Estate planning is vital, but not necessarily straightforward. It can be complex, and to be effective must be tailored to an individual’s circumstances and preferences. This article describes one of the many estate planning techniques that can be used to target client needs, IRA Stretch Trusts. This tactic is becoming increasingly relevant, given that IRAs have now been a popular tax deferred vehicle for nearly 40 years. As a result, IRAs are now an important component of most retirement plans, and subsequently, estates. This article will outline a particular type of financial trust that can help protect the IRA assets left to heirs.
When a holder of a traditional IRA passes away, the account is passed along to any non-spouse designated beneficiaries in what is known as an “Inherited IRA”. The new holder of the IRA must begin taking Required Minimum Distributions (RMDs) the following year, with the amount of these distributions being based on the life expectancy of the inheritor (recipient). These distributions will be considered part of the inheritor’s income and will taxed at their resulting income tax rate. Depending on the circumstances of the recipient, the optimal strategy for tax efficiency may be to withdraw only the required minimum distribution (RMD) from the IRA each year, achieving what is called the maximum IRA “stretch-out”. It may be that beneficiaries are unaware of the full ramifications of distribution rules, and choose an action (such as cashing out the IRA or rolling it over into their own IRA) that triggers immediate taxation of the entire amount of the inherited IRA at the beneficiary’s highest marginal tax rate.
An IRA stand-alone trust (alternatively known as an IRA stretch trust, designated beneficiary trust, or IRA inheritance trust) can be used to avoid such a costly error. This type of trust can guarantee that the IRA will be stretched out over the longest possible period, avoiding unnecessary taxation. This withdrawal strategy can preserve the tax deferred status of the inherited assets, sometimes even for multiple generations.
Beyond tax-related benefits, the Stretch Trust might be appropriate if the individual planning for the disposition of their estate were concerned about the safety of those assets from misuse by the beneficiary or outside legal circumstances. For example this type of trust offers increased protection in the case of outside claimants on the assets of the beneficiary, such as in the case of divorce or lawsuits. These trusts also allow the trustee to remain eligible for need-based government assistance programs such as Medicaid or disability income assuming the income received from the RMD is less than the maximum allowable level of income for these programs. It also ensures that the assets will remain in the beneficiary’s family, as opposed to allowing the spouse of the beneficiary to pass those assets to a future spouse or children from another marriage. Another circumstance would be if the beneficiary has little experience handling money, or has a penchant for instant gratification. The trust, by stretching out the distribution, would protect them from being taken advantage of or from utilizing the funds too rapidly or inappropriately. Along the same lines, a stand-alone trust can be ideal for a minor beneficiary or any other beneficiary considered to be incapable of handling their own financial affairs.
These trusts may not be ideal for every family or every situation. To make this strategy worth the cost, it is best to have at least $200,000 in the IRA to be inherited, and the beneficiary should be expected to outlive the IRA holder by at least 10-15 years. If you have any questions about whether an IRA stand-alone trust is right for your circumstances, or want help with implementation, please contact your advisor.