Estate planning is a continually evolving area of the law. To ensure that your family’s affairs are in order in the event of your death, it is important to continually update your estate plan as the law changes and your life circumstances change. As an estate planning attorney one of the more common questions that I hear from many Tennessee families is in regard to their IRA accounts.
Nearly every family that I work with has an IRA account. Perhaps it is a traditional IRA that you opened and contributed to over many, many years. Or, perhaps it is an old 401(k) from your employer that has been converted into an IRA since your retirement. Whatever the case may be, many families have questions on how to protect their IRAs and how to pass on their IRAs to their children and spouse. Rightfully so, an IRA is usually one of the largest assets that a person holds.
The common planning aspect that people will complete with their IRA accounts is by completing beneficiary designations. In almost every case, the holder of the IRA will designate his or her spouse as the sole beneficiary of the IRA account. In the event that the account holder’s spouse predeceases, the individual will most likely name their adult child or children as equal beneficiaries of the IRA account.
Example: John died with three children, Jim, Ben, and Eric. John had an IRA account valued at $300,000 on the date of his death. Prior to John’s death, he completed the beneficiary designation forms naming his three children as equal 1/3 beneficiaries of his IRA account. Within the weeks and months that followed each one of John’s children called the IRA plan administrator and withdrew their entire $100,000 share from the IRA. The result of this was the $100,000 inheritance was included on each child’s income tax return for the tax year that each child withdrew their $100,000 share.
This is a far too common occurrence when adult children inherit an IRA account. Due to poor money management, poor decision making, or even not having knowledge of the tax consequences, adult children will withdraw their share from the IRA. Not only does this subject the adult child to income tax consequences, but it also subjects the inheritance to claims from creditors, lawsuits, and spousal claims in a divorce proceeding.
A very smart way to protect your children’s IRA inheritance from unnecessary income taxes and creditor claims is through an IRA Trust. Just as in the example above, the owner of the IRA account would complete beneficiary designation forms. However, with an IRA Trust, the account owner would name the IRA Trust as the sole beneficiary of the IRA.
The IRA Trust creates a very favorable planning vehicle for families to create a mandatory stretch out of their IRA account to their children, grandchildren, or other named beneficiaries.
Example: John, who died with three children, contacted his financial advisor to change his IRA beneficiary designation to name the John IRA Trust as the new beneficiary. When John died, his $300,000 IRA was transferred into the John IRA Trust, where it was to be administered over the lifetime of his three adult children. Due to John planning in this manner, his three children experienced their inheritance growing over their lifetime and deferring a considerable amount of taxes that would have been due immediately had the children been given immediate access to their inheritance in the IRA.
However, another important aspect of setting up an IRA Trust is that the asset can enjoy a level of creditor protection for your adult children. The benefit of the IRA Trust that was mentioned above allows for the IRA to be distributed over the course of the lifetime of the beneficiaries and can result in the trust and the IRA funds lasting for several years and even decades. However, another important benefit is that the IRA Trust can be written as an accumulation trust. This allows the trust to receive the Required Minimum Distribution (RMD) from the IRA each year resulting in the IRA greatly increasing in value over the life of the named beneficiaries. In addition, an IRA Trust providing that the RMDs are to be distributed into the trust as an accumulation trust and not to the named beneficiaries each year, results in the IRA, and essentially, the inheritance being protected from creditors, lawsuits, and divorce claims.
However, a quick note. A recent United States Supreme Court Decision has determined that inherited IRAs are not protected in bankruptcy. Therefore, it is an open question of law as to whether an IRA Trust will provide complete protection including bankruptcy protection for the beneficiaries of an IRA Trust.
Nevertheless, individuals with large IRA accounts find it very beneficial to establish an IRA Trust to protect their children’s inheritance.
If you have questions or concerns regarding the proper comprehensive estate plan to put in place for your family to ensure a smooth transition of your wealth to the next generation, then please contact our office for a complimentary visit and conversation so that we can discuss your estate planning needs in further detail.
We look forward to hearing from you!