Given the enormous amount of wealth held in retirement accounts, it is critical that individuals properly name the beneficiaries of these assets and protect them from creditors, predators, divorcing spouses and lawsuits. During your lifetime, your retirement funds have asset protection and, therefore, cannot be taken in a lawsuit. Unfortunately, as soon as retirement accounts are inherited, the shield of creditor protection evaporates. In order to remedy this problem, the creation of a retirement plan trust should be considered.
A retirement plan trust is a special type of trust. In addition to creditor and predator protection, a retirement plan trust offers the following advantages:
Divorce protection. Keeps the retirement funds within the family bloodline and out of reach of the beneficiary’s soon-to-be ex-spouse and his or her children from a previous marriage.
Lawsuits. Protects the funds in the event of a lawsuit against the beneficiary.
Spendthrift protection. Prevents a beneficiary from squandering the funds through reckless spending or gambling.
Special needs planning. Protects the funds for a special needs beneficiary without jeopardizing his or her state assistance and, instead, allows for proper planning for such beneficiary.
Minor beneficiaries. Allows minor beneficiaries to enjoy the funds without the need for a court-appointed guardian or conservator.
Investment management. Allows for experienced investment management and oversight of the account assets by a trustee, which is especially valuable for a beneficiary who is not financially savvy.
Tax Planning. Facilitates generation-skipping transfer (GST) tax planning to ensure that estate taxes are minimized, or even eliminated, at each generation.
Surviving Spouse as Beneficiary
If the beneficiary of the retirement plan is a surviving spouse, the spousal beneficiary possesses the unique right to roll over inherited retirement benefits into their own retirement plan. In that case, the spouse may make additional contributions to the plan, the 10 percent penalty applies to early withdrawals, no minimum distributions are required until age 70½ and the spouse enjoys creditor protection.
However, if the spouse instead takes the benefits as a spousal inherited IRA and not a rollover to his or her own plan, the retirement account is not considered a retirement account under federal bankruptcy law and, therefore, is not protected from creditors. Because the spouse cannot make additional contributions, must take required minimum distributions (RMDs) immediately and can withdraw from the plan at any time without penalty, all creditor protection is likely lost.
Accordingly, creating a retirement plan trust for the benefit of a spouse is important for creditor protection reasons, as well as when there is a second marriage with a blended family, when coupled with disclaimer planning or for a spouse who eventually needs nursing home care and seeks to qualify for Medicaid.
Non-Spouse as Beneficiary
For a non-spouse beneficiary, inherited IRAs are vulnerable to creditors. In order to protect the retirement funds, a retirement plan trust is necessary.
The preferred type of retirement plan trust to protect the inherited IRA is referred to as an “accumulation trust.” When the retirement plan trust is structured as an accumulation trust, beneficiaries can enjoy not only protection of the plan balance, but also protection of the annual distributions required from the account. Provisions would be included to permit the trustee full discretion over whether to accumulate the RMDs in trust as opposed to passing them out immediately to the beneficiary. These provisions ensure asset protection over the funds in the account. Because the trustee enjoys the full discretion over whether and when distributions will be made, the beneficiary cannot force a distribution from the trust and, therefore, neither can a creditor of the beneficiary.
The alternate type of retirement plan trust, a "conduit trust", does not permit the accumulation of required distributions from the plan, but instead requires that they be distributed out immediately to the beneficiary where, in most states, the protection of the trust is lost. The trust conduits or channels the RMDs to the beneficiary, and they become available to the beneficiary’s creditors and predators, regardless of whether the trustee is given discretionary distribution authority. Even so, the plan balance will remain protected.
Additionally, a conduit trust automatically qualifies as a designated beneficiary (DB) under the IRS safe harbor provisions. If a trust isn’t a DB, then the retirement funds will be depleted over five years instead of the beneficiary’s life expectancy. However, if properly drafted, an accumulation trust may also qualify for this favorable treatment.
A “toggle trust” is a hybrid of a conduit trust and an accumulation trust. A toggle trust is a more flexible solution because it allows the choice of which type of trust to use to be made at a later date. This trust allows a “Trust Protector” to make that decision based on the needs and circumstances of the beneficiaries at the time of death of the retirement plan owner. Accordingly, if the beneficiary is a responsible adult with no creditor problems, the Trust Protector may decide to utilize a conduit trust for that beneficiary. If not, the Trust Protector may choose to use an accumulation trust in order to achieve maximum creditor protection.