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IRA Trusts

IRA Designated Beneficiary Trust (DBT)

Because a Living Trust serves other objectives, it is my opinion that it is not a good candidate as the IRA beneficiary. The Living Trust usually provides that Trust funds shall be used to pay the Trustor's existing or final debts and taxes which benefits the Trustor's estate. As a result, the IRS has been successful in obtaining rulings that the estate is also a beneficiary of the Trust. If it is so determined, the estate, with zero life expectancy, can cause catastrophic tax ramifications and preclude any "stretch" IRA distributions to the individual Trust beneficiaries.

A better solution with clients having significant IRA funds is to designate an IRA Designated Beneficiary Trust (DBT) as the IRA beneficiary. If there is a surviving spouse, the DBT can be designated as the contingent beneficiary to the surviving spouse as the primary beneficiary. This Trust is specifically designed as a recipient of IRA funds to be distributed to the Trust beneficiaries with extended life expectancies. Additionally, the Trust provisions typically preclude any IRA funds to be utilized for the IRA owner's debts, taxes or any other expenses owed by the estate. The ruling in PLR 200537044 indicated that reserving funds for estate debts would not cause the Trust to be considered an Accumulation Trust discussed below.

If the Trustee is given discretionary authority over distributions to the beneficiaries, this could provide asset protection features regarding creditor protection for such beneficiaries. If the Trust is designed with this objective it would be considered an "Accumulation," as opposed to a "Conduit" Trust. This determination is important regarding the issue of the shortest life expectancy rule for distributions. If the Trustee is required to immediately distribute all IRA funds received by the qualifying Trust, it is considered to be a "Conduit" Trust. As a result, only the life expectancies of the primary beneficiaries are taken into consideration regarding the shortest life expectancy issue. Reg. §1.401(a)(9)-5, A-7(c)(3), Ex. 2. However, if the Trust is created for asset protection in mind and the Trustee is given the authority to accumulate IRA funds, all potential beneficiaries, are taken into consideration. This would include the primary, contingent and any beneficiaries who could be designated through the exercise of powers of appointment by a beneficiary in the Trust. For example, if the powerholder could appoint to beneficiaries who are older than the primary beneficiary, the life expectancies of such beneficiaries would be considered in the shortest life expectancy determination. This could result in a drastic reduction in the period of distribution.

Trust beneficiaries are not ordinarily allowed the benefit of the separate share rules in which separate Sub-Trusts are arranged for each beneficiary. For example, if children and grandchildren were designated, individually, as beneficiaries of an IRA, each beneficiary could arrange a separate account and take distribution over their individual life expectancy. This is known as the separate share rule and must be arranged by December 31st of the year following the year of the IRA owner's death. This, of course, benefits a younger beneficiary who is, then, not subject to the shorter life expectancy of an older beneficiary. As regards Trusts, the IRS issued PLR 200537044, which did allow for the separate share rule to be applied to Trusts on the condition that the individual Sub-Trusts of the DBT were named as the IRA beneficiaries. Based on this PLR, it is important that Sub-Trusts be designated as the beneficiaries with the IRA custodian rather than the Trust itself. Of course, the private letter ruling issued was valid for the requesting taxpayer and cannot be relied on by other taxpayers. However, it gives some insight as to how the IRS might rule on this issue.

IRAs Now A Creditor Target

In the recent U.S. Supreme Court case of Clark v. Rameker, creditors will begin to zero in on Inherited IRAs.

What is an Inherited IRA? These are IRAs inherited by non-spouse beneficiaries. Typically, spouses rollover IRAs and become the IRA owner if they are designated as the beneficiary. But non-spouse beneficiaries do not have that option. Characteristics of an Inherited IRA are as follows:

  1. The beneficiary cannot make contributions to such IRA;
  2. The beneficiary must take annual distributions, at least equal to the Minimum Required Distribution (MRD);
  3. The Beneficiary can withdraw the entire fund at anytime without a tax penalty.

In the Clark v. Rameker case, the mother left her daughter a $450,000.00 IRA on her death. The daughter took MRD for nine years then filed for Chapter 7 bankruptcy when the IRA was valued at $300,000.00. The daughter claimed the IRA as an exempt retirement fund which was protected from creditors. Previously, the Fifth Circuit had ruled that an Inherited IRA was protected, but the Seventh Circuit created a conflict with the Fifth Circuit by ruling that the Inherited IRA was not protected. Based on this conflict, the U.S. Supreme Court heard the case and upheld the Seventh Circuit ruling.

WHAT DOES THIS MEAN FOR CLIENTS?

Simply stated, your IRA will be a target for creditors on your death if it is left to a non-spouse beneficiary since the IRA will be classified as an Inherited IRA.

WHAT CAN YOU DO TO PROTECT YOUR IRA FOR YOUR BENEFICIARIES?

Something that I have done for years with clients is prepare an IRA Designated Beneficiary Trust (DBT).

The IRA DBT is a Trust that is arranged specifically for IRAs/Retirement plans. The key to this arrangement is that the Trust, rather than an individual, is designated as the IRA beneficiary. For this reason, the Inherited IRA would be protected because it is payable to a Trust. The Trust beneficiaries would ultimately receive the IRA funds depending on the terms of the Trust. If the individuals or Trust Beneficiaries were threatened by creditors or were requited to file for bankruptcy, the Inherited IRA, payable to the Trust, would be protected.

Example #1:

Samantha's parents set up IRAs naming her, individually, as the IRA beneficiary. On each parents' death, Samantha becomes the beneficiary of an Inherited IRA. Samantha and her husband have creditor problems because of his businesses and ultimately file for bankruptcy. Based on the ruling in the Clark case, her Inherited IRA will not be protected from creditors.

Example #2:

Becca's mother has a 401K and an IRA which she desires for Becca's financial security. A financial planner informed the mother about the Clark case, so she sought out an attorney who was experienced in IRA DBTs. An IRA/Retirement Fund DBT was arranged, designating the Trust as the primary beneficiary of the IRA and 401K. Becca was the sole DBT beneficiary.

After Becca's mother passed away, the Inherited IRA funds were payable to the Trust and then distributed to Becca by the Trustee on terms provided in the Trust. Later, when Becca incurred creditor problems as a result of a bad real estate investment, her Inherited IRAs remained protected by the Trust and out of reach of her creditors.

Conclusion

If you have an IRA or Retirement plan, which is to ultimately benefit your children, grandchildren, or other beneficiaries, planning is required. You individually, or you and your spouse together, should seriously consider the asset protection of an IRA/Retirement Fund Designated Beneficiary Trust. In light of the Clark v. Rameker decision by the U.S. Supreme Court, this is an essential planning technique in the estate.

Jack E. Stephens, J.D., LL.M. has implemented IRAs into his Trusts and Estate Planning for years. He wrote a book, Avoiding Tax Traps In You IRA, which was endorsed by Kiplingers and included a segment on the use of IRA Trusts for clients.

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