Mat Sorensen


May 12, 2015

I’ve had a number of inquiries lately about when to use a separate IRA Trust as the beneficiary of your IRA. IRAs, like bank and savings accounts, are passed on to the heirs of the deceased IRA owner according to the beneficiary designation form that is on file with the IRA custodian. This form will typically list a spouse as beneficiary and then maybe the children of the IRA owner as the contingent beneficiary. In the event that the spouse has already passed away, the IRA would then be inherited by the children listed as contingent beneficiaries. Many individuals with large IRAs would like their IRA accounts to pass on to their children or grandchildren according to the terms of a trust document whereby the funds, and their heirs access to the funds, can be controlled over time. For example, if the IRA owner were to die and pass on the IRA account to a minor beneficiary then that minor could withdrawal the entire IRA upon their 18th birthday. Not only is a large sum of money in the hands of a teenager a bad idea, but if the child takes a distribution of the entire sum then it will cause a significant tax liability to the 18 year-old heir that could have otherwise been stretched out over the heir’s lifetime if the IRA has been passed down and distributed over time according to the terms of the the IRA Trust. In other words, the legacy left to the child is eaten up by poor tax planning and teenage decision making. When an individual (or properly drafted trust) inherits an IRA, that IRA must be distributed according to the required minimum distribution rules (“RMD”). These rules allow a spouse to roll over the IRA to their own IRA and that is common option for spouses who inherit an IRA. However, children or other beneficiaries who inherit an IRA cannot roll the IRA over to their own IRA but do have the option, if exercised properly, to take the annual RMD over the heirs lifetime. This is a great option for younger heirs (e.g. children or grandchildren) of IRAs as it allows them to keep the IRA in a tax deferred or tax free account for a longer period of time and allows the IRA to continue to stay invested. That being said, just because an IRA heir is better off taking the IRA and the RMD over their own lives doesn’t mean that they will actually do so as many IRA heirs simply take a lump-sum distribution and subject themselves and their inheritance to significant up-front tax . As a result, many IRAs are better off being distributed over time and an IRA Trust can be used to properly plan and restrict the IRA such that the distributions do occur over time.

While the IRA Trust is great for planning the distribution of a large IRA over time, I have seen it marketed improperly to clients and as a result I wanted to clear that air regarding a couple of myths I have seen regarding IRA Trusts.

Myth #1. IRA Trusts do not give an IRA owner the ability to stretch out their IRA any longer than could occur if the IRA named individuals on their IRA beneficiary designation. I recently had a client ask me about an IRA Trust. This client was told that the IRA Trust would allow the IRA owner to pass on their IRA to their children and that the IRA would not need to be distributed within 5 years of the IRA owner’s death but rather could be “stretched-out” and distributed over the lifetime of inheriting child. They were told that the only way to accomplish this “stretch option”, whereby distributions from the IRA occur of the heirs lifetime, was through an IRA Trust. This unfortunately is a half-truth because the IRA Trust is not providing or allowing the “stretch” option. In actuality, the so called stretch option can be achieved simply by naming the younger heirs on the beneficiary designation form. As a result, the IRA Trust should not be set up solely because the IRA owner would like to stretch out the IRA to their heirs. As discussed previously, the IRA Trust can be drafted to ensure that the IRA is actually stretched out and not drained by an heir but it is not the Trust itself that is giving the heir this option. The laws regarding IRAs and RMD already allow the younger heir to inherit the IRA and have it distributed over their lifetime regardless of whether the IRA is inherited via an IRA Trust or not.

Myth #2. IRA Trusts Should Not Cost $5,000. I had a client ask about setting up an IRA Trust and this client was quoted a little over $5,000 by another attorney simply to establish an IRA Trust. While an IRA Trust is its own stand-alone document, it should not cost more than a couple thousand dollars to establish and we can handle them for even less than that. Unless you have a very significant IRA (over a few million dollars) and you have some pretty unusual plans for distributing your IRA, an IRA Trust can be set up at a reasonable fee.

Now that we have the myths out of the way, I’d like to make note of two important facts to know about IRA Trust.

Fact #1. IRA Trusts are Unique and Take Special Planning. While an IRA Trust doesn’t need to cost $5,000 to set-up, it also shouldn’t be set up for $99 . There are special rules and requirements for IRA Trusts and the Trust need to be established such that it is a “see-through” trust under law. This requires some special drafting and planning in the estate plan process. While a well drafted revocable living trust should contain a clause regarding IRAs and while it will contain “see-through” trust language for the IRAs, that alone should not be relied on for those persons with large IRAs who would like their IRA to be inherited by younger heirs and distributed over time. As a result, I recommend having a separate IRA Trust to ensure that the IRA is properly distributed and managed upon your death.

Fact #2. Your Spouse Shouldn’t Be an Heir Under an IRA Trust. Spouses should not receive an IRA inheritance through an IRA Trust. Rather, in most situations, they should be listed on the beneficiary designation form of the IRA. The reason for this is simple, spouses can directly inherit and IRA and can roll their deceased spouses IRA over to their own IRA. This spousal rollover isn’t possible with the IRA Trust and in general, the IRA Trust doesn’t need to be used to control distributions of an IRA over time to a spouse in the same way it can be used to distribute an IRA to a child or grandchild.

Fact #3. If Your IRA Is the Be Inherited By Multiple Children Then Special Planning Should be Taken. If you are planning to have your IRA be inherited by multiple children or grandchildren, then special attention must be taken as the rules for Trusts for IRAs states that the RMD rules of the oldest living child listed on the Trust will be used as the RMD for all beneficiaries. This is troublesome for a younger child or grandchild as they could otherwise “stretch-out” their share of IRA distributions over time but if proper planning and drafting doesn’t occur. They may be forced to take distributions from the IRA under a compressed and accelerated RMD schedule based on the oldest living heir that is part of the Trust. Consequently, it is highly recommended that you take addition planning steps to ensure that the IRA is distributed to each child or grandchild through a properly drafted trust so that they can use their own younger life-time in stretching out the IRA and its tax deferred benefits.

In sum, an IRA Trust is a great tool to ensure that assets from an IRA are passed on in the most tax-deferred manner possible. The IRA Trust protects the heirs from themselves, and their potential impulse to drain the IRA, and also protects the IRA from the creditors of the IRA’s heirs. As a result, an IRA Trust should be considered as an additional item for persons with large IRAs who intend to pass on their IRAs or other retirement accounts to children or grandchildren.

By: Mat Sorensen, Attorney and Author of The Self Directed IRA Handbook

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