If you are like many mid-career professionals, then your retirement accounts may comprise an enormous portion of your net worth. To the delight of estate planners and clients, qualified retirement accounts (401(k)s and IRAs) receive favorable treatment upon the owner’s death in a few areas. First, retirement accounts are non-probate assets. They have their own beneficiary designations, which determine to whom they pass, rather then going through the Probate Court process. Second, the designated beneficiaries of a retirement account can elect to stretch the Required Minimum Distributions (RMDs) over their own lifetimes, thereby realizing huge tax deferral savings.
However, probate and tax avoidance are not the only aspirational goals of estate planners. They also strive to protect clients’ assets from their children’s financial woes, usually through the use of a trust. But there are stringent rules regarding the use of trusts for retirement accounts.
When an improperly drafted trust is named as the beneficiary of a retirement account, it could accidentally trigger an IRS requirement that the account be distributed within five years of the decedent’s death. Furthermore, even if the trust is correctly drafted, it will normally require that the retirement account be distributed over the life expectancy of the oldest potential beneficiary, even when some beneficiaries are much younger. In both these scenarios, the tax deferral benefit is greatly reduced.
In order to defer distributions (and thereby taxes) over each beneficiary’s own life expectancy, each beneficiary must have a separate trust designated as the beneficiary of their share of the retirement account. Even still, these separate trusts will only achieve the maximum stretch in certain circumstances. First, the trust will receive the maximum stretch if all RMDs received by the trust are immediately distributed to the trust beneficiary. This conduit trust guarantees tax deferral, but it does nothing to protect the distributions from the beneficiary’s creditors. Alternately, if the trust accumulates the RMDs, then it can protect them from the beneficiary’s creditors. However, the tax treatment of this accumulation trust is uncertain. It may still receive the maximum tax deferral, if there are no potential beneficiaries with a life expectancy longer then the primary beneficiary of the trust. Unfortunately, this result can be difficult to obtain, and may thwart the client’s other estate planning goals.
One novel solution is to designate separate conduit trusts as the beneficiaries of a retirement account, but also give a Trust Protector the power to change them into accumulation trusts in the event that a beneficiary encounters financial trouble. This structure guarantees the maximum tax deferral so long as the beneficiary has no asset protection concerns. Then, if/when such concerns arise, the Trust Protector can toggle the provisions of the trust so that its assets are beyond the reach of creditors.
Confused? You should be. This is very complicated stuff, and should only be done by an experienced estate planning attorney. If it is done properly, then even a modest retirement account can be worth millions when deferred over the life expectancies of children or grandchildren.