INTRODUCTION
The United States Supreme Court in a 9-0 unanimous ruling held that an inherited IRA is not protected in bankruptcy under federal law.[1] Heidi Heffron-Clark inherited an IRA from her mother in 2001 and filed for bankruptcy nine years later. The court held that the IRA was not shielded from her creditors, because the funds were not earmarked exclusively for retirement. The Supreme Court indicated that creditor protection does not apply to inherited IRAs for a number of reasons:
- Beneficiaries cannot add money to an inherited IRA like IRA owners can to their accounts;
- Beneficiaries of inherited IRAs must generally begin to make Required Minimum Distributions (RMDs) in the year after they inherit the accounts regardless of how far away they are from retirement;
- Beneficiaries can take total distributions of their inherited accounts at any time and use the funds for any purpose without a penalty. IRA owners must generally wait until age 59-1/2 before they can take penalty-free distributions.
The court held that inherited IRAs do not contain funds dedicated exclusively for use by individuals during retirement. As a result, the favorable bankruptcy protection afforded to retirement funds under the Federal Bankruptcy Code does not apply.
The court did not rule on whether a Spousal Rollover IRA is protected from creditors. Like other IRA owners, if the money is rolled into their own IRA, they may have to pay a 10% early-withdrawal penalty if money is taken before age 59-1/2. If the money is not rolled over into the Spousal Rollover account, then it would appear that the assets will not be protected in bankruptcy.
A way to safeguard IRA assets from creditors is to name a trust as beneficiary of the IRA.
TRUST AS BENEFICIARY
The best practice is to name a standalone retirement trust as beneficiary for IRAs and other tax-deferred conduit accounts. Naming a beneficiary outright has several disadvantages:
- The money could be available to the beneficiary’s creditors, spouse, or ex-spouse.
- A young adult or even older beneficiary may be tempted to take out larger distributions or even cash out the entire account.
- If the beneficiary is a spouse, the spouse would be able to name new beneficiaries.
- If the beneficiary has special needs, the IRA could cause a loss of government benefits.
- If the beneficiary becomes incapacitated, a guardian would have to be appointed for the beneficiary.
- If the beneficiary is a minor, distributions will need to be paid to a guardian; if no guardian has been appointed, one will have to be appointed by a court.
♦ IRA Trust Advantages. If IRA monies are left directly to heirs, the funds may be squandered by the heirs, defeating any benefit of long-term tax deferral benefits. In addition, if the heir is divorced, the IRA funds may be subject to claims of the non-heir spouse. Depending on state law, the IRA funds may also be vulnerable to claims of creditors.
Naming a trust as beneficiary provides more control. A trust can be drafted to protect the assets from a beneficiary’s creditors and even from the beneficiary’s own poor choices. In the event the beneficiary has special needs, the trust can be drafted to protect the beneficiary’s entitlement to government programs. Finally, no guardianship proceeding is needed upon the beneficiary’s incapacity. A separate trust designed specifically to control the IRA is recommended. It is best that the trust not be part of a revocable living trust or any other trust. A “standalone retirement trust” is preferred.
♦ Professional Trustee. When an IRA is paid to a standalone retirement trust or any other trust, it is important to consider a professional trustee. The rules regarding inherited IRAs are complex and family member trustees are often unfamiliar with them. This could cause a loss of important tax benefits.
♦ Income Tax Rates. To the extent that distributions are retained by the trust, the separate rate schedule for trusts and estates is applied.[2] These rates are significantly higher than the tax rates for individuals.
If the IRA distribution is distributed by the trust to trust beneficiaries, the trust receives an income tax deduction. To the extent that the trust beneficiary, who is a U.S. citizen or resident, has the unlimited right to take retirement benefits out of the trust, the trust is a “grantor trust” and distributions are taxed at the beneficiary’s rate rather than the trust rate.[3]
♦ Trust as Designated Beneficiary. A trust may qualify as a designated beneficiary. This is important in order to preserve the ability to stretch the required payments from the IRA out over the lifetime of the beneficiary. In order for a trust to qualify, there is a four-pronged test:
- The trust must be valid under state law or would be but for the fact that there is no corpus.[4]
- The trust is irrevocable or will, by its terms, become irrevocable upon death of the IRA owner.[5]
- The beneficiaries of the trust are also beneficiaries of the IRA and they are identifiable.[6]
- The trust documentation must be provided to the Plan Administrator.[7]
The trust documentation includes the following:
- Required Minimum Distribution (RMD) Prior to Death. If the IRA owner designates the trust as the beneficiary of the entire benefit and the IRA owner’s spouse is the sole beneficiary of the trust, the spouse can be treated as the sole Designated Beneficiary if the employee either (a) provides the plan administrator with a copy of the trust instrument and agrees that if the trust instrument is amended at any time the IRA owner will, within a reasonable period of time, provide the plan administrator with a copy of each such amendment, or (b) provide the plan administrator with a list of all beneficiaries of the trust (including contingent and remaindermen beneficiaries with a description of the conditions of their entitlements sufficient to establish that the spouse is the sole beneficiary) and certifies that to the best of the IRA owner’s knowledge, the list is correct and complete and agrees to furnish the administrator with any amendments within a reasonable period of time.
- Required RMD After Death. The IRA owner must either (a) provide the plan administrator with a final list of all beneficiaries of the trust (include contingent and remaindermen beneficiaries with a description of the conditions of their entitlement) as of September 30 of the calendar year following the calendar year of the IRA owner’s death and certify that to the best of the trustee’s knowledge, the list is correct and complete and agree to provide a copy of the trust instrument on demand, or (b) provide the plan administrator with a copy of the actual trust document.
If an IRA owner has designated a trust for the sole benefit of his/her spouse and the terms of the trust are such that the spouse is considered the IRA owner’s sole beneficiary for minimum distribution purposes, the minimum distributions to the IRA owner are determined based on the IRA owner’s and spouse’s actual joint life expectancy.
♦ Trust Beneficiaries as Designated Beneficiaries. If a trust is the beneficiary of an IRA, separate account treatment for benefits is prohibited even if the trust terminates immediately upon the participant’s death and is divided into separate shares or sub trusts.[8] If separate account treatment is an important goal, the separate accounts must be created in the beneficiary designation form and the separate accounts must be left directly to the different beneficiaries. If the trust is designated as beneficiary, the required distributions will be based on the life expectancy of the oldest beneficiary of the trust.
In order for benefits payable to a trust to be treated as separate accounts, there are two requirements:
- There must be actual separate trusts that are created at or before Participant’s death (benefits payable to a single trust cannot be treated as “separate accounts” under any circumstance), and
- Benefits must be divided, at the Plan level, into separate accounts payable to those separate trusts by the December 31 deadline. This means that the division of the IRA into separate accounts must also be made in the beneficiary designation form rather than simply naming a trust that is divided into sub-trusts.[9]
An IRA trust can be drafted as either a conduit trust or an accumulation trust.
♦ Conduit Trust. Under a conduit trust the trustee must immediately distribute any IRA or plan benefits received by the trust (whether as a required minimum distribution or otherwise) to the trust beneficiaries. RMD payments are determined by the single life expectancy of the trust’s conduit beneficiary, but trust distributions may be sprayed to other beneficiaries younger than the conduit beneficiary as well.[10]
The trust distributions will be measured by the life expectancy of the initial beneficiary, so if that beneficiary dies any older beneficiaries will still receive the payout based on the life of the initial beneficiary. Following the conduit beneficiary’s death, the trustee may accumulate plan benefits.
Pros: All income is distributed to beneficiary and tax paid at beneficiary’s rates.
Cons: MRD subject to beneficiary’s creditors.
♦ Accumulation Trust. A trust named as a beneficiary of an IRA can be designed as an accumulation trust. Under an accumulation trust the trustee can retain IRA distributions rather than pay them out as received. The problem is that where an accumulation trust is used, the shortest life expectancy of all of the possible beneficiaries is used to determine RMD. An accumulation trust should be used when the beneficiary is a special needs trust.
Pros: IRA protected from beneficiary’s creditors.
Cons: May pay tax at trust’s rate.
♦ IRA Trust. Under an IRA trust a trust protector can be appointed. The trust protector must be unrelated by blood to the trust beneficiary but may have a personal relationship, such as financial advisor, attorney, CPA, or friend. The trust protector can change a conduit trust to an accumulation trust by avoiding the provision that requires immediate payout of the IRA distributions to the primary trust beneficiary. This gives the trustee the discretion to accumulate funds.[11]
♦ Spousal Planning. Planning for retirement assets for a surviving spouse is greatly assisted by portability.[12] Under this provision, the first spouse to die can leave his or her unused federal estate tax exemption to the surviving spouse. This is known as the “deceased spousal unused exclusion amount” or “DSUEA.” There are three advantages to portability:
- Estate Tax Savings. There can be considerable estate tax savings in situations where the poorer spouse dies first.
- Outright Gifts. The new law permits outright gifts to a surviving spouse while avoiding payment of taxes without utilization of a credit shelter trust.
- Step Up. Assets, other than retirement plans, included in the estate of the first spouse to die and then again in the estate of the second spouse to die receive a step up in basis on each death.
While credit shelter trusts offer a number of advantages for non-retirement assets, it is usually a disaster for retirement assets. This is for several reasons:
- Shrinkage. The amount of assets in the retirement plan of the first spouse to die that are left to a credit shelter trust may have declined significantly between the date of death of the first spouse and the surviving spouse. This is because of required minimum distributions and the tax on those distributions. The tax will be larger, because the distributions made to the trust will be required to be larger than if the retirement plan had been rolled over into a spousal IRA.
- Conduit Trust. If the trust was a conduit trust, then all unspent after-tax proceeds will be included in the surviving spouse’s taxable estate, which contravenes the purpose of the credit shelter trust. Prior to portability, there was a tradeoff between the positive income tax outcome of a spousal rollover and the negative estate tax outcome. Portability solves that problem for most married couples.
Begley Law Group, P.C. has served the Southern New Jersey and Philadelphia area as a life-planning firm for over 85 years. Our attorneys have expertise in the areas of personal injury settlement consulting, special needs planning, Medicaid planning, estate planning, estate & trust administration, guardianship, and estate & trust litigation. Contact us today to begin the conversation.
[1] Clark v. Rameker, 573 U.S. _____ (2014).
[2] I.R.C. § 1(e).
[3] I.R.C. § 678; I.R.C. § 672(f).
[4] Treas. Reg. § 1.401(a)(9)-4, A-5(b)(2).
[5] Treas. Reg. § 1.401(a)(9)-4, A-5(b)(2).
[6] Treas. Reg. § 1.401(a)(9)-4, A-5(b)(3).
[7] Treas. Reg. § 1.401(a)(9)-4, A-5(b)(4).
[8] WPLR 2003-17041, 2003-17043 and 2003-17044.
[9] P.L.R. 2004-32027 and 2004-32029.
[10] P.L.R. 200227059.
[11] P.L.R. 200537044; Harvey B. Wallace, II, Retirement Benefits Planning Update, Probate and Property, American Bar Association (May-June 2006); Wealth Preservation Update, Morris Law Group (Mar. 2007), www.law-morris.com.
[12] I.R.C. § 2001(b)(1).
