Retirement accounts, including IRAs and 401(k) funds, are often some of the largest assets our clients own. People typically have three main concerns when planning to pass their retirement funds on to the next generation:
- They want to stay out of probate;
- They want to delay taxes as long as possible; and
- They want to protect their funds from their children’s legal and money problems.
Unfortunately, basic estate planning is only able to accomplish two of these goals at a time. The simplest way to pass on a retirement account at death is through a direct beneficiary designation on the account itself. A direct beneficiary designation keeps the account out of probate, and it will give the beneficiaries the ability to continue the tax deferral through their own life expectancies (if they are wise enough to leave the money alone). On the other hand, a direct beneficiary designation does nothing to protect the funds from the creditors of the beneficiaries or from their potential ex-spouses, nor does it protect the funds from the beneficiaries’ own poor money management.
Because of the downfalls inherent in direct beneficiary designations, some opt for a slightly more complex estate plan; they direct their retirement funds to a revocable living trust at death. This planning strategy also keeps the funds out of probate. And while all living trusts do not contain asset protection clauses designed to protect the heirs’ inheritance, a properly drafted living trust can contain protective provisions designed to ensure that the inheritance passing through the trust is kept out of the reach of the beneficiaries’ creditors and out of the hands of potential ex-spouses. A living trust can also contain provisions that protect the heirs from their own poor money management. On the other hand, when retirement funds pass through a living trust, the beneficiaries are forced to pay all taxes on the funds within five years of the death of the previous owner of the retirement accounts; they are not permitted to delay the taxes the way they could with a direct beneficiary designation. This can be a huge hit to the future growth of these funds.
There is a better way – an option that can meet all three planning goals at the same time. This planning option involves the use of an IRA Trust.
The IRA Trust is the best of all worlds. At first glance, an IRA Trust looks very much like any other trust; however, the IRA Trust contains special tax terms included for a very specific purpose. The IRA Trust is designed and drafted specifically to allow people to pass on their retirement funds in the best way possible, meeting all three goals typically expressed by planners.
First, use of an IRA Trust keeps the retirement funds out of probate, just like a direct beneficiary designation and a revocable living trust. This is huge considering attorney’s fees alone can reach 5% of the value of a person’s probate estate, and the probate process locks up the assets in the estate for no less than six months.
Second, use of an IRA Trust protects the retirement funds, keeping them out reach of the beneficiaries’ creditors and out of the hands of their potential ex-spouses. Use of an IRA Trust can also shelter the funds from the beneficiaries’ own poor money management if appropriate, putting control of the funds in the hands of a trusted individual. Those who plan to pass their retirement funds to young children or grandchildren have an even greater incentive to use an IRA Trust; this trust will allow them to name a trustee of their own choosing to manage the retirement funds for the benefit of their underaged beneficiary until they are old enough to manage the funds themselves.
Third (and this is the most interesting and least understood point, even among professionals), the taxes due on retirement funds passing through a properly drafted IRA Trust can be deferred based on the life expectancy of each beneficiary, resulting in huge tax savings and potentially explosive growth in the funds over time. The potential tax-free growth is even more staggering when the beneficiary is a young child or grandchild.
When it comes to passing retirement funds to the next generation, the IRA Trust really is the best of all worlds.