By: Jesse C. Chapel
Revocable trusts and retirement accounts are commonly used in financial and estate planning. Retirement accounts have tremendous tax advantages for both us and our children. In some cases, a client may want to designate their revocable trust as a beneficiary to their retirement account. This makes sense in many cases depending on the person’s family situation and estate planning goals. However, the trust agreement needs to be drafted very carefully, otherwise naming the trust as the beneficiary can jeopardize some of the tax benefits retirement accounts provide.
The tax code does not give us many tax exemptions, but retirement accounts are one of the few exceptions. Traditional Individual Retirement Accounts (IRAs) and Roth IRAs have different advantages, but the one thing they have in common is that the money grows tax free as long as its stays in the account. In the case of traditional IRAs, it might be more accurate to state that the tax on the growth is deferred, but generally a tax deferral is in substance a tax exemption.
It gets even better. The tax code allows this tax free growth to continue for our named beneficiaries, such as our kids, who inherit these accounts. These are often called an Inherited IRAs or Inherited Roth IRAs. The tax code does have rules for when our kids must take distributions, which are called Required Minimum Distributions. The beneficiary can spread out the RMDs over their life expectancy (as determined by a table produced by the IRS). This is sometimes called a “stretch-out” because the beneficiary can stretch-out the distributions over their lifetime. The tax savings through a stretch of distributions out can be substantial.
Generally speaking, a good strategy is to name the spouse as the primary beneficiary and the children as back-up beneficiaries. In some cases, however, we may not want our kids to inherit the account outright, because they may be too young or not situated to handle a significant inheritance. The alternative would be to name the trust as the back-up beneficiary to the spouse. The problem here is that when a retirement account is left to a trust there is the risk that the account may have to be distributed out within five years of your death. The opportunity to stretch-out the distributions over your children’s lifetime may be lost, which in effect would decrease the amount your child will ultimately inherit.
The good news is that there are ways to avoid this result. IRS has allowed a stretch-out of distributions over a trust beneficiary’s life expectancy, but certain provisions must be included in the trust agreement.
If you want to name a trust as a beneficiary, you should consult counsel, because it gets complicated. You will be doing your kids a big favor.
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Posted on Tue, October 18, 2016
by Andrews Davis filed under