In the Clark v. Rameker decision (2014), the Supreme Court determined that inherited IRAs are not "retirement funds" under federal bankruptcy law. This means that, unlike with retirement accounts, these assets are accessible by potential creditors. It's a situation that may have left many of your clients asking, "What does this mean for my estate planning strategies for my IRAs?"
To help you answer this question, I'll discuss what impact this ruling may have on your clients' trust planning and IRAs, as well as how you can help your clients safeguard their assets and accomplish other estate planning objectives.
The Supreme Court Ruling
The Supreme Court found that inherited IRAs do not constitute protected retirement funds under federal bankruptcy law because the holder:
- Cannot make additional contributions
- Is required to withdraw funds from the account
- Is permitted to withdraw the entire balance of the account at any time without penalty
In light of this, a surviving spouse who inherits retirement benefits is left in a potential gray area:
- He or she may elect to treat the inherited IRA as his or her own, in which case the traditional rules applicable to IRAs apply (e.g., the holder may make additional contributions, the holder is subject to a 10-percent early withdrawal penalty), and the asset is protected.
- The spouse may leave the asset as an inherited IRA, although the Supreme Court's rationale seems to leave open the question as to whether it would be protected from his or her creditors.
Given such uncertainty, how can you help your clients safeguard their assets?
The Role of Trust Planning
One option your clients can use to protect their beneficiaries from creditors is to name a trust as beneficiary. Correctly drafted trusts have long been effective in accomplishing planning strategies, including:
- Creditor protection (for the grantor and the trust beneficiaries)
- Divorce planning (for mixed families or children)
- Spendthrift protection (to control a beneficiary's access to funds)
- Special needs planning (to protect a beneficiary's right to government benefits)
- Planning for minor beneficiaries (to control distribution of assets without the use of a guardian or custodial account)
Unfortunately, estate planning with IRAs and trusts isn't always a "have your cake and eat it too" scenario. The crux of the matter comes down to:
- Balancing the required minimum distribution (RMD) options available to the trustee
- Related income tax considerations
- Ability to provide asset protection
In any case, using a trust to accomplish your clients' planning goals requires multifaceted consideration of interests that are often competing. To better understand the options available, let's examine how different kinds of trusts benefit certain objectives.
If the trust satisfies the IRS look-through trust rules, the trustee may take RMDs over the life expectancy of the oldest individual beneficiary. One of the primary requirements is that all of the trust beneficiaries must be identifiable individuals.
In contrast, if individual beneficiaries are directly named as the IRA beneficiary, they may set up their own IRA beneficiary designation accounts for their shares and take RMDs over their own life expectancies.
It's important to note that a look-through trust can't exercise the spousal rollover option. For example, if a surviving spouse is the income beneficiary with children as remainders, upon the surviving spouse's death, the trust must continue its RMDs based on the surviving spouse's life expectancy. As a result, the IRA assets will be consumed more quickly.
Although the IRS RMD rules govern the timing of distributions from an IRA to a trustee, the timing of when assets are distributed from the trustee to the beneficiaries depends on the kind of look-through trust in place. Let's explore the two most common types: conduit trusts and accumulation trusts.
Conduit trusts. A conduit trust is a safe harbor look-through trust in which the primary beneficiary is the only recognized beneficiary for RMD purposes.
- The trustee must distribute all RMDs to the beneficiary as soon as he or she receives them from the plan.
- There's no authority for the trustee to accumulate plan distributions in the trust.
As the trustee must distribute all plan distributions, these assets are not subject to the trust's higher tax rates. Notwithstanding the income tax advantages, the lack of trustee authority to accumulate plan assets does not support planning for a client whose primary goal is asset or spendthrift protection.
Accumulation trusts. These trusts are not safe harbor trusts and may or may not pass the look-through trust rules.
- This trust provides the trustee discretion to accumulate plan distributions inside the trust, rather than distributing immediately to the beneficiaries.
- Some or all of the potential remaining beneficiaries will be included under RMD rules.
- For stretch purposes, RMDs are distributed over the life expectancy of the oldest beneficiary.
Also, assets retained in trust may enable creditor or spendthrift protection for:
- Beneficiaries and their descendants from potential claims resulting from divorce, poor financial management, or other situations
- IRA beneficiaries who live outside of states that have exemptions for inherited IRAs
Because the trustee is not required to pay out the full plan distribution to the beneficiaries, it's important to analyze the impact of trust income taxation. Amounts remaining in the trust may be taxed at a higher tax rate. Another downside to having the IRA payable to an accumulation trust is that the surviving spouse cannot treat the IRA as his or her own.
Considering the Supreme Court's decision, the complexity of the IRS RMD rules, and the complicated tax concerns for trusts, many attorneys now recommend the use of a stand-alone trust. This trust comes in many forms, including conduit and accumulation trust provisions. But the stand-alone trust earns its name because it's a separate trust document:
- Planning for IRA assets is kept separate from the client's other estate planning objectives, thus minimizing the risk that these estate planning objectives will interfere with the IRS RMD rules for retirement benefits (and vice versa).
- A well-drafted stand-alone IRA provision can meet the requirements of a designated beneficiary trust while also being easier for the custodian and trustee to read, understand, and implement.
The Bottom Line
The use of trusts with IRAs has always been a complex planning area for many clients to digest, and navigating IRS rules may be complicated. But a trust can make sense if asset protection is a high priority for your client. A trust that incorporates the client's other planning objectives is an even better bonus.
To be sure, it's important for your clients to work with their attorney if an IRA is anticipated to be a trust asset, as well as to understand the potential consequences of leaving retirement funds outright to beneficiaries rather than to a trust. The bottom line is that there may be competing goals that you and your clients should examine before they decide on the appropriate beneficiaries for their IRA assets.
Have you discussed trust planning and IRAs with your clients as a means of protecting assets? Has the Clark v. Rameker decision affected your estate planning strategies? Please share your thoughts with us below!