Qualified Plan Trusts – How to Create a Lasting Legacy

For most people, retirement plan funds account for a significant portion of our wealth. After all, Congress incentivizes us to put money away now to be used in later years. This is evidenced by the IRS allowing us take deductions for certain retirement plan contributions thereby lowering our annual incomes and allowing for the tax-deferred growth of those contributions. As a result, many people turn to retirement plans to put money away for their golden years.

What should you do regarding these plans in the event of your death? Most people simply name a beneficiary and think nothing more about it. However, this plan often causes unintended and disastrous consequences leaving your beneficiaries to manage the money for themselves as they see fit. Statistics show that the average inheritance lasts 24 months or less! While these inheritances include all of your assets, your retirement plans play a big part.

This article looks at an alternate method of handling your retirement plans after your passing that can provide invaluable benefits to your heirs while protecting your heirs from themselves, creditors, and predators. Wouldn’t it be wonderful if you could leave your heirs your retirement plan assets knowing that they will be taken care of for their lives? Using retirement plan trusts may be the perfect fit for you and your family.

Designating Individual Beneficiaries

Most people simply name their spouse as the beneficiary of their retirement accounts. IRS rules allow a spouse to “rollover” the account into their own. This rollover allows the spouse to postpone taking the required minimum distributions until the spouse is 70.5 years old. Upon the spouse’s death, whoever inherits the account could “stretch out” the distributions over their own life expectancy.

By way of example: John names his wife Jane as the beneficiary of his IRA. John dies when Jane is 60 years old. Jane can rollover John’s IRA into her own IRA and delay taking any distributions for 10.5 more years. Jane dies when she is 80 and leaves her IRA to their son, James, who is 50 years old. James will be able to “stretch out” the distributions over his own life expectancy. This allows for the funds to continue growing tax-free and James can spread out the income tax liability over a longer period of time.

While this may sound appealing, there are some major drawbacks to this method. First, only a spouse is permitted to “rollover” a decedent’s retirement account. In the previous example, if John had left his IRA to James, James would not have been permitted to delay taking distributions until he was 70.5 years old. Instead, he would be required to begin taking distributions in the year after John’s death. This causes income tax issues as well as eliminates the tax-deferred growth on the portion that James would be required to take out.

Moreover, when your spouse is named as the beneficiary of your retirement account, it becomes hers upon your death, leaving you without a say as to who should receive your retirement account upon her death. Using the above example, if Jane received the proceeds via a “rollover” Jane could decide to leave the entire account balance to her second husband upon her death. Presumably John would have preferred for James to receive his money over Jane’s new husband.

Naming Your Child as Beneficiary

To remedy the problem we saw in the previous example, a great number of people will simply name their children as the beneficiary instead of their spouse. If John names James as the beneficiary of his retirement plan, he will ensure that James is provided for. However, James will be unable to rollover the retirement plan into his own retirement plan but he can opt to stretch out the distributions over his life expectancy.

This method has a glaring downfall that you need to be aware of. Your child has the option to “stretch out” the distributions over their lifetime. This option is just that – an option. James could decide to liquidate the account and withdraw all of the funds at once. Older, more mature children may be able to be trusted to make an educated decision regarding his options. A younger child or a child with spending issues may not be trusted with a large sum of money. A younger child may want to go to Las Vegas and put all of the money on red; go on an extended European vacation; buy that hot new sports car that he or she always wanted. He may be too young to understand the importance and advantages of allowing the money to grow tax-deferred to be used in his or her retirement years.

Retirement Plan Trusts

The solution for many families is utilizing retirement plan trusts (RPT). Structured properly, RPTs provide the best of both worlds – continued tax deferred growth and a stream of income that your children cannot outlive!

We already explored the potential pitfalls of naming your spouse as the beneficiary of your retirement account. These pitfalls can be prevented by simply naming a RPT as the beneficiary. This is especially true in second marriage situations, where the spouses would like to avoid the possibility that the survivor will leave the account to someone other than the deceased spouse’s children. For second marriage situations, a great tool is to name a RPT as the beneficiary of your retirement plan and make your spouse the beneficiary of the RPT.

For practical purposes, these trusts function to receive distributions from your retirement account and then the trust distributes payments to your named beneficiary. Since Jane never becomes the owner of the retirement account she cannot name a different beneficiary to receive the funds upon her death. Even if Jane were to remarry, she would have no authority to leave John’s retirement account to her new husband instead of to James.

Additionally, RPTs allow you to maximize your estate tax exemption upon your death. Currently, Congress taxes estates that are over $5.45 million dollars. This is a per-person deduction that must be used at the time of your death. Therefore, each spouse can leave $5.45 million dollars – for a total of $10.9 million – to their children estate tax free. If John were to leave everything outright to Jane, he would have wasted his $5.45 million exemption because Jane is entitled to inherit everything from John estate tax free because of the unlimited marital deduction. If John instead leaves his retirement plan to a RPT to be used for Jane’s lifetime and ultimately go to the children upon her death, he can save them a significant amount of money in estate taxes.

While the estate tax free amount is a huge number, the amount is tied to the whims of Congress. We all know Congress changes its mind quite often. About 10 years ago, the exemption amount was not $5.45 million per person… it was $600,000 per person.

Naming a Trust as Beneficiary Instead of Your Child

As we have seen, naming a child as the beneficiary of your retirement account can cause unintended and disastrous problems. Remember… the average inheritance lasts less than 24 months! An RPT can solve most all of these problems.

A common problem arises when your child is a minor. Pursuant to state law, minor children cannot own property. Therefore a guardian must be designated to manage the minor child’s property for them until they reach 18 – at which point the guardian will be required to hand over all property to the child to manage on their own. Depending upon the situation, the Court may need to select someone as the child’s guardian. You have no control over how the guardian uses the funds from your retirement plan. You may think that the person is trustworthy, that they will do the right thing, or that laws prevent them from doing anything dishonest. You would be wrong!!

If a trust is named as the beneficiary of your retirement account, you will be able to name a trustee of the trust who will be responsible for managing your child’s money, including the distributions from the retirement account, for their benefit until they reach whatever age you indicate within the trust document.

Even if your child is not a minor, an RPT can protect your child from himself, his spouse, and his creditors in a way that directly designating your child cannot. By naming an RPT as beneficiary, you can be sure that your child does not receive full control over the money at the age of 18 – you can designate any age you want – thus, ensuring that your child does not withdraw the entire account and spend it unwisely before he is able to understand the benefit of allowing the money to grow tax-deferred over his lifetime.

Additionally, using an RPT protects the money from third parties, including your child’s spouse in a divorce or your child’s creditors. If James ever got divorced, his spouse would not have a claim to any of the money in the retirement account because it would protected by the terms of the trust. Moreover, if James was ever in an accident and was sued as a result, the plaintiff would not be able to access the money in the retirement account if the trust was the beneficiary.

Does an RPT Protect My Children From Bankruptcy?

YES! In fact, it is the only way to do so. A recent Supreme Court case, Clark v. Rameker, held that inherited IRAs are not considered protected retirement funds – and are thus subject to creditors’ claims if the beneficiary files for bankruptcy. The Court reasoned that, even though Clark was not yet at retirement age, the account was not a protected retirement fund because she was not using it as one.

In reality, this means that in the case of bankrupt estates, inherited IRAs will now be considered assets – fully available to satisfy creditors’ claims. If you pass a retirement plan down to a child or grandchild, that inherited money will no longer be protected if your beneficiary must file for bankruptcy.

Careful estate planning and the use of RPT can ensure that IRAs remain safe from your beneficiary’s creditors.

How Do I Set Up an RPT?

You should use a qualified attorney to prepare any RPT document. The complexities and the amount of money involved usually dictate so. The last thing you want to do is make a drafting mistake that blows up the whole purpose of creating the RPT.

In order to satisfy IRS rules, the trust must satisfy four requirements and it must satisfy a fifth one if the trust beneficiaries are to have the option to “stretch out” the distributions over their life expectancy:

  1. The trust must be valid under state law;
  2. The trust must be irrevocable;
  3. All trust beneficiaries who will receive money from the retirement account must be identifiable from the trust document itself;
  4. Documentation of the trust must be provided to the retirement plan administrator by October 31st of the year after the year of your death;
  5. All trust beneficiaries must be individuals (in order to qualify for the “stretch out”).

Another problem arises in the case of multiple trust beneficiaries. IRS rules state that distributions must be taken out over the life expectancy of the oldest beneficiary. In cases where a spouse and children are listed as beneficiaries means that the children will be required to withdraw funds based on the spouse’s life expectancy. This effectively shortens the length of time the children may benefit from the trusts as well as prevents the money from growing tax-deferred for a much longer period.

Fortunately with careful planning this can be avoided. Your RPT can allow for “separate shares” for your spouse and children and, if these shares are named as the retirement account beneficiaries, your spouse and children can take distributions over their own life expectancies.

Conclusion

If all of this sounds confusing, it is! This can be a very complicated process to undertake on your own. However, with careful planning and the help of a qualified attorney, this complicated process can be much easier. The benefits of creating RPTs far outweigh the up-front work that is required. RPTs offer your loved ones important protections that cannot be achieved if they are directly named as beneficiaries.

For more information, contact Green Law, PLLC at (806) 548-2953. Let’s explore whether an RPT is the correct option for you and your family.