Can Retirement Trusts Help Protect Beneficiaries?

Originally published in Wealth Point, June 2018)

While most people have considered who would be the beneficiary of their retirement assets, many have not explored how the beneficiary would receive these assets. A retirement trust may assist you in ensuring multi-generational control over how the assets would flow, while helping your beneficiaries extend the income stream and insulate them from potential unknown risks. We encourage you to talk to your advisor to see if a retirement trust has a place in your wealth plan.

WHAT TO THINK ABOUT AFTER YOU COMPLETE A BENEFICIARY DESIGNATION FORM

Whether you have one individual retirement account (IRA) or several, or other similar retirement savings plans (such as a 401(k), 403(b) or 457), it’s highly likely that you did this one thing — you completed a beneficiary designation form, filling in the names and information for your beneficiaries, or people who would receive your retirement assets upon death.

While your thoughts for your beneficiaries may have ended there, it’s important to consider how your beneficiaries will receive these assets. Most people are unaware that without proper planning, beneficiaries may be harmed—more than helped—when inheriting an IRA. This is alarming, as retirement accounts frequently make up a significant portion of a person’s assets. According to the Investment Company Institute (ICI), total US retirement assets were $28.2 trillion as of December 31, 2017, and comprised 35 percent of all US household financial assets at the end of 2017, as shown in Chart 1.

WHAT HAPPENS TO IRA ASSETS WHEN IT PASSES TO BENEFICIARIES?

An IRA owner is required to take required minimum distributions (RMDs) once he/she reaches age 70½. Upon the passing of an IRA owner, inheriting beneficiaries can choose to either take the distributions over their life expectancy or take the assets over a 5-year period. These distributions begin in the year after the plan owner’s passing, and the inheriting beneficiary cannot defer the RMDs until he/she is age 70½, unless he/she is a surviving spouse.

Regardless of the distribution option chosen, one thing is certain, beneficiaries will need to pay taxes as they withdraw funds from the account. Ideally, beneficiaries will defer paying that tax for as long as possible by taking only the annual RMD. Unfortunately, beneficiaries often take more than the RMD, not because they need it, but because they receive bad advice, are unaware of the tax impact, or may be spendthrifts. As a result, significant income taxes are imposed much earlier than required and beneficiaries lose the benefit of compounding, tax-free growth. Without careful consideration, passing the IRA to a beneficiary may result in a host of other problems:

  • When an IRA is left outright to a beneficiary, the original IRA owner loses control of who will eventually inherit the IRA assets after the death of the first beneficiary. This can be a problem with blended families, or a mixed family as a result of a second marriage.
  • The IRA beneficiary is too young or may be incapacitated, unable to manage the IRA funds.
  • A disabled beneficiary could lose state and federal government benefits upon receipt of IRA funds.
  • Lawsuits filed against a beneficiary or bankruptcy would result in the loss of the IRA funds.
  • If a beneficiary gets a divorce, the divorcing spouse could take the retirement assets.

“STRETCH” INHERITED RETIREMENT ASSETS TO CAPITALIZE ON TAX-FREE GROWTH

The ability for IRA investments to grow tax free makes inherited IRAs one of the most valuable assets when planning for intergenerational transfers of property. For example, as shown in Chart 2, a $1.0 million IRA, inherited by a 40-year old beneficiary could be worth $4.5 million or more over the beneficiary’s lifetime.

Source: ICI, December 31, 2017


Source: Financial Engines calculator

Postponing these withdrawals by taking only the annual RMD is one “stretch” strategy that beneficiaries can use. Another “stretch” strategy is for the initial IRA holder to designate a retirement trust as a beneficiary. A retirement trust helps create a continuing source of income for your beneficiaries while also providing protection against all the risks discussed above. A retirement trust is perfect for individuals who have substantial assets ($300,000+) in their retirement account and expect some of those assets to go to their beneficiaries.

A retirement trust may offer more control over who receives your assets and how it may be used by your beneficiaries. It’s important  to note that when a trust is the beneficiary of an IRA, the terms of the trust must adhere to specific requirements to obtain maximum “stretch” over the beneficiary’s lifetime. A standard revocable trust generally does not meet these requirements.

Even if you have no current concerns about how your beneficiaries will manage the IRA assets after your death, a retirement trust may protect your beneficiaries from unknown risks that may arise later. Talk to your advisor to see if retirement trusts can serve as a smart planning solution for your wealth planning needs.

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