It is pretty safe to say that almost everyone has heard of an individual retirement account (IRA), but not many people know about an IRA beneficiary trust. Part of this may be that IRAs were not originally designed to be wealth transfer vehicles for anyone other than a surviving spouse. However, in 2003, the IRS issued regulations permitting a non-spouse beneficiary who is inheriting an IRA to “stretch out” the taxable Required Minimum Distributions over his or her own lifetime. This not only applies to traditional IRAs, but also to Roth IRAs and 401(k), 403(b), SEP and SIMPLE plans, which I will refer to herein generally as IRAs.
The ability to stretch out the distributions allows for the compounding of the investments inside the IRA, tax free, over a much longer period of time, thus, substantially increasing the amount of money that is ultimately distributed. This makes an IRA an attractive and efficient way to pass significant wealth from one generation to the next, even when just starting with a moderately valued IRA. For example, a $200,000 IRA inherited by a 40-year-old could be worth in excess of $1 million over his and his children’s lifetimes. Furthermore, now that the estate tax exemption amount has increased significantly, obtaining maximum income tax results is a prime planning objective that we all need to keep in mind.
To accomplish this, one should consider using a specifically designed standalone IRA beneficiary trust, separate from a living trust. Why? Because of the complexities imposed by the IRS regulations on when a trust is considered a “designated beneficiary” and thus eligible for the stretch out, a living trust with its usual administrative provisions often cannot meet the requirements set up by the IRS, or it is at least very difficult to “firewall” provisions within the living trust that meet the requirements from other provisions of the living trust that do not. It is also easier for the IRA custodian or administrator to understand and implement the provisions of standalone trust rather than IRA provisions buried within a living trust.
Why a trust? Naming individuals as beneficiaries exposes the IRA investment to a host of potential problems. There is a high probability that the beneficiary will “blow up” the stretch out by taking a lump sum distribution rather than the Required Minimum Distributions and being subjected to the entire IRA being taxed at that time. Also, the assets in the inherited IRA generally are not protected or exempt from creditors. There are risks of lawsuits and creditors seizing the IRA assets, including divorce. Plus, there the potential issues of the beneficiary’s poor money management skills, or the beneficiary being elderly, too young or disabled and unable to manage the money, to name a few. A trust can provide the means to minimize or eliminate these risks.
A standalone IRA beneficiary trust is an important estate planning strategy. It is not only specially designed to meet the IRS requirements for a designated beneficiary trust, it will also ensure the stretch out and may provide protection against the most common problems that may occur when an individual is named as beneficiary.