This is another in the series of blogs on the basics of estate planning. In the last blog in the series, we looked at how trusts can be used to help with Medicaid planning. In this blog, we’ll see how trusts may be used with retirement plans and IRAs.
A retirement plan (like a 401(k)) or an IRA may name an individual, a trust, or something else as the beneficiary of the benefits. If an individual is named, that individual’s life expectancy is used. You’d use the single life table which can be found in IRS Publication 590B, Appendix B, Table I. For example, a beneficiary who is 18 at the death of the participant (owner) would have a life expectancy of 65 years. As a result, for their first required distribution, they would be required to take a distribution of 1/65th of the prior year-end balance. In subsequent years, they would subtract one from the denominator of the prior year, so it would be 1/64th of the prior year-end balance. By the time the beneficiary reaches their life expectancy, they will have taken out all the assets from the retirement plan or account. However, there can be disadvantages for an individual as the beneficiary.
- The individual may be underage
- The individual may be a spendthrift
- The individual could have creditors
- The individual could have special needs
- The individual may not be able to manage money
In order to address these concerns, the benefits may be left to a trust for the benefit of the beneficiary. A trust for the beneficiary has the following benefits:
- The trust can keep the assets during the beneficiary’s minority, thus avoiding a court proceeding
- The trustee can use their discretion regarding distributions to the beneficiary, within the standards set by the trust
- The trust may be drafted to provide asset protection
- The trust may be drafted as a special needs trust and thus not an “available resource” for the purposes of government assistance
- The trustee (not the beneficiary) manages and invests the assets in the trust
When a trust is the beneficiary of retirement benefits, the trust may be either an “accumulation trust” or a “conduit trust.” If there is any way distributions from the retirement plan/account may not be paid to (or demandable by) the beneficiary, then it is an accumulation trust. If the beneficiary will get the distributions under all circumstances, then it is a conduit trust.
This is significant because with a conduit trust you only look at the current beneficiaries of the trust, while with an accumulation trust you also must look at all remainder beneficiaries. Remainder beneficiaries include anyone who might get the assets and it includes contingent remainder beneficiaries like grandma or a charity.
So, let’s look at an example. Bill leaves a trust for his son Johnny, age 18. At Johnny’s death it goes to his kids, but if he has none it goes to grandma, age 70, but if she is not there the assets go to the American Red Cross. If this trust is an accumulation trust, we must look to the ages of all current and remainder beneficiaries of the trust to determine the identity of the beneficiary with the shortest life expectancy. Johnny’s life expectancy is 65 years and grandma’s life expectancy is 17 years. The American Red Cross, as a non-individual, has no life expectancy.
If the trust were drafted as a conduit trust, distributions could be taken by the trustee using Johnny’s 65-year life expectancy. If the trust were drafted as an accumulation trust, you’d have to look at all current and remainder beneficiaries. The worst beneficiary is the American Red Cross, which has no life expectancy. Sometimes, a trust may include language that eliminates a charity as the recipient of retirement plan assets. If the trust had such language, the 17-year life expectancy of grandma would be used.
Sometimes there is a trade-off between various concerns. For example, let’s say Johnny is a spendthrift. If Johnny has the ability to take the distributions from the retirement plan (a requirement for a conduit trust), he may waste them. In choosing how to draft the trust and counsel the client, this must be weighed against the income tax advantages of a longer stretch on distributions. Perhaps the trustee can use their discretion in the distribution of other assets. For example, let’s say the IRA has $300,000. The required minimum distribution will be about $5,000 in the first years. Without the retirement plan, perhaps the trustee would have paid for a place for Johnny to live and would have given Johnny $500 per month for an “allowance.” With the IRA distribution, the trustee might only give Johnny $100 per month. On the other hand, if the IRA is extremely large and the beneficiary has addiction issues, for example, there may not be a satisfactory way to achieve the stretch and the other objectives of the trust.
In upcoming blogs in the series, I’ll cover more on the Basics of Estate Planning.
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (800) 846-1555