The reasoning is, because the beneficiary cannot make additional contributions or delay distributions until retirement, it is not a retirement account. There is, in fact, nothing to prevent a beneficiary from withdrawing funds, or even clearing out the account, at any time. As a result, these funds must also be available to satisfy the beneficiary’s creditors during bankruptcy. Following the same logic, an inherited IRA is also subject to divorce proceedings.
This is not great news for parents who have planned to leave large IRA accounts to their children or grandchildren, with the desire to continue the tax-deferred earnings for many more years over their lives.
Fortunately, there is a solution. By using a trust as the beneficiary of the IRA, you can continue the tax-deferred earnings over a beneficiary’s life expectancy and protect your hard-earned savings from the beneficiary’s creditors.
The Key Takeaways
Inherited IRAs are not protected from the beneficiary’s creditors in bankruptcy.
Using a trust as beneficiary can continue the tax-deferred earnings over a beneficiary’s life expectancy and protect these savings from the beneficiary’s creditors.
Using a Trust as Beneficiary of an IRA
Using a trust as beneficiary of an IRA or retirement plan account will let you use the oldest beneficiary’s life expectancy to stretch out the tax-deferred growth. It will let you keep control over when the beneficiary receives distributions, and can protect the asset from the beneficiary’s creditors (including bankruptcy), predators (those who may have undue influence on the beneficiary), irresponsible spending, and divorce proceedings. You can even provide for a beneficiary with special needs without jeopardizing government benefits.
In order for the trust to qualify, it must meet certain requirements, including that a) it must be valid under state law; b) it must be irrevocable not later than the death of the owner; c) all beneficiaries of the trust must be individuals (no charities or other non-persons) and they must be identifiable from the trust document; and d) a copy of the trust document must be provided to the account custodian by a certain date.
Because the trust’s oldest beneficiary’s life expectancy must be used to determine the distributions, many people opt for a separate share for each beneficiary or even a separate trust for each beneficiary. These are called “stand alone retirement trusts” because they are created solely for retirement plan and IRA assets. (A revocable living trust would still be used for other general estate planning purposes.)
What You Need to Know
Planning for IRAs and other tax-deferred savings plans is not something to be taken lightly and not a task to try to master yourself. The laws are complicated, and a simple mistake can be disastrous and irreversible. Because there is often a lot of money involved with these plans, it pays to work with an estate planning attorney who has considerable experience in this area.
A conduit trust requires that all distributions from the IRA or retirement plan must be distributed to the trust’s beneficiary(ies). (The trust is simply a “conduit” from the plan to the beneficiary.) These distributions are not protected from a beneficiary’s creditors and have no asset protection.
With an accumulation trust, the distributions may be kept within the trust instead of being distributed to the beneficiary. Assets that remain in the trust are protected from the beneficiary’s creditors, but any undistributed income kept in the trust will be subject to higher income tax rates than what an individual would pay on the same amount.
A “trust protector” can be given the power to change the trust from a conduit to an accumulation trust. This can be valuable if there is a change in the beneficiary’s circumstances (due to disability, drug problems, etc.), making it advantageous to keep the distributions in the trust.
Your attorney will be able to suggest the best combination of beneficiary designations for both the IRA or retirement plan and your Trust(s). Having these options will let your beneficiaries make good decisions based on the circumstances at that time. For example, if your spouse is in ill health when you die, it may make sense for your spouse to disclaim an IRA so that your children can inherit it and have distributions paid over their longer life expectancies.
It is essential that you take action to ensure that your IRA can’t be seized by your beneficiaries’ creditors. You should call a local estate or elder lawyer to discuss the matter. The attorney must analyze whether a Standalone Retirement Trust is appropriate to protect both your beneficiaries and your assets.