Many of us take advantage of tax deferred retirement accounts. These retirement accounts include those under 401(k) plans, 403(b) plans, Individual Retirement Accounts (IRAs) and less common arrangements. The use of such retirement accounts defers income taxation and can result in significant benefits.
First, contributions to retirement accounts typically are made on a pre-tax basis (whether through employer and employee contributions that are withheld from paychecks or by making deposits to an IRA). Second, the earnings in retirement accounts are deferred. Third, when distributions are taken, and taxes are ultimately payable, it is possible that you will be in a lower tax bracket (always subject to changes in the tax laws) than the tax rate applicable to you when the income was actually earned.
Do retirement benefit accounts provide any tax benefits to beneficiaries?
Properly structured, the assets and earnings in an individual’s retirement account can still enjoy substantial income tax deferral, for the benefit of the account beneficiaries, after the account holder has died. For example, if an individual names their child as the beneficiary of a retirement account, the child/beneficiary could decide to continue to defer taxation on the account by only taking minimum required distributions calculated based on the child’s anticipated life expectancy. The younger the beneficiary, the greater the potential income tax deferral benefit.
An analysis of the income tax benefits available by deferring distributions from a retirement account are beyond the scope of this post, but a good analysis with numerical examples can be found here. Depending on the exact circumstances, stretching out the distributions from a retirement account can increase exponentially the overall benefits from the account.
Why do retirement accounts warrant special attention in estate planning?
Frequently, retirement accounts represent a significant portion of an individual’s wealth. As such, it is important that retirement accounts be considered when developing an estate plan. Incorporating retirement accounts in an estate plan is sometimes made difficult by the fact that administration of a retirement account at death is not controlled by traditional estate planning documents, but rather by the beneficiary designation form for the account.
It is quite common for someone to name their children either as primary or contingent beneficiaries of retirement accounts. There is nothing wrong with this plan so long as the original account holder is comfortable with the idea that their children would be able to pull out all of the money from the account immediately. In an estate plan where the individual wanted to retain assets in trust for his/her children, leaving a retirement account outside of a trust may be inconsistent with the overall plan.
One may think that you can have the best of both worlds (enjoying both income tax deferral and being able to put controls over the account) by simply naming a traditional trust as the beneficiary of the retirement account. Unfortunately, it is not that simple.
Depending on whether or not the account holder was already taking required minimum distributions, naming a traditional trust (or the account holder’s estate) as the retirement account beneficiary will result in the account either (i) needing to be liquidated over five years if the account holder was not already taking required minimum distributions (i.e., the account holder died before age 70 1/2) or (ii) being subject to required distributions based on the account holder’s life expectancy using the IRS’s actuarial tables if the account holder died after age 70 1/2. Neither of these situations are good when compared to the potential income tax deferral that would be available by taking the required minimum distributions over the lifetime of a younger beneficiary.
There is a way to get the best of both worlds by using a trust that is designed with the purpose of being named as beneficiary of a retirement account, a Retirement Benefits Trust.
What are the benefits of a Retirement Benefits Trust?
Retirement Benefits Trusts generally serve the purpose of being able to “stretch” the account’s distributions over the lifetime of a beneficiary (to take advantage of continued income tax deferral as described above) while maintaining administrative controls over the retirement account. As mentioned above, the ability of a beneficiary to defer income taxes on the retirement account is possible by simply naming an individual beneficiary (or beneficiaries) for the account; however, by designating beneficiaries in that manner, the beneficiaries will also have the ability to fully invade the retirement account without restriction – something that may be inconsistent with the account holder’s wishes.
In addition, a specific type of Retirement Benefits Trust, described below, may offer additional protection from a beneficiary’s creditors.
Are there different types of Retirement Benefits Trusts?
Essentially, there are two types of Retirement Benefits Trusts. The first type is referred to as a “conduit trust.” The term “conduit” accurately describes the arrangement as merely placing a trustee between the retirement account and the trust beneficiary (commonly the child of the account holder).
In a conduit trust, the trustees determine the amount of distributions to take from the retirement account. If the trustees determine that the beneficiary does not need significant funds from the retirement account, then the trustees can simply take the required minimum distributions from the account (this maximizes the deferral of income taxes as described above) and pay those amounts over to the beneficiary. The trustees of a conduit trust are obligated to give the trust beneficiary all of the proceeds distributed from the retirement account less fees. If the trustees determine that the beneficiary should be given more money, the trustees can always choose to take additional distributions from the retirement account and give those distributed amounts to the beneficiary. A conduit trust does not accumulate money separate and apart from the retirement account.
The second type of Retirement Benefits Trust is referred to as an “accumulation trust.” An accumulation trust gives the trustees more flexibility as the trustees are not required to make immediate distributions to the beneficiary. Instead, the trustees can take distributions from the retirement account and continue to hold and invest the proceeds in a separate account established by the trust. Unlike a conduit trust, an accumulation trust allows for accumulation of money inside the trust (even accumulation of the retirement account’s required minimum distributions).
If creditor protection is a concern, it may be prudent to use an accumulation trust since the trustees can refrain from making distributions while creditor issues are outstanding. This creditor protection is important as a result of a Supreme Court case under which an inherited IRA was not considered an exempt asset in bankruptcy. See Clark v. Rameker.
Under what circumstances should you consider using a Retirement Benefits Trust?
How strongly you feel about using a Retirement Benefits Trust will likely turn on a number of circumstances including: (i) the value of your retirement account assets; (ii) whether any of your anticipated beneficiaries may not act prudently with the retirement account assets; and, (iii) whether your anticipated beneficiaries have potential exposure to creditors.
As with all other planning, the proper course depends on the exact circumstances, but in many cases, Retirement Benefits Trusts are not beneficial to use for a surviving spouse as the beneficiary. It may be best to name a surviving spouse as the primary beneficiary of a retirement account and name Retirement Benefits Trusts (for children or grandchildren) as contingent beneficiaries.
The costs of properly establishing Retirement Benefits Trusts and the ongoing expenses to administer the trusts once in place must be considered before incorporating such trusts into an estate plan. Use of the trusts may only be justified where the retirement account holds significant assets or where a beneficiary has creditor issues.
As you can see from the above, a Retirement Benefits Trust is a great tool to add controls over the administration of a retirement account following an account holder’s death without losing the potential benefit of continued income tax deferral. Retirement Benefits Trusts are not warranted in all circumstances, but should be considered in the development of any estate plan.