Reasons to set up a Third Party Supplemental Needs Trust as an Accumulation IRA Stretch Trust

In a previous post, I described the Reasons to Set up a 3rd Party Supplemental Needs Trust as an Irrevocable Life Insurance Trust.  The same Third Party Supplemental Needs Trust can also be set up as an IRA Stretch Trust. 

 If a Special Needs person is named as beneficiary of an IRA, 401k, 403b or any other asset, that could ruin their ability to qualify as for SSI and Medicaid.  However, paying retirement money to a traditional Third Party Supplemental Needs Trust can cause income tax problems.  Accordingly, we usually recommend that the Supplemental Needs Trust be created with provisions that allow a slow withdrawal of the retirement account over the lifetime of the beneficiary into a trust for the following reasons:

• A traditional Third Party Supplemental Needs Trust can be named as a beneficiary of a retirement account, however, that is usually very tax inefficient from an income tax perspective as the IRS will require the retirement money to be paid to the trust within 5 years, and it will be taxed and the very high trust rates.  
• To minimize income tax consequences, the trust should be designed as a modified IRA Stretch Trust.
• An IRA Stretch Trust requires the Trustee to withdraw a certain amount each year from the retirement accounts which name the trust as the beneficiary.  The amount the Trustee is required to withdraw from the retirement account into the Supplemental Needs Trust is known as the Required Minimum Distribution (RMD) Amount.  The Required Minimum Distribution Amount is a based upon a formula set by the IRS that is tied to the life expectancy of the beneficiary of the trust (the Special Needs person). 
• By taking out only the RMD each year, the IRA can continue to grow tax deferred. After the trustee withdraws the RMD from the retirement account into the Third Party Supplemental Needs Trust, the trustee may leave the money in the trust or distribute it to the Special Needs person subject to the normal limits of Special Needs Trusts.  
• PLANNING NOTE: This should never be set up as a Conduit Stretch Trust as that will ruin the benefits of the Special Needs Person.  A Conduit Stretch Trust requires the RMD be distributed to the beneficiary every year.
• PLANNING NOTE: In order to establish the Special Needs Person's life as a measuring life for IRS tax purposes, and have the Third Party Supplemental Needs Trust be treated as an Accumulation Trust, upon the death of the Special Needs Person, the balance of the trust and the retirement money can ONLY be paid to a person who is younger than the Special Needs Person.  
• PLANNING NOTE: If you think that the client may wish to benefit an older sibling of Special Needs Person, consider making that older sibling the measuring life.

One downside to naming a properly designed Third Party Special Needs Trust with accumulation provisions as the beneficiary of a retirement account is that the income tax rates for trusts is higher than that of an individual.  However, if you wish to engage in special needs trust planning and provide a special needs person access to money from a retirement account, this appears to be one of the most tax efficient ways of doing so while also preserving the the government benefits of the special needs person.  

It should be noted that when doing Special Needs Trust Planning, sometimes, if parents have more than one child, they will name name a non Special Needs child as beneficiary of retirement money and a trust for the Special Needs Child as beneficiary of other assets. This is a completely viable alternate type of plan, but care should be considered regarding what happens if that other child predeceases the parents.

The Biggest Danger of a Roth IRA Conversion

After speaking with a client who did a ROTH IRA conversion last year, I realized that there is a major danger to these conversions. You cannot assume that the financial instituion will designate the same beneficiaries on the ROTH IRA as had been named under the traditional IRA. Many financial instituions will send out beneficiary designation forms separately, long after the converison has been done. If the owner is not expecting it, he or she may just throw away the form.

It is very important for anyone who has done a ROTH IRA conversion to double check the beneficiaries on the new account to ensure they are what you want. This is particularly true if you want to name an IRA Stretch Trust.

IRA Planning in Light of Robertson v. Deeb

In December of 2009, the Florida Court of Appeals concluded in Robertson v. Deeb, 16 So. 3d 936 (Fla. 2d DCA 2009), that the beneficial interest that a person owns in an inherited IRA may be subject to garnishment. In other words, an IRA that you inherit may be taken by your creditors. This is different from an IRA that you establish yourself, or a retirement plan like a 401(k) or 403(b), which are all protected against creditors.

The result itself did not surprise me much until I read and article by Kristen M. Lynch and Linda Suzzanne Griffin in the April 2010 Florida Bar Journal. Intuitively, it made sense that a creditor can go after an asset that you inherit. Usually, the rule of thumb is that unless an asset is specifically exempted, a creditor can sue to get it.

What made this case unusual, and what I was not aware of, is the fact that there was a specific statute on point, F.S. Section 222.21, which seems to indicate that money payable to the "beneficiary" of an IRA is exempt from all claims of creditors. The Court, however, stated that a beneficiary who inherits an inherited IRA is not entitled to the same protection as a beneficiary who contributes to his or her own IRA.

I do not wish to argue the merits of the Court's decision, but I will point out that as a result of this case, anyone who has a substantial IRA should seriously consider establishing a trust for their loved ones which has "stretch" and asset protection provisions.

For many people, their IRAs are their biggest asset. It is clear, now more than ever, that if you wish to protect your IRA from creditors, you cannot simple name your loved ones as the beneficiaries without risking it being taken. Moreover, you cannot simple name a traditional trust as the beneficiary without incurring large income taxes. You need to do comprehensive IRA planning.

IRA Stretch Trusts

What is a Stretch IRA Trust?

Trusts in General - A trust is a legal relationship that exists when one person or an entity (the Trustee) holds title to money or property for the benefit of one or more people (the Beneficiaries). The terms of the relationship are decided by the person providing money to the trust (the Grantor), and are usually in writing.

Stretch IRA – The term Stretch IRA refers to a plan, following the death of the IRA holder, to withdraw only the minimum amount allowed by law. This amount is known as the required minimum distribution. The resulting benefit of this plan is that the assets inside the IRA can continue to grow tax-deferred over the lifetime of the named beneficiaries. Either a traditional IRA or a ROTH IRA may be stretched.

Design of a “Stretch IRA Trust” - A “Stretch IRA Trust” is a flow-through trust designed to guarantee the extension of payouts of your IRA for as long as possible after your death. This is accomplished by allowing the trustee of the Stretch IRA Trust to take out the required minimum distribution, absent emergency. The trust is specially created for the sole purpose of being named as the Designated Beneficiary of an IRA. The reason a special trust is needed is because the provisions of most trusts will not qualify as a flow-through trust. In contrast, should a non-qualified trust be named as the Designated Beneficiary, all the income tax would be due in year one and there would be no further opportunity for tax deferred growth – the worst outcome possible.

What are the Benefits of a Stretch IRA Trust?

Guarantees Deferred Payout of IRA – A plan to stretch out an IRA is merely a plan until the person you name as your beneficiary decides to withdraw the entire amount, creating a huge income tax. Naming a Stretch IRA Trust as the beneficiary of your IRA will ensure that your loved ones defer the built in tax for as long as possible. This is especially useful for young or irresponsible children/grandchildren.

Allows for Control of Assets After You Die – You can set the terms of an IRA Stretch Trust so that your heirs receive money over time, rather than in a lump sum. You can also control where the money goes at the death of the beneficiary if the beneficiary should die before all the money is distributed.

Asset Protection - A trust can protect your money from creditors and make it less likely your heirs will fritter away their inheritance.

Allows for Post-mortem Planning – It is difficult to do much planning with IRAs, but in the event your children do not need the money, creating a trust structure will permit your children to transfer the IRA to their heirs, via disclaimer, without fear that the money will be squandered.

Avoids Over-funding of Spouse for Estate Tax Purposes - A trust structure can both provide income for a surviving spouse and allow both spouses to make proper use of their tax exemptions, thereby minimizing federal and state estate taxes upon the second to die.

Who Should Consider an IRA Stretch Trust?

Individuals with Significant IRAs or ROTH IRAs - Individuals with substantial wealth trapped in their IRA or ROTH IRA may benefit from a Stretch IRA Trust as a way to guarantee that income taxes are reduced, the assets continue to grow on a tax deferred basis, the assets are protected from creditors, and your wealth is preserved. This is particularly helpful for individuals who have young or irresponsible children/grandchildren.

Couples in a Second Marriage – An IRA which names a second spouse as a beneficiary, rather than children of the first marriage, can frequently lead to unintended results - like the money going to the children of your spouse rather than to your children! Giving the money to your spouse in trust will ensure that the money is available for spouse, but also provide for any remainder to go to the people you truly wish to benefit.

What Is Involved In Creating an IRA Stretch Trust?

Hiring an Attorney – When choosing an attorney to prepare your IRA Stretch Trust, you should choose an attorney who is knowledgeable in estate planning, retirement planning, current tax law and asset protection law.

Choosing a Trustee – You can hire either a corporate trustee or an individual trustee. Many people simply have their spouse or a relative act as trustee. You may also have a corporate fiduciary and another person act as co-trustees.

Cost - The cost of an IRA Stretch Trust varies from practitioner to practitioner as well as each client’s needs. How complicated you wish to make the trust and how many beneficiaries you wish to name may also be a factor in the cost. Nevertheless the cost will almost always be far less than the anticipated savings.

Beneficiary Designation Forms – Whether you create an IRA Stretch Trust or plan to stretch an IRA without a trust, it is imperative that you correctly fill out the beneficiary designation forms associated with your IRA to avoid one or more of your loved ones from being inadvertently left out or to avoid paying unnecessary taxes.

Maintenance – An IRA Stretch Trust generally requires no maintenance until after the death of the IRA holder.