Stand Alone Retirement Account Trusts
I have been drafting estate plans for about twenty years. For about twenty years, I have successfully avoided making trusts the beneficiary of retirement accounts, save for a few occasions. However, recent federal court cases stripping the asset protection benefits of inherited Individual Retirement Accounts (IRAs) have put an end to that streak. Protecting retirement accounts from a beneficiary’s creditors requires a stand-alone retirement account trust.
Let’s start with why I have avoided directing retirement account proceeds to trusts for so many years. In a nutshell, doing so is complex. I do not like complex if it can be avoided. Complex estate plans do not get successfully implemented by the average client.
In a broad sense, the underlying goals of estate planning and retirement accounts are very different.
Retirement accounts are about putting cash away, today, for the owner to use during retirement.
Distributions from a retirement account are mandated by federal law. Trust planning is typically about
making distributions based upon need, avoiding estate taxes, protecting inherited assets from a beneficiary’s creditors and perhaps creating a nest egg for generations to come. Federal law does not mandate distributions from trusts.
Describing the problem as being complex is not very helpful for those who like technical explanations.
So, here we go; and I am going to use round numbers to make this a little easier and speak in general terms (meaning don’t take this as the Gospel because I am leaving many technical details, out).
First, forget about the typical “living” or “revocable” trust. A living or revocable trust is typically a Grantor Trust. Grantor Trusts typically pay income tax at the trust maker’s individual tax rates. The trust maker is more formally called the Settlor or Grantor. I am focusing on trusts created for individuals other than the trust maker where the trust maker is deceased or gave up all control over the trust property. These trusts are called Non-Grantor Trusts. Non-Grantor Trusts file income tax returns and pay income taxes like any other person.
Income tax rates for Non-Grantor Trusts are quite high. A Non-Grantor Trust with $12,000.00 in taxable income is taxed at 39.6% before tacking on the recent ObamaCare 3.8% tax (ultimately expected to rise to 8.8%) and the Colorado state income tax of 4.63%. So, once the trust has $12,000 in taxable income, each additional $1,000.00 of trust income gets hit with about $480 in income tax ($1,000.00 * (39.6% + 3.8% + 4.63%). This is pretty close to a 50% tax whack. Ouch!
Wait, don’t panic. It is not as bad as it seems. First, most trusts are Grantor Trusts during the life of the trust maker / settlor and get taxed to the trust maker at the trust maker’s individual income tax rates.
No trust tax return. No nasty trust tax rates. Second, trust income tax is typically on trust income that is not distributed to a beneficiary. Typically, a distribution of trust income to a trust beneficiary carries out the trust income to the beneficiary’s personal income tax return at the beneficiary’s personal income tax rates.
Ready for a twist? Trust income is not the same as taxable income. The entire distribution from a traditional IRA is considered taxable income regardless of whether the distribution is made to an individual or a trust. For example, a $1,000,000.00 traditional IRA that makes a $50,000.00 distribution in 2014 triggers income tax on the entire $50,000.00 distribution. However, if the beneficiary is a trust, trust accounting principles allocate the $50,000.00 distribution of taxable income to trust income and principle. Continuing the example, 10% of the distribution ($5,000.00) may be allocated to trust income and 90% of the distribution ($45,000.00) to trust principle. That allocation can result in taxable income getting “trapped” in the trust as trust principle and getting taxed at about 50%. Frankly, even if the entire distribution was allocated to income, only by distributing the income to or for the benefit of the beneficiary are the trust income tax rates avoided; which defeats many of the reasons why estate planning trusts are created in the first place.
Ready for another twist? While a trust can be named beneficiary of a traditional IRA, doing so can trigger recognition of all deferred income unless the trust contains certain provisions. The trust must be drafted to qualify for something we call the “see-through trust rules” to obtain continued deferral of income tax after the account holder’s death. Continuing the $1,000,000.00 traditional IRA example, not complying with the see-through trust rules can result in about $500,000.00 in income tax shortly after the death of the retirement account holder. If estate tax is owed in addition to the income tax, 80% of the retirement account can be lost to taxes. If in addition to income and estate tax the generation skipping transfer tax is triggered, we can create scenarios where more tax is owed than we have account proceeds.
If you are still with me, perhaps you now see why I try to avoid making trusts the beneficiary of retirement accounts. It can be done. I have done it over the years when the situation warranted it.
However, many of the benefits sought in an estate plan are lost and it can be quite complex to properly draft. So, why consider a stand-alone retirement account trust, now? What are the benefits?
The benefit of a stand-alone retirement account trust is asset protection for the retirement account beneficiary. Recent federal court cases stripped inherited IRAs of creditor protection. Previously, all inherited IRAs kept all the creditor protection features enjoyed by the account holder including bankruptcy protection. Now, the creditor can attach to the retirement account, take the money, and cause the beneficiary to incur phantom income and actual income tax. That’s right. The creditor can take the inherited retirement account and the beneficiary could get stuck with the income tax bill for the “distribution”.
The solution is to make a stand-alone trust the beneficiary of the retirement account. It is called a stand-alone trust because the only property going into the trust is the retirement account, and there is only one beneficiary per trust. This makes the trust drafting much simpler and less complex. The trust is designed to pass all income tax consequences out to the beneficiary as annual distributions are made from the retirement account to the trust. The trust provides asset protection from the beneficiary’s creditors. The beneficiary can even be the trustee.
Recent federal court cases have stripped the creditor protection benefits of inherited retirement accounts. Consider whether a stand-alone retirement account trust is a better way to pass inherited retirement accounts on to beneficiaries.
