Part II: Naming an Accumulation Trust as the Beneficiary of an IRA

Last month we discussed the benefits of naming a Conduit Trust as the beneficiary of an IRA.  A Conduit Trust allows the IRA to remain tax deferred thereby stretching the Required Minimum Distributions over the lifetime of the trust’s beneficiary which could be a young child or grandchild.  The ability to continue tax-deferred growth over a long period is a key benefit.  As a Conduit Trust is also the named beneficiary, minor children who become beneficiaries will not require a guardianship proceeding.

However, while a Conduit Trust affords these advantages, there are some notable drawbacks.  First, a Conduit Trust requires that all Required Minimum Distributions be distributed immediately outright to the beneficiary.  In cases where the beneficiary is a spendthrift, is at risk for divorce or is in a litigious profession such as physicians, the forced distributions are left wide open and unprotected from creditor claims. Second, a Conduit Trust cannot withdraw retirement account proceeds and accumulate them inside the trust.

Accordingly, a second option is to name an “Accumulation Trust” as the beneficiary of the IRA.  An Accumulation Trust allows  to receive the Required Minimum Distributions and then use their ultimate discretion in making distributions.  This way, distributions from the IRA can be kept within the trust and accumulated rather than being immediately distributed to the beneficiary.  As such, the trust assets have added protection against creditors. This is especially helpful where the beneficiary is a spendthrift and protects against inexperience.

In drafting the trust, special attention must be paid to the governing provisions. Specifically, in order to be able to use the principal beneficiary’s life expectancy for Required Minimum Distribution calculations, the trust agreement must prohibit trust distributions to anyone who is older than the person whose life expectancy is used to calculate the Required Minimum Distributions.  This can be quite limiting as typically named contingent beneficiaries such as spouses or older siblings cannot be so designated.  The trust assets can never pass to any older sibling or relative which may be contrary to the owner’s wishes.  Perhaps equally limiting, only individuals can be beneficiaries which prevents one from designating a charity.  If any of these requirements is not satisfied, the trust will not qualify for stretching.  As such, an Accumulation Trust is probably useful only for certain, older, beneficiaries.

New Congressional Update:   Congress’ Senate Finance Committee recently proposed legislation eliminating the beneficial tax “stretch” and replacing it with a mandatory 5-year liquidation rule for non-spousal beneficiaries.  Under the proposed legislation, an inherited traditional IRA would have to be liquidated generally within 5 years of the original owner’s death.  It will be interesting to see whether any of this legislation is approved.  Stay tuned.

For more information or if you have any questions about estate planning and taxation, please contact Judson M. Stein, Chair of the Trusts & Estates Practice Group, at 973-230-2080 or jstein@genovaburns.com or John A. Grey and Lauren M. Ahern, Associates in the Trusts & Estates Practice Group.

The Tax Advantages of Naming a Conduit Trust as the Beneficiary of an IRA

IRA’s can represent a large portion of an individual’s retirement assets. For this reason, care should be taken to ensure these assets receive the best tax treatment and are protected from creditors such as divorcing spouses. Indeed, the divorce rate today is close to 50%. The hallmark of IRAs is “tax-deferral.” This means that the investment earnings such as interest, dividends and capital gains accumulate tax free while in the account. The ability to widen or “stretch-out” the IRA’s distributions over a beneficiary’s life expectancy yields more income than if the account was simply cashed out. It follows that the younger the beneficiary, such as a child or grandchild, the longer the tax-deferred growth exists; the very goal of this tax planning.

Required Minimum Distributions  

In general, when an IRA holder turns 70 ½ years old, they must begin taking their distributions (often referred to as “Required Minimum Distributions”). Required Minimum Distributions are based upon the individual’s age and life expectancy.  After the IRA holder passes away, and providing there is a designated beneficiary, that beneficiary gets to use their own life expectancy for taking Required Minimum Distributions. The failure to take a Required Minimum Distribution triggers a 50% penalty of the amount not properly withdrawn.  Conversely, if there is no designated IRA beneficiary, the assets have to be withdrawn rather quickly; namely, within 5 years after the owner’s death. To illustrate, an IRA which is to be paid to the account holder’s estate or a charity is considered as having no designated beneficiary.

Married Couples

Married couples typically name the surviving spouse as the direct beneficiary of their IRA. The key benefit here is that following the first spouse’s death, the surviving spouse can rollover the IRA into his or her own IRA (commonly known as a “Spousal Rollover”). The rollover allows the assets and perhaps most importantly, any growth or appreciation therein to remain tax-deferred.  At the age 70 ½, the surviving spouse can then begin taking their Required Minimum Distributions based upon their own life expectancy.

Planning for Widows, Widowers and Single Individuals

Estate planning for the single client presents unique challenges. It is noteworthy that IRAs are exempt from the reach of creditors; as such, they afford asset protection. To illustrate, if an individual pursues bankruptcy or is named in a lawsuit, the funds held in their IRA are protected from creditors.

However, when an IRA is left to a child, grandchild or other beneficiary, it is treated as an “Inherited IRA.” Unfortunately, Inherited IRAs do not receive the same favorable asset protection afforded Spousal Rollovers. Courts have opined that Inherited IRAs are not precisely “retirement funds” and as a result, they are not exempt from an individual’s creditors such as divorcing spouses. Most individuals do not want a child’s ex-spouse to get their IRA. The question thus becomes what can be done to protect this wealth.

The “Conduit Trust

One effective strategy is to name a “Conduit Trust” as the beneficiary of the IRA. With a Conduit Trust, all distributions from the IRA are required to be immediately distributed to the trust’s beneficiaries.  In general, where a trust is named as the beneficiary of an IRA, the beneficiary with the shortest life expectancy is deemed by the IRS to be the beneficiary; as such, this beneficiary’s life expectancy is then used to determine the Required Minimum Distributions. However, qualifying a Conduit Trust as a designated beneficiary under the tax rules is quite taxpayer friendly as the beneficiary to receive distributions is considered the only beneficiary which the IRS will construe in assessing which beneficiary of the trust has the shortest life expectancy. This makes compliance much easier and helps maximize tax deferral.

Most importantly, Conduit Trusts afford asset protection as the IRA will now be exempt from the reach of creditors such as divorcing spouses. Furthermore, it will allow the IRA to remain tax deferred thereby stretching the Required Minimum Distributions over the lifetime of the trust’s beneficiary which could be a young child or grandchild. As the Conduit Trust is the named beneficiary, minor children will not require a guardianship proceeding. The establishment of a trust also affords the grantor control over how the asset will be inherited and prevents a beneficiary from simply cashing it out thus defeating the tax-deferred benefits. As with any estate planning, such benefits should be weighed against the potential drawbacks which include for example, the additional cost of setting up a trust, the added complexity and trust accounting.

By not designating a Conduit Trust as the beneficiary of an Inherited IRA or by simply having the IRA pass outright, one may face serious setbacks.  First, if the intended beneficiary passes away and the new beneficiary is a minor, the parties will have to go to court for the appointment of a legal guardian. Thereafter, and following this potentially burdensome process, any distributions must be paid to a court appointed guardian. Second, even providing the beneficiary is an adult, they may seek to liquidate the entire account, which will trigger a substantial tax and end any tax-deferred growth. All of these outcomes may very well contradict the original owner’s final wishes.  Moreover, and equally problematic, the funds themselves are readily available to the beneficiary’s creditors, which include a divorcing spouse. In light of the high divorce rate, this is a very real concern today.

In summary, naming a Conduit Trust as the beneficiary of an IRA affords creditor protection, spendthrift protection, control over estate planning and maximizes tax-deferral. In addition to maximizing the tax objectives, using a trust in this context helps prevent the chance of unintentional beneficiaries inheriting the asset thereby keeping it in the family.

For more information or if you have any questions about estate planning, please contact Judson M. Stein, Esq., Chair of the Trusts & Estates Practice Group, at 973-230-2080 or jstein@genovaburns.com or John A. Grey, Esq., member of the Trusts & Estates Practice Group, at 973-230-2088 or jgrey@genovaburns.com.

No IRA Rollover Relief for Taxpayer Who Used IRA Distribution as a Short-Term Loan

In PLR 201625022, the IRS refused to waive the 60-day rollover requirement for a taxpayer who used her IRA distribution as a short-term source of funds pending the sale of her vacation home.  In general, there is no immediate tax where the distributions from an IRA are rolled over to an IRA or other eligible retirement plan.  For the rollover to be tax-free, the amount distributed from the IRA generally must be recontributed to the IRA or other eligible retirement plan no later than 60 days after the date that the taxpayer received the withdrawal from the IRA.  A distribution rolled over after the 60-day period will be taxed (and also may be subject to a 10 percent premature withdrawal penalty tax).

However, the IRS may waive the 60-day rule if an individual suffers a casualty, disaster, or other event beyond their reasonable control and not waiving the 60-day rule would be against equity or good conscience.  The IRS will consider several factors in this analysis such as the time elapsed since the distribution and inability to complete the rollover due to death, disability, hospitalization, incarceration, restrictions imposed by a foreign country, postal error and errors committed by a financial institution.

In the present case, the taxpayer’s daughter’s home was in foreclosure.  As such, the taxpayer and her spouse put their vacation home up for sale in order to raise funds to purchase their daughter’s home.  Prior to the sale of their vacation home and in order to avert foreclosure, the taxpayer took a distribution from her IRA on April 24, 2015.  The distribution was used to purchase her daughter’s home on April 27, 2015.

The taxpayer intended to redeposit the distributed amount into her IRA within the 60-day rollover period which ended on June 23, 2015.  Nevertheless, the sale of the vacation home was not completed until July 1, 2015 and the taxpayer did not have sufficient funds available during the 60-day period to complete the rollover.  The taxpayer indicated that her spouse was willing to take a distribution from his IRA within the 60-day period to complete the rollover but that her medical condition prevented this from occurring.  She attempted to complete the rollover once she received the funds from selling the vacation home, but the 60-day period had expired.  Accordingly, the taxpayer requested a waiver of the 60-day requirement.

On balance, the IRS denied the taxpayer’s request for relief.  Although the taxpayer represented that her inability to complete a timely rollover was caused by her medical condition during the 60-day period, the IRS was not convinced in light of her continued work and travels.  Specifically, the IRS found that her failure to complete a timely rollover was instead due to her use of the funds as a short-term loan to purchase her daughter’s home which left her unable to recontribute the amount to her IRA until after the sale of her vacation home was completed.

For more information or if you have any questions about estate planning, please contact Judson M. Stein, Esq., Director of the Trusts & Estates Practice Group, at 973-230-2080 or jstein@genovaburns.com or John A. Grey, Esq., member of the Trusts & Estates Practice Group, at 973-230-2088 or jgrey@genovaburns.com.