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  • Rick Kozlowski

Trusts and Retirement Assets

Updated: Jun 24, 2019

Increasingly, people are turning to the use of trusts in order to control the access to, and use of, their wealth after they die. Trusts are used to protect young or vulnerable children from receiving too much money too soon. They are used in second marriages in order to ensure that assets are protected for the children of a first marriage. Trusts are also used to help minimize or eliminate estate taxes, maintain privacy and avoid probate.


Retirement assets, such as IRAs and 401(k) plans, comprise a large portion of many people’s estates. Such assets are notoriously difficult to incorporate into an estate plan because they cannot be transferred during life and they are subject to numerous, arcane income tax rules. Using a trust as a vehicle to control retirement assets after death poses particular challenges because of these rules.


In particular, naming a trust as a beneficiary of a retirement plan will determine how quickly the plan assets must be distributed – and therefore how quickly they will be subject to income taxation.


This blog will describe the rules that govern the interplay between trusts and retirement plans and how those rules determine the income taxation of plan assets. For the ease of discussion, I will refer only to IRAs – the same rules apply to 401(k) plans, etc.


The Basics

The name of the game for IRAs? Maximum income tax deferral. During an IRA owner’s lifetime, the earnings of an IRA are not subject to income taxation. This permits the assets to grow tax-free – a significant benefit over a long period of time.


The quid pro quo for income tax deferral is that the owner must begin taking distributions from the IRA beginning at age 70½ (and paying tax on those distributions). Such distributions are known as “RMDs” (required minimum distributions). When the owner dies, various rules apply in setting the RMDs for those who inherit the IRA, whether they be spouses, children, etc. With respect to estate planning, often the trick is to try and continue, as much as possible, the deferral of income taxes after death -- while maintaining control of the IRA via a trust.


The IRS permits a trust to be a designated beneficiary of an IRA, provided: (1) it is valid under state law, (2) it is irrevocable (either upon creation or upon the death of the IRA owner), (3) the IRA custodian is provided a copy of the trust documentation, and (4) the trust’s underlying beneficiaries are all identifiable, living breathing individuals.


The first 3 IRS requirements are a snap. With respect to the 4th, the question is: who are the underlying trust beneficiaries? Their identity is critical because the IRS uses the life expectancy of the oldest trust beneficiary to determine the trust’s RMDs. The older the beneficiary, the larger the RMDs (and therefore the shorter the deferral).


Identifying the Trust Beneficiaries

Luckily, the IRS has provided guidance in determining which trust beneficiary’s life will be used to set RMDs. According to the IRS, if the income beneficiary of a trust is entitled to receive outright distributions of all RMDs, then that beneficiary’s life is the one used to set the RMDs (no other trust beneficiaries need to be considered). This type of arrangement is known as a “conduit trust,” and is a simple way in which to create a trust that has easily determined RMDs.


The problem with a conduit trust is that the outright distributions of all RMDs is often in direct conflict with the IRA owner’s goals. For example, if the trust is designed to benefit children, and those children are young, have special needs, or are spendthrifts, then it might not be prudent to require the outright distributions of all RMDs. Rather, the trust might give the trustee the power to accumulate the RMDs – an arrangement known as an “accumulation trust.”


In order to identify the beneficiary of an accumulation trust, it is necessary to analyze the trust to determine when an outright distribution of RMDs (or the entire trust principal) eventually occurs. Once that level is reached, no subsequent beneficiaries (or their life expectancies) need to be considered. The trick is to identify when the outright distribution will occur and who the potential beneficiaries will be.


A few examples help illustrate the differences between conduit and accumulation trusts:


(1) A trust for a surviving spouse with income and principal payable at the discretion of the trustee. The remainder is paid outright to children. This is an accumulation trust (RMDs are not required to be paid out). Because the spouse is the oldest beneficiary, her life is used to set the RMDs. Very straightforward.


(2) A trust for children that requires all RMDs to be distributed during their lifetimes in equal shares, with the principal passing outright to grandchildren. This is a conduit trust – the age of the oldest child sets the RMDs.


(3) A trust for a surviving spouse with income and principal payable at the discretion of the trustee, with continuing trusts for the owner’s siblings under the same discretionary regime (an accumulation trust). On the death of the last sibling, the remaining assets are paid to the IRA owner’s parents. Since the parents are potential beneficiaries and there are no outright beneficiaries in between, they are trust beneficiaries and the life expectancy of the oldest of them is used to set the RMDs (not a good result).


(4) Same fact pattern as (3), except on the death of the last sibling, the remaining assets are paid to the owner’s favorite charity. Since the charity is not a living, breathing individual, there is no designated beneficiary (a charity has no life expectancy). All of the IRA assets must be withdrawn within 5 years after the year of death!


What to Do

If you have retirement assets and desire to control their disposition after your death, a trust will help you achieve that goal. You should try, if possible, to minimize the income taxation of those assets. The type of trust you employ will dictate the income tax results. If you plan to employ a trust and name it as a beneficiary of your retirement plan, you should first discuss this issue with your estate planner to ensure that you won’t inadvertently (and unnecessarily), accelerate the income taxation of the retirement assets.