One of the most challenging roles of parenting is finding the proper balance between protecting children too much and not enough. In the early years, we cover electrical outlets, protect household edges with soft bumpers, and spend hours analyzing all the safety features of car seats. Parental protection then evolves to monitoring what our children access on the Internet or conversations about the dangers of drugs and alcohol. Of course, this protectionism eventually loosens up so that by the time child three or four arrives, we are only concerned if the large piece of week-old hot dog the toddler just ate from under the couch was in the dog’s mouth for more than four seconds.
There is a similar balance of protecting too much and not enough that we face when it comes to planning for our kids if we are no longer around during their childhood or early adulthood. Yet for all of the attention that we devote to keeping our children safe, the unfortunate reality is that many of us either ignore these decisions by failing to construct an estate plan that properly addresses our largest assets or we take the time to draw up a will that facilitates the distribution of assets but really does not provide any protections. The former scenario is analogous to skipping a car seat, altogether. The latter scenario is more like buying an expensive car seat with all the safety bells and whistles but failing to buckle in the child that sits in it.
We hope that our children are never subjected to a dangerous car crash but most parents take the important precautions to protect children in the event of such an unfortunate occurrence. We also hope that our children never face the prospect of losing their parents at a young age but it is critically important to prepare for an occurrence, however remote the likelihood. Consider the scenario where six or seven-figure life insurance proceeds, savings, and home equity proceeds fall into the lap of an 18-year old child without any guard rails or bumpers. Consider the mistakes that most college-aged students with a huge financial windfall would likely make.
I recently interviewed Atlanta-based estate planning attorney, Tim Curtin, about one key aspect of preparing an estate plan and protecting young children – the complex choices of naming a trust as beneficiary of an IRA or retirement plan. As detailed in this prior posting, too many people make hugely consequential and irreversible mistakes when naming the beneficiaries for their retirement accounts. Given that IRAs, 401(k) plans, and other retirement plans comprise the bulk of investment savings for most mid-career professionals and that the common mistakes of a child beneficiary inheriting these accounts could have dramatic detrimental impact, this is a critical topic for mid-career professionals to spend time addressing. The following is a summary of my conversation with Tim about this topic.
What are the disadvantages to naming young children as IRA or retirement plan beneficiaries, without a trust?
- Unencumbered access. Any child who directly inherits a retirement plan has immediate access to all funds in the retirement account upon turning 18 or 21 (depending on the state), regardless of what any last will and testament says. While this can be a benefit, we rarely find parents that want for their young child to have unencumbered access to 6-figure accounts before heading off to college.
- Dramatically unfavorable tax treatment. The potential loss in lifetime tax savings from an uninformed 18-year old immediately distributing a retirement account rather than exploiting the tax-favorable “stretch” option is enormous. Anyone sweating over the modest time and dollar costs of creating an estate plan should consider that the excess tax costs and opportunity costs of a $500,000 inherited retirement account distributed outright to an 18-year old rather than by way of a stretch IRA exceeds $11 million over a lifetime[i].
- Subject to creditor claims. The 2014 Clark v. Rameker Supreme Court ruling made clear that inherited IRAs, unlike regular IRAs, are not protected from creditor claims in bankruptcy when left outright to a non-spouse beneficiary[ii].
Why use a trust as IRA or retirement plan beneficiary?
- Asset protection. A trust provides protection from creditors that an inherited IRA does not. Assuming that an inherited IRA is left to a third party trust and the beneficiary or beneficiaries have limited control of the trust assets, the inherited IRA retains robust asset protection provided by the trust.
- You appoint a trustee to oversee IRA assets. Since minors cannot legally own property, someone must be appointed to oversee assets until a minor beneficiary reaches the age of majority (18 or 21). This means that in many cases, the probate or surrogates court appoints a conservator to oversee the IRA – and this person may not be who you would have chosen. When an IRA passes to a trust instead of outright to a minor beneficiary, the trustee named in the trust becomes the one to oversee IRA assets.
- Favorable tax treatment. Properly naming a trust as beneficiary of a retirement account can ensure that the inherited account qualifies for the most tax-favored distribution schedule, deferring taxes as long as possible (or, in the case of an inherited Roth account, retaining the benefit of tax free growth as long as possible). Alternatively, leaving an IRA outright to a beneficiary can result in irreversible and painful damage. One mistake, either because of bad advice, no advice, or just ignorance can lead to immediate taxation and the lost benefit of tax deferred or tax free growth.
- Protection from mistakes. For a number of reasons, it may not be appropriate for a college-age child or even someone in their 20’s or 30’s to inherit a large 6-figure retirement account without any guardrails. Naming a trust as retirement plan beneficiary for a large retirement account can allow for the targeted beneficiary to have access to the funds over time, rather than all at once.
What are the drawbacks to naming a trust as beneficiary of a retirement plan or IRA?
The biggest hindrance to using a trust as beneficiary is simply the cost of establishing the trust. However, for people who are already creating or updating estate documents, the cost of adding language so that a testamentary trust (a trust that is established upon death according to the deceased’s will) qualifies as a proper look-through retirement plan beneficiary should not be significant. In fact, many good estate attorneys already have the necessary “look-through” language in their documents so that there is no additional expense.
My will creates a trust when I die. Should I name this trust or my estate as beneficiary of my retirement accounts?
Regardless of how well drafted your will may be, naming your estate as beneficiary has the same result as not naming a beneficiary when it comes to the unfriendly tax payout terms. Alternatively, naming a testamentary trust created by your will as beneficiary can be a good solution but “you have to be really careful”, says Tim.
In order for a trust to qualify for the favorable look-through tax treatment, it has to meet four criteria outlined in the internal revenue code. The most challenging of these four criteria is the requirement that the beneficiaries of the trust must be identifiable as designated beneficiaries. Importantly, this means that the trust beneficiaries have to be living individuals so a charitable beneficiary (even one with a small fractional interest) named in the trust can destroy the look-through treatment. This also creates problems for a trust where the trustee has authority to name additional beneficiaries in the future since those beneficiaries are not identifiable in advance.
One more important piece of trust language to consider is how the trust deals with required minimum distributions to be annually paid from the IRA or retirement account. Most of the wills we see do not have language that specifically requires minimum distributions to be passed out of the trust to underlying income beneficiaries. There may be valid reasons for this absent language such as a desire to give the trustee additional control. However, any trust that permits the trustee to accumulate IRA distributions or simply does not mandate the required distributions be paid to the beneficiaries is considered an accumulation trust (rather than a conduit trust, where IRA distributions are forced out to identifiable beneficiaries).
One potential drawback of an accumulation trust is that the beneficiary language has to be properly drafted to avoid highly unfavorable tax treatment. Without proper drafting to restrict beneficiaries and accommodate mandatory distributions, a retirement plan that uses an accumulation trust as beneficiary may be required to payout over an accelerated period – destroying advantages of the stretch IRA. Moreover, income that accumulates inside the trust is subject to compressed trust tax brackets where the highest tax bracket starts at $12,400 of income (2016) versus $466,950 for a married couple.
What it all means
A lot more could be said about this topic. This article only scratches the surface of the the complex look-through treatment of trusts for tax purposes and does not even address setting up independent trusts before death (not upon death) to serve as retirement plan beneficiaries. The key takeaway is that every parent who intends to leave signifiant IRA or retirement plan assets (>$250,000, according to Tim’s opinion) to a child or grandchild under the age of 25-30 should strongly consider utilizing a trust that is properly equipped for such purpose. It is a relatively easy decision and low-cost solution that way too many parents overlook to their children and grandchildren’s potential detriment.
[i] The ‘Stretch Roth IRA’ illustration assumes that a $500,000 Roth account is distributed based on minimum distribution rules for an 18 year old beneficiary with Roth assets growing at a pre-tax return of 7.0% and non-Roth assets growing at an after-tax rate of 5.5% ‘Non-Stretch Roth IRA’ illustration assumes a $500,000 Roth IRA is immediately distributed and grows at the same 5.5% after-tax rate.
[ii] Seven states have bankruptcy exemptions that exempt inherited IRAs from creditor claims in bankruptcy.