AUSTIN, Texas — Designating a trust as a beneficiary of an IRA isn’t getting any less complex, but with the demise of pensions and other defined benefit plans, it’s certainly getting more vital to financial advisors and their clients.
Estate and retirement plan attorney Natalie Choate discussed the increasingly important tool in a speech to an audience of some 100 planners at NAPFA’s spring conference. The author of “Life and Death Planning for Retirement Benefits,” now in its eighth edition, warned that the situation could turn into a mess that’s “really not your department,” because attorneys write the trusts.
When a client intending to leave an IRA to a spouse or children through a trust dies, it’s often difficult to tell exactly how they wanted it distributed, according to Choate.
“You probably may have, once or twice, run across an estate planning attorney who doesn’t know this stuff,” she said to appreciative laughter. “It’s pretty rare, I admit, but it doesn’t happen more than once or twice a week, right?”
U.S. households have amassed a cumulative $9.3 trillion in all types of IRAs, the Investment Company Institute found in a December study. IRAs constitute a third of U.S. retirement assets — up from 21% two decades earlier — and 11% of all household assets, compared to 7% in the late 90s.
Using trusts as a way of ensuring that a client’s inheritance doesn’t get spent all at once by the beneficiary presents a challenge. The instruments must satisfy complex criteria for the IRS to consider them “see-through” or “look-through,” thereby making the IRA eligible to be paid out over the beneficiary’s lifetime expectancy, Choate says.
“You’ve got three separate tracks that you have to navigate and keep in mind,” she said, citing required minimum distribution rules, income taxes and trust accounting. “You have these responsibilities.”
To be a see-through instrument, IRS rules dictate that the trust meet five requirements: it must be valid under state law; irrevocable when the IRA holder dies; be given to the plan administrator by Oct. 31 of the year after the death; name specific people as beneficiaries; and make it possible to identify the “oldest possible” beneficiary.
The last two requirements pose the most difficulty, Choate says, pointing out that the IRS hasn’t defined which beneficiaries it’s referring to between several types of them. The oldest possible beneficiary might also cause problems if minors are supposed to receive the inheritance.
Planners “have to be very particular about how these trusts are written and how they’re actually executed,” agrees planner Scott Beaudin of Burlington, Vermont-based Pathway Financial Advisors. There are also additional costs associated with administering the trust, he added.
Beaudin noted that his RIA has significantly more clients with IRAs containing millions of dollars than it did 10 or 15 years ago, when they more commonly ran to six figures. He attributes the change to the country’s shift to defined contribution plans from pensions.
“It was less concerning that $100,000 went to Johnny who’s a spendthrift,” Beaudin says. “It’s more concerning when it’s a million-dollar IRA. That’s what we see in certainly our practice.”
To enable clients to restrict outlays from their IRAs after death, advisors should see to it that the estate attorneys create either the simpler, and more widely used, conduit trust or the more complex accumulation trust, according to Choate. Conduit trusts distribute the RMD through a trustee, while allocation trusts allow the trustee to hold on to the RMD so it grows with the principal. IRS guidelines name only those two kinds of trusts as examples of instruments that meet its standards, Choate says.
“We know these work. So I’m telling the planners — use these safe harbors. Don’t go out into the wilderness and come up with fancy inventions,” she said. “If you care about a life expectancy payout for your trust, you would want to be in one of these safe harbors.”
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