to allow collection against an inherited IRA.

Q:  Is there anything I can do to avoid that result?

A:  At least in some circumstances, the Clark decision will influence your choice of designated beneficiaries. The clear solution to this dilemma would be to name a trust as the beneficiary.  If the trust is drafted to be “qualified” under a complex set of tax rules, the desired result of the child inheriting an IRA to be held for that child’s retirement (and outside the reach of creditors) can still be accomplished.  In light of the Clark decision, it’s more important than ever for you to understand the option of making your IRA payable to a qualified trust for the benefit of your desired individual beneficiaries.  The trust will provide your beneficiaries with much stronger asset protection compared to designating that same individual as an IRA’s outright beneficiary. Again, however, a trust should be drafted to qualify as a designated beneficiary under the IRC Section 401(a)(9) regulations.

Q: Does the Clark case apply to my spouse as a beneficiary?

A: The distinction between a spouse or a non-spouse played an important role in the court decision.  The tax law give preference to spouses and allows a surviving spouse to “step into the shoes” of the deceased IRA holder.  However, because of this Clark case, spouses who inherit IRAs should now seriously evaluate whether to roll those inherited IRA funds into the spouse’s own IRA (a choice which also involves tax and other considerations).  If a rollover is accomplished, the account is no longer an inherited IRA for the spouse.  The rollover option is not available to children or other non-spouse beneficiaries.

Q: What are some of the limitations to the Clark case? 

A: The debtor in Clark had filed bankruptcy under federal exemptions and so that decision is specifically applicable to debtors who have inherited an IRA, and relied upon exemptions within the meaning of Bankruptcy Code Section 522(b)(3)(C) of the federal bankruptcy code.  Tennessee has different bankruptcy exemptions and TCA 26-2-105(b) also exempts qualified retirement plans, making it not immediately clear whether a Tennessee court might apply the same logic in Tennessee.  Inherited IRAs appear much more protected, because our statute seems to focus on whether the account is “qualified” rather than a “retirement account”.  However, until a court or the legislature acts to specifically include inherited IRAs as exempt under Tennessee law, those funds may be at risk.

Q: What is likely to happen in response to the Clark case?

A: IRA providers should update their procedures and, if applicable, add a notice to their written IRA materials to reflect this distinction between inherited IRAs and other IRAs.  Our office also would anticipate that more states may now consider legislation to explicitly protect inherited IRAs.

TENNESSEE DIFFERENCES

Q: Okay, but if Tennessee is different and IRAs are automatically creditor and lawsuit protected for my beneficiaries by the exemption statute, why do I need the IRA Inheritance Trust to gain this protection?

A: If your children live in another State (not Tennessee), the creditor and lawsuit protection available to an IRA can differ from state to state. Most states do not offer IRAs the same creditor and lawsuit protection as company retirement plans. In fact, few States have the type of exemption Tennessee has. Federal law also gives higher protection to employer plans (such a 401(k) plans). So, an IRA Inheritance Trust can afford significant protection for your beneficiaries’ lawsuit and creditor exposure. This is also one of the factors you must consider if you’re thinking about rolling over your 401(k) or other company plan into an IRA. However, most people don’t have significant exposure to creditors and lawsuits, unless they operate a business or own rental real estate, or are a professional like a doctor who could be sued. In addition most folks insurance (homeowners, auto and umbrella insurance policies) can protect them from most creditors. Therefore, for most people, the rollover makes a lot more sense than leaving your money in the company plan because now your beneficiaries will be able to take advantage of the maximum income tax stretch-out.  Furthermore, as explained above, Tennessee has a bankruptcy exemption for IRAs. 

Q: If IRAs are protected for my beneficiaries in bankruptcy, why use a Trust?

A: Even if the IRA beneficiary seeking bankruptcy protection may have an exemption, we don’t ever want things to get to the last resort of a bankruptcy, which is why the IRA Inheritance Trust is important.  It can provide enhanced protection against divorces, lawsuits and other third-party claims so your beneficiaries may not have to declare bankruptcy!

NEEDED EVEN BEFORE THE CLARK CASE          

Q: If I’m not concerned about my children’s creditors and I feel that my children are responsible enough to do the proper “stretch” to save those inherited IRA funds for their retirement, is there any reason to do a trust?

A: Even though you may feel a child as a beneficiary is responsible enough to take care of the stretch-out on his or her own (or will seek proper advice), there are lots of reasons why I’ve found this does not occur. For example, your son may not be aware of the required minimum distribution rules and his available choices - simply having the custodian send him a check.  Or your daughter may think she can merely rollover your IRA into her own existing IRA.  Both of these instances will cause your entire IRA to be taxed immediately and blow the stretch-out rules.  These things happen more often than you might suspect, because you have no guarantee that your beneficiaries will seek your financial advisors’ advice first, before they run to the custodian to issue a check. And don’t forget that your beneficiary’s spouse (or some other third-party) may influence your beneficiary to withdraw the money and spend it (or loan it to them)! So, while it sounds good in theory to rely on your beneficiaries to do the stretch-out (and you trust your financial advisor to guide them through it), you take a big risk if you don’t use the IRA Inheritance Trust.

But let’s assume the best - that your child does the stretch-out properly. There’s still the issue of protecting his or her inherited IRA from claims of a spouse in divorce, creditors and lawsuits, loss of future government benefits they may need if they ever become disabled or require nursing care, and a possible estate tax when your child dies and passes down your remaining IRA to your grandchildren.  An IRA Inheritance Trust also provides substantial protection against these potential problems when you consider that the stretch-out of your IRA may occur for many years after you die.  These protections become very important reasons to set up an IRA Inheritance Trust.

DETAILS OF SETTING UP

Q: How difficult is it to file the special beneficiary designation form needed and are there problems with custodians accepting it?

A: Your attorney can prepare for you a letter instructing how the custodian should reflect your intended trust as the beneficiary. In most cases, the custodian will then give you their beneficiary form to complete, incorporating this information. Every custodian has its own beneficiary form and they are changing all of the time, so our firm only gives you a general directions letter to get started. I usually have your financial advisor help you with completing the custodian’s specific form and then your attorney may assist you by checking to make sure it is correct. Our experience has been that some custodians do not immediately accept the form that you fill out; however, once the custodian has spoken to our law office and we have explained how and why it will work, the problem has always gone away. In the rare event that you do have a custodian who simply refuses to accept your beneficiary form, then the simple solution is to move your IRA to another custodian, which can be easily accomplished, usually without having to change any of the investments in the account. (Just the threat of moving your account will usually get your current custodian to say yes!)

Q: If my IRAs total less than $150,000 would the IRA Inheritance Trust be appropriate?

A: I use $150,000 as a “rule of thumb” for whether it is cost effective to pay to have a trust done.  If your total IRAs exceed $150,000, then assuming your beneficiaries will live at least 10 years after you, the difference between having the Trust and not can literally be worth over $1 million, based on past investment performance. However, I have run across situations where people need an IRA Inheritance Trust even though their total IRAs are smaller. For example, a widow whose only assets are a home, a small bank account, a $100,000 IRA, and who lives off of her Social Security check might need a trust - if she has a daughter who is disabled and receiving government benefits and the mother did not want those benefits to be cut off, with the IRA forced to be drained - which would happen if the daughter received the IRA directly as beneficiary. This lady also wanted the stretch-out to be available so that the IRA funds could last for the longest time possible and supplement her daughter’s government benefits. Therefore, even though she only had a $100,000 IRA, we would advise her to set up an IRA Inheritance Trust. There can be other situations where the Trust will be warranted even though you have less than $150,000 in IRAs. This is the type of issue that your estate planning attorney can address at your initial consultation.

ROLLOVERS

Q: Why isn’t my 401(k) or other company plan permitted to use the income tax stretch-out once my beneficiary receives it?

A: A company plan’s own provisions can override the stretch-out rules provided by the IRS. Pretty much every company plan I know of forces a non-spouse beneficiary (like a child) to take all of the money out of the plan within 5 years of your death, many in as little as one year. The plan Trustee or custodian simply does not want to have the responsibility and expense of maintaining the account for that beneficiary’s remaining life expectancy. This is why, if you have money at your 401(k) or other company plan and you’re already retired, or you’ve already reached normal retirement age under the plan, you may want to seriously consider rolling it over into an IRA, so your family or other loved ones will be able to take advantage of the income tax stretch-out and the tremendous family wealth compounding in future years.

Q: Can I rollover my 401(k) or other company plan to an IRA if I’m still working?

A: This depends on your individual plan provisions and you should probably see a financial advisor who can review them for you. Certain plans still do not permit lump sum rollovers even at retirement. In some plans, they now provide that, if you have already attained the normal retirement age, say 55, even if you’re still working, you may rollout the balance that was in the account at age 55. You need to check with a qualified financial advisor.

Q: Does the IRA Inheritance Trust create a lot more paperwork after I die, such as additional tax returns?

A: For the most part, it’s a fairly easy trust to use since the only asset payable to it is the IRA and, for most beneficiaries, the distributions from the IRA will pass from the Trust to them. Each beneficiary’s Personal Asset Trust portion of your IRA Inheritance Trust will need a taxpayer identification number and will have to file Trust tax returns, but these are very simple and usually cost only about $200 a year, a small price to pay for all of the protections the Trust affords them.

REQUIRED MINIMUM DISTRIBUTIONS

Q: I have been told that if a Trust were named as a beneficiary, then the oldest beneficiary’s life expectancy would be used and then shorten the stretch-out for the other beneficiaries – or worse, cause distributions over only 5 years.  Isn’t there some problem with naming a Trust as a beneficiary?

A: That’s correct for a typical Trust - it’s not a good idea to name your Revocable Living Trust as beneficiary. However, our IRA Inheritance Trust has specifically addressed and solved this problem by carefully following the IRS regulations and by naming each child’s (or other beneficiary’s) Personal Asset Trust (or sub-share) directly as IRA beneficiaries, rather than the IRA Inheritance Trust itself. The IRS has approved this approach in a Revenue Ruling dated back to 2005.

Q: What if the IRS changes its mind about the Private Letter Ruling for the IRA Inheritance Trust or the tax laws change?

A: Remember, the IRA Inheritance Trust is a revocable trust, meaning you can amend (or change) it at any time you wish. I cannot guarantee you that the IRS rules or the laws won’t change in the future, but you can check with your attorney and financial advisor to keep you apprised of any important changes and help you determine if an amendment of your Trust is warranted. This is really no different than with your regular Revocable Living Trust or other estate planning documents. I recommend you meet with your attorney every three years to be sure all of your documents are up to date.

Q: What if I will need to take more than the required minimum distributions (RMD) in my later years in order to support myself - will the IRA Inheritance Trust still make sense for me

A: This is where a good financial advisor can assist you. You’ll always want to plan to have sufficient liquid assets outside your IRAs, as a safety net, if you need more to live on than the IRA required minimum distributions.  If you can clearly see right now that you absolutely have no alternative but to spend down your IRA - and that will happen quickly - then an IRA Inheritance Trust may not be right for you.

Q: If my child inherits my IRA through this Trust and then passes away and it goes to my grandchildren, can those grandchildren use their own life expectancies for determining the stretch-out of their required minimum distributions?

A: No. The first non-spouse beneficiary, here your child, sets the life expectancy for every beneficiary that inherits after him or her. So the grandchildren use whatever remaining life expectancy the parent would have had, according to an IRS table. If you want the grandchildren to use their own, much longer life expectancies and take advantage of the tremendous additional wealth-building opportunity, you should name the grandchildren to receive some or all of your IRA as primary beneficiaries under the IRA Inheritance Trust. I think this is very smart planning, particularly if you can make up the amount not received by your child in other ways, such as through life insurance. When the child receives the life insurance, both estate tax and income tax free, unlike non-Roth IRA distributions, and the grandchildren take advantage of a much longer stretch-out period - so everyone actually comes out better!

Q: What if my daughter doesn’t need or want her portion of my IRA that she inherits under the IRA Inheritance Trust - can she disclaim it so that her child (my grandchild) can then get it and use the grandchild’s own much longer life expectancy to stretch-out the taxable distributions and thereby accumulate more family wealth?

A: Yes. We can build into the Trust the ability of a beneficiary to disclaim or refuse to accept some or all of his or her inheritance, in which case it would then pass down to the next Trust beneficiary. In most cases, our firm even gives the first beneficiary the right to name who that secondary beneficiary will be, such as one or more of their children, and determine how and when those children will receive it. The IRS approved this provision in the 2005 Ruling.

MORE DETAILS FOR MARRIED COUPLES

Q: Does each spouse normally need to get their own IRA Inheritance Trust because we both have IRAs?

A: If there are no children from a prior marriage, it is possible to name the spouse as the primary beneficiary (and the IRA Inheritance Trust as secondary). Here’s the reason why. Typically, if the husband dies first, the surviving spouse rolls over the husband’s IRA into her name and specifies her IRA Inheritance Trust as the new beneficiary, because this gives her the flexibility to continue to use the account and also to change or amend her Trust. For most “blended” couples, each spouse will have their own IRA Inheritance Trust. 

Q: This is my second marriage and my “blended” family includes two children from my previous marriage plus my stepson. In my case, do I alone set up an IRA Inheritance Trust or would you do a Trust for each spouse?

A: If you wish for your surviving spouse to have the use of your IRA, in the event she needs it, but you also want to lock in your IRA to pass to your own biological children when your surviving spouse dies, you will only have an IRA Inheritance Trust for you and name your Trust as your primary beneficiary, rather than the surviving spouse. Your Trust will provide your spouse with the necessary support but she won’t be able to name someone other than your children to receive what’s left when she dies. Your spouse may not have the need for a separate IRA Inheritance Trust unless your spouse also has his or her own IRAs and she likewise wants to lock in the distribution to her children after you die and/or protect it from creditors or divorce.  The cost of the second trust if needed would cost nearly as much as the first, but you can both make sure the other is taken care of and yet know that your own children will ultimately get your separate IRA.

Q: What if I want some of my IRA to go to charity - how does the Trust work then?

A: If you know you want to make a gift to charity at your death, it can be very smart to give your charity part of your IRA, because a charity does not pay any tax on the (non-Roth) IRA monies when they are withdrawn and the monies can go a lot farther than if an individual had received them and then had to pay tax. However, naming a charity to receive some of your IRA through your IRA Inheritance Trust can cause problems and jeopardize the stretch-out for other beneficiaries. If you want a charity to receive some of your IRA, it’s best to name the charity directly as the beneficiary for a percentage share and allow the remaining portion of your IRA to pass through to the IRA Inheritance Trust. If you only want the charity to be a secondary beneficiary, if one of your primary beneficiaries does not survive, that gift should be handled in your regular Revocable Living Trust and funded with assets other than your IRA.  We can help with details on naming charities as beneficiaries.

NEXT STEP

Q: If I want to make sure the stretch is available to my children or grandchildren but in a way that gives them asset protection, what do I do next?                                     

A: If you feel an IRA Inheritance Trust is right for your family, schedule an appointment with an attorney who does these regularly.  We hope you will choose Carpenter & Lewis PLLC.  Let us help you.

Q. What do I need to bring to the attorney to establish an IRA Inheritance Trust?

A:     Please bring the names and dates of birth of your family members and copies of your most recent retirement account statementsWe will ask you questions on what you wish to happen about the timing and distributions at the meeting.

Carpenter & Lewis Estate Attorney Consultation:  For a consultation with one of the estate attorneys at Carpenter & Lewis, please call (865) 690-4997 or you may prefer to send an e-mail to:  contact@carpenterlewis.com.
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