And now we have finally reached the last portion of our spread on protecting your inherited retirement funds. Please read the previous entries from March, April, and May to capture the entire article!

Benefits and Detriments of Creating a Retirement Plan Trust to Be the Beneficiary of an IRA or Qualified Plan

The Retirement Plan Trust, like any estate planning technique, is not a panacea. One size definitely does not fit all. To determine whether a Retirement Plan Trust is an appropriate option for a particular client requires a weighing of benefits against disadvantages.

Retirement Plan Trust Benefits

Establishing a Retirement Plan Trust and naming it as the beneficiary of an IRA or qualified plan can provide a number of benefits. These include:

  • Spendthrift protection – Protecting the individual trust beneficiary from his or her temptation to waste “found money.”
  • Predator protection – Even if the individual beneficiary does not have spendthrift tendencies, there are many out there whose interest lies in separating the beneficiary from their money and property.
  • Creditor protection – Ours is a litigious society in which we never know who is going to be the target of a lawsuit. A trust makes the beneficiary a less attractive “target.”
  • Divorce protection – With the national divorce rate above 50%, it is impossible to determine which marriages will stand the test of time. A Retirement Plan Trust keeps the inherited IRA from being divided or even lost in a divorce.
  • Government benefits protection – As with divorce, whether a healthy beneficiary will suffer some catastrophe that makes him or her dependent on needs-based government programs is unpredictable. Inheriting an IRA can easily disqualify someone from receiving needs-based government benefits until the IRA is exhausted.
  • Providing consistent investment management (often from the participant’s investment advisor).
  • Estate planning.
  • Control over use of the retirement plan/IRA assets (e.g., to fund education, start a business, or buy the beneficiary’s first home or, in the case of a mixed family, to prevent diversion away from the owner/participant’s descendants).

Retirement Plan Trust Disadvantages

The disadvantages of using trusts generally are all applicable to Retirement Plan Trusts. These are: the legal costs to create the trust, the trustee fees to administer it, and the need to file income tax returns if the trust accumulates income; and greater complexity. However, the Retirement Plan Trust can be designed to mitigate these disadvantages, such as by making it revocable until the owner/participant’s death.

The benefits of using a trust generally outweigh the costs, particularly from an asset protection perspective. This is especially true in the context of inherited IRAs, which otherwise have no asset protection.

Retirement Plan Trust Distribution Provisions

The IRS regulations describe two types of trusts that are the beneficiaries of qualified plans and IRAs: (1) Conduit Trusts, and (2) Accumulation Trusts.

The Conduit Trust

The term “Conduit Trust” does not appear in the law or the regulations. It is a term that practitioners use for a particular kind of trust described in the examples given in the IRS regulations. In that example, the trust required the trustee to immediately distribute to the beneficiaries ALL amounts taken from the IRA. This trust is called a Conduit because it serves merely as a vehicle to get the distributions to the beneficiaries and the Trustee has no discretion in the matter beyond deciding how much to take out of the IRA or plan account. The Conduit Trust is an IRS “safe harbor” that automatically qualifies as a “designated beneficiary.”

The compressed brackets of the trust are not a problem because the IRA distribution income is entirely attributed to the beneficiaries. On the other hand, a Conduit Trust is not a good choice for a beneficiary in need of asset protection or remaining eligible to receive needs-based government benefits.

A final advantage of the conduit trust is the opportunity it affords to name non-individuals as successor beneficiaries. In a conduit trust, the “designated beneficiary” test is made only by looking at the first tier of lifetime beneficiaries – the ones who will be beneficiaries on the participant/owner’s death.

The Accumulation Trust

Under an Accumulation Trust, the trustee has the discretion to determine when (and perhaps whether) to make distributions from the trust. That discretion is independent from the requirement to take distributions from the qualified plan or IRA. The trustee may distribute the RMDs and other IRA distributions, but is not required to do so.

With Accumulation Trusts, the key issue is to determine which beneficiaries are “countable” for determining whether the trust qualifies as a “designated beneficiary” and whose life expectancy governs. The regulations tell us that all beneficiaries are countable unless such beneficiary is deemed to be a “mere potential successor” beneficiary, with little guidance as to what constitutes a “mere potential successor.” While there are a number of IRS Private Letter Rulings (“PLRs”) that provide insight into the IRS thinking about accumulation trusts, it must be borne in mind that each PLR is only applicable to the particular taxpayer to whom it was issued.

Having It Both Ways

A recent PLR (number 200537044) gives guidance as to how the attorney team member can draft the Retirement Plan Trust as a Conduit Trust initially, so that we have certainty as to the life expectancy factor, while giving a Trust Protector the ability to “toggle” the trust to an Accumulation Trust, if necessary. This toggle affords the client even more flexibility than does an Accumulation Trust.

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