Careful wording of IRA beneficiary designations can put a client’s beneficiaries in a position to grow those funds income tax-deferred (or income tax-free, in the case of a Roth IRA) for an extended period of time. Use of the named beneficiaries’ life expectancies, in place of the decedent’s, allows us to create this extra time to grow the assets. Depending on the size of the IRA, the compounding of interest over the extended period of time can have dramatic effects.
An IRA can be a wonderful wealth building tool, provided that your clients’ heirs understand the potential for growth and are patient enough to let the IRA work for them. Known as a “Stretch IRA” strategy, many of us have advised clients of this planning option. One concern clients often have about implementation of this strategy is uncertainty regarding their heirs’ patience and financial foresight. The planning chain is only as strong as its weakest link. So, will those heirs have the self-control and wisdom to leave the money in the IRA and let it work?
There are no early withdrawal penalties on an inherited IRA so an heir could easily blow the stretch. For those worried about their heirs’ financial stability or self-control, a separate IRA trust can help assure that those heirs get the right guidance and take the long view.
There are many reasons that a separate trust just to receive retirement plan assets makes sense. Many attorneys think it can be done with only one master trust, there are many benefits of a separate trust established only to hold retirement plan/IRA assets after death. Just a few of those benefits are:
- A separate trust increases the likelihood that the trusts will survive later planning by another attorney who does not understand or appreciate the complexities of estate planning with IRAs. Attorneys routinely revoke, restate or amend old trusts, but would take more care in doing so with a specially labeled trust.
- A separate trust increases the likelihood of a successor trustee appreciating the complexities of administering separate trusts with IRAs and retirement plan assets. This is especially true of individual trustees where this is more of a problem.
- A separate trust increases the likelihood of the successor trustee not overlooking RMD issues, especially when the decedent was already in pay status.
- A separate trust increases the likelihood that debts, taxes and expenses will not and cannot be paid from the retirement plan trust, which helps to avoid losing Beneficiary Designation status. For the many attorneys who do not often customize their tax payment and apportionment clauses, this is an advantage.
- A separate trust allows the Will and/or Living Trust to be simpler and less confusing to the client. This is especially true for the engineers and other clients who insist on understanding every word and paragraph of the trust.
- A separate trust allows the main Will and/or Living Trust to easily name older beneficiaries, charitable beneficiaries and allow for normal marriage and adoption provisions. It allows the main trust to contain broad general and limited powers of appointment, and other clauses that permit great flexibility – clauses that are problematic in a trust designed to hold retirement plan assets.
- A separate trust allows the living trust to have the broadest spendthrift, no-contest, incentive/disincentive or other clauses that act to restrict or eliminate income payouts to a beneficiary, which would be problematic in a trust designed to hold retirement benefits.
- A separate trust simplifies tracing of the immediate payout of RMDs out to the beneficiary that is required in a conduit trust.
- A separate trust allows clearer directions to trustees to exhaust assets in order of tax preferred priority without worrying about diversification rules overriding tax preferences. For instance, discretionary distributions come out of the trust holding ordinary assets first, then retirement plan assets, then IRAs, then Roth IRA/401(k) trust assets.
- A separate trust makes later amendments simpler, when tax law or retirement asset mix changes the dynamics of the planning. Especially where trusts are designed to potentially accumulate retirement plan assets (aka accumulation trusts) – the state of the tax law is ever evolving with PLRs still coming out to explain the 2002 Regulations. Changing just the beneficiary designation or separate trust years later when things change is easier than reworking the entire master trust.
Many of the problems noted above can also be solved through use of a trusteed IRA, which can have even greater administrative simplicity and advantages. However, trusteed IRAs are usually only available for larger accounts and not through all financial advisors. They do not work for working clients with significant retirement plan assets that cannot be rolled over. They may present problems for clients who do not want to change IRA custodians or their current investment advisor. Finally, they can’t provide the maximum restrictions on beneficiaries necessary for special needs trusts and other extreme situations.
For many clients, the idea of a separate trust for IRA/retirement assets makes sense. In those situations, a discussion among you, your client, and a qualified estate planning attorney should yield a result which speaks to all your client’s planning goals while keeping IRA assets intact (and benefiting future generations) for years to come.