Retirement Plan Trust

Written by: Carmen Sheppard

Article written by Jonathan B. Osler, Esq.

If you are reading this article, chances are good that you have done an excellent job socking away funds in an Individual Retirement Account (IRA) or in multiple IRAs.  Indeed your IRA may be the single largest asset in your investment portfolio, or even your entire estate.  Because IRAs are such valuable assets, it is therefore vital to plan for how your IRA will be distributed when you pass away.  The realm of IRAs can be tricky, however, as retirement plans are governed by a set of complex regulations.  Poor planning can lead to major tax consequences down the line for beneficiaries, or simply fail to meet your objectives.  If you have a large IRA—typically $250,000 or greater—then you should consider leaving your retirement account to a Standalone Retirement Plan Trust (RPT), rather than transferring it to your beneficiaries outright, or through a Revocable Living Trust.  This article explores the numerous advantages of using an RPT for the disposition of your retirement account—read on to learn more! 

Before we discuss the RPT, there are a few key characteristics of IRAs that everyone should keep in mind when doing IRA planning.  For example, although the tax code requires beneficiaries of an inherited IRA to withdraw a percentage of the IRA each year—this is called a required minimum distribution (RMD)—it allows the remainder of the principal to continue growing tax-deferred.  The RMD is determined by the beneficiary’s age and life expectancy, and the younger the beneficiary, the smaller the RMD that is required to be withdrawn each year.  Although the beneficiary of an inherited IRA must take out the RMD, the tax-deferred growth in the account can far surpass the amount that must be withdrawn, so the account actually becomes larger over time.  This concept is commonly referred to as the IRA “stretch-out,” and it is far better for the beneficiary from a tax perspective in comparison to cashing out the IRA in a lump-sum distribution.  If the beneficiary takes the lump sum, he or she will owe ordinary income tax on the entire balance of the IRA—resulting in the beneficiary losing up to 37% of the IRA in taxes right off the bat!  In addition to the stretch-out, it is important to know that your IRA is protected from creditors (up to an amount determined under federal bankruptcy laws and adjusted for inflation annually; for 2018 this number was just under $1.3 million).  However, due to a recent Supreme Court ruling, inherited IRAs received in an outright distribution do not enjoy the same creditor protections.  Finally, for those with Revocable Living Trusts, if the IRA pays out to your trust and the trust has multiple beneficiaries, the RMDs for all beneficiaries will be tied to the eldest beneficiary’s age.

Now to better appreciate the benefits of the RPT, it is important to understand the disadvantages of naming a beneficiary outright as the recipient of your IRA.  With an outright distribution, you have no control over the treatment of your IRA.  A beneficiary could squander a significant portion of the IRA in taxes alone by choosing to cash out the IRA immediately or by withdrawing it over five years.  Due to lack of guidance or financial immaturity (among other reasons) the beneficiary may sacrifice the stretch- out without comprehending the consequences.  Also an outright distribution leaves the IRA vulnerable to the beneficiary’s creditors, which can include a spouse in divorce or a plaintiff in a lawsuit.  Further, a distribution to a minor must be paid to a guardian, and if no guardian exists, the court will step in and manage the IRA through a custodial account.  Upon reaching the age of majority the beneficiary takes full control of the IRA, opening the door for mismanagement of the account as a result of the beneficiary’s age and financial irresponsibility.  Additionally, if the beneficiary predeceases you and no contingent beneficiary is named, the IRA becomes subject to the court’s probate process—and a deleterious consequence of probate is that the IRA must be cashed out, with all the taxes due immediately.  If a beneficiary is incapacitated, there is the risk that an outright distribution of the IRA will result in court interference and loss of government benefits.  Finally, if the beneficiary is your spouse, he or she can take the “spousal rollover” and name new beneficiaries, perhaps against your original wishes. A blended family this could mean disinheritance of your children from a prior relationship.

Thankfully, all the potential negative consequences of an outright distribution can be avoided with the Standalone Retirement Plan Trust.  By creating an RPT, you can control the disposition of the IRA through the terms of the trust.  The RPT can be set up to prevent the beneficiary from cashing out the IRA or taking distributions that exceed the annual RMD, thereby ensuring that the beneficiary receives the maximum stretch-out.  Moreover, by naming a trust as the primary beneficiary of the IRA, your beneficiary receives the benefit of asset protection, which keeps the IRA out of the hands of creditors or a spouse in divorce.  The trust also guarantees continuity in the event of the beneficiary’s death, as the terms provide for successor beneficiaries as well as Trustees to manage the RPT—a significant benefit if the next beneficiary in line is a minor.  By virtue of the IRA being held in trust, the asset cannot accidentally become subject to probate or court interference.  The RPT also can be designed to provide for an incapacitated beneficiary or a beneficiary with special needs, and to prevent the beneficiary from losing or failing to qualify for government assistance. Importantly, the RPT can protect against accidental or intentional disinheritance in blended families; for example, the trust’s terms could dictate that your spouse receives RMDs for life, with the remainder of the IRA passing to your children from a prior relationship.  And, if you already have a trust-based plan, such as a Revocable Living Trust, RPTs can be used to circumvent the rule that ties RMDs to the age of the eldest beneficiary.  The IRA can be subdivided and designated to multiple RPTs, each with its own beneficiary, and the beneficiary of each separate trust then takes RMDs based on his or her own life expectancy.  With this method, the IRA can be split between your child and a grandchild, for example, without the grandchild taking RMDs based on the life expectancy of the parent.  Thus, RPTs are an excellent complement to an existing trust-based plan, as both your specific goals for the IRA and general wishes for the disposition of your estate can be achieved through the coordinated use of separate trusts.

When conducting IRA planning, the RPT can be a superb tool for meeting your objectives.  If you have a large IRA, and you wish to maximize the tax-deferred stretch-out and to provide asset protection for your beneficiaries, then the RPT is an ideal vehicle for achieving your goals.  To learn more about how the Standalone Retirement Plan Trust can form an essential part of your estate plan, contact us today to schedule a conversation with one of our Estate Planning attorneys.