IRA trust: An estate-planning tool that stretches out distributions

When concerns exist about the money management skills of a child, a trust can protect assets and offer a stable flow of income.

This summer, the United States Supreme Court issued an opinion that held inherited Individual Retirement Accounts do not receive protection in a bankruptcy filing. This means that a child who has a business fail could lose money handed down in an inherited IRA. Another concern for many individuals is that a beneficiary may immediately spend down the inherited IRA account.

One way to avoid these situations is through a trust that limits the amount a beneficiary can access from the inherited IRA. A trusteed IRA, for example, puts a limit on withdrawals based on the minimum annually distribution the Internal Revenue Service requires an heir take out. Remaining investments continue to grow either tax-deferred, or in the case of a Roth IRA tax-free.

The stretch IRA becomes a way to help children get a jump on their own retirement savings. For instance, a $100,000 IRA account inherited at age 42 could grow two or three times in value over the individual’s life. Cashing out the IRA on the other hand might mean taxes eat into the inheritance leaving as little as $60,000 to the child.

Risks with using a trust

It is important to speak with an experienced Massachusetts estate planning attorney when contemplating this approach.

There are two main risks involved. In some cases, a trust might pay higher taxes than the heir might, because tax rates for trusts are usually higher than individual income tax rates. The other risk is that the IRS does not view the trust as a “conduit” or “see-through” trust and does not allow stretched out withdrawals. This could happen when a listed beneficiary of a trust is not a person, but a charity since there is no life expectancy to use for determining the stretched-out withdrawals.

In general, inherited IRAs must be distributed completely (i.e. liquidated) within five years of when the original owner dies.

One possible drawback with controlling distributions is that heirs do not have the flexibility to access a larger portion of the funds in special circumstances. An heir who would like to access money to pay for a wedding might not be able to especially when the trustee is a generic asset-manager.

Beneficiary designations

Remember that provisions in a will rarely control the distribution of most IRAs, including both private and employer-sponsored 401(k) and 403(b) plans. Beneficiary designation forms are common on these accounts. Often these forms are only one page and completed at the start of employment.

It is therefore important to review beneficiary-designation forms and name the “conduit” or “see-through” trust as a beneficiary on the original owner’s IRA.

As part of any comprehensive estate planning process, review of beneficiary designations is crucial especially after the birth of a child, divorce or lose of a loved one. An IRA may be one of the largest assets of an estate and an estate-planning attorney can explain taxation issues as well as the benefits of stretching the IRA through a trust.

Keywords: Retirement accounts, beneficiary designations, estate planning