Trust for IRA

In this blog, we’ll see how trusts may be used with retirement plans and IRAs.

A retirement plan (like a 401(k)) or an IRA may name an individual, a trust, or something else as the beneficiary of the benefits. If an individual is named, that individual’s life expectancy is used. You’d use the single life table which can be found in IRS Publication 590B, Appendix B, Table I. For example, a beneficiary who is 18 at the death of the participant (owner) would have a life expectancy of 65 years. As a result, for their first required distribution, they would be required to take a distribution of 1/65^th of the prior year-end balance. In subsequent years, they would subtract one from the denominator of the prior year, so it would be 1/64^th of the prior year-end balance. By the time the beneficiary reaches their life expectancy, they will have taken out all the assets from the retirement plan or account. However, there can be disadvantages for an individual as the beneficiary.

• The individual may be underage

• The individual may be a spendthrift

• The individual could have creditors

• The individual could have special needs

• The individual may not be able to manage money

In order to address these concerns, the benefits may be left to a trust for the benefit of the beneficiary. A trust for the beneficiary has the following benefits:

• The trust can keep the assets during the beneficiary’s minority, thus avoiding a court proceeding

• The trustee can use their discretion regarding distributions to the beneficiary, within the standards set by the trust

• The trust may be drafted to provide asset protection

• The trust may be drafted as a special needs trust and thus not an “available resource” for the purposes of government assistance

• The trustee (not the beneficiary) manages and invests the assets in the trust

When a trust is the beneficiary of retirement benefits, the trust may be either an “accumulation trust” or a “conduit trust.” If there is any way distributions from the retirement plan/account may not be paid to (or demandable by) the beneficiary, then it is an accumulation trust. If the beneficiary will get the distributions under all circumstances, then it is a conduit trust.

This is significant because with a conduit trust you only look at the current beneficiaries of the trust, while with an accumulation trust you also must look at all remainder beneficiaries. Remainder beneficiaries include anyone who might get the assets and it includes contingent remainder beneficiaries like grandma or a charity.

So, let’s look at an example. Bill leaves a trust for his son Johnny, age 18. At Johnny’s death it goes to his kids, but if he has none it goes to grandma, age 70, but if she is not there the assets go to the American Red Cross. If this trust is an accumulation trust, we must look to the ages of all current and remainder beneficiaries of the trust to determine the identity of the beneficiary with the shortest life expectancy. Johnny’s life expectancy is 65 years and grandma’s life expectancy is 17 years. The American Red Cross, as a non-individual, has no life expectancy.

If the trust were drafted as a conduit trust, distributions could be taken by the trustee using Johnny’s 65-year life expectancy. If the trust were drafted as an accumulation trust, you’d have to look at all current and remainder beneficiaries. The worst beneficiary is the American Red Cross, which has no life expectancy. Sometimes, a trust may include language that eliminates a charity as the recipient of retirement plan assets. If the trust had such language, the 17-year life expectancy of grandma would be used.

Sometimes there is a trade-off between various concerns. For example, let’s say Johnny is a spendthrift. If Johnny has the ability to take the distributions from the retirement plan (a requirement for a conduit trust), he may waste them. In choosing how to draft the trust and counsel the client, this must be weighed against the income tax advantages of a longer stretch on distributions. Perhaps the trustee can use their discretion in the distribution of other assets. For example, let’s say the IRA has $300,000. The required minimum distribution will be about $5,000 in the first years. Without the retirement plan, perhaps the trustee would have paid for a place for Johnny to live and would have given Johnny $500 per month for an “allowance.” With the IRA distribution, the trustee might only give Johnny $100 per month. On the other hand, if the IRA is extremely large and the beneficiary has addiction issues, for example, there may not be a satisfactory way to achieve the stretch and the other objectives of the trust.

COMMUNITY vs SEPARATE PROPERTY

     In common law states, typically the surviving spouse may elect against the will of the predeceasing spouse and get what would be the intestate share. This is often around 1/3 of the “estate.” In some common-law states, the “estate” against which the survivor may elect is the augmented estate, including non-probate assets such as a revocable trust. In other states, the survivor may only elect against the probate estate.

     About one-half of the separate property states have “tenancy-by-the-entirety” or “TBE.” This form of ownership is akin to joint tenancy property, except it is limited to a married couple. Depending upon the state, TBE may be available only for real property or for both real and personal property (like an investment account). Also, the couple must act together in order to encumber or sell the property. As a result, TBE property offers cheap creditor protection, with limitations.

     First, if the creditor is a creditor of both spouses, like someone who slips on the front walk of the residence, the property can be reached. Second, if the spouse without creditor issues dies, then the property goes automatically to the spouse with creditor issues and is no longer in TBE. Finally, in the event of divorce, the TBE would be severed, typically into tenants-in-common property.

     Nine states have community property, all but one of them is west of the Mississippi River. They are Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Wisconsin, and our own state, Washington, This is another in the series of blogs on the basics of estate planning. In this blog, we’ll look at common differences between community property and separate property states.

     As stated above, nine states, including Washington, have community property, namely Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, and Wisconsin. In addition, Alaska allows you to elect into community property for property held in a community property trust. Other states may follow Alaska’s lead and legislation is pending elsewhere to do so.

     Community property varies somewhat from state to state. The general notion is that all fruits of labor of either spouse is the property of the spousal community and should be shared equally. In Washington, the presumption is that property acquired during marriage is community, unless there is proof the property was brought into the marriage, there is a contrary agreement, the property was a gift or inheritance, or the property was the separate property of one of the spouses prior to the move to the community property state.

     The character of the property is determined based on the domicile of the parties and the source of funds. The manner in which the property is titled is not dispositive. Often, this is a frustration to attorneys not accustomed to community property. Thus, if John is married and earns a paycheck and the paycheck goes into his bank account titled in his name alone, the funds are still community property. If he then takes the funds and buys another asset, that asset is also community property. In other words, there is tracing of the source of the funds. The tracing can be very difficult at times. But, there are presumptions that apply which may vary by state.

     Each spouse has an equal right to manage community property but has exclusive management rights over their own separate property. At divorce, the court has the power to divide community property, but may not reallocate separate property. In Washington, community property must be divided equally.
At death, each spouse has a right to transfer their one-half of the community property. However, if the decedent spouse does not choose to do so, all of the community property becomes the property of the survivor. Again, this discussion is based on Washington.

     From an income tax perspective, it is usually better to have community property. This is due to the “step-up” in basis. At death, all of the property of the decedent gets a basis of the fair market value at their date of death (or alternate valuation date). However, the decedent is deemed to have one-half interest in all of the community property. Thus, both halves of the community property receive a step-up in basis. This is normally desirable. However, though it is named a “step-up” in basis, the basis might be lowered if the fair market value is lower than the basis before death.

     For example, let’s say a couple owns Blackacre with a basis of $100,000 and a value of $1,000,000. Excluding any possible discounts, each half of the property has a basis of $50,000 and a value of $500,000. If it is not owned as community property, the decedent’s half gets a basis of $500,000 while the survivor’s half retains a basis of $50,000. Thus, the combined basis of the property would be $550,000. If the property were community property, each half would get a basis of $500,000 for a total basis of $1,000,000. This is called a “double step-up” in community property states and is typically a major advantage to that form of ownership.

     In addition, Alaska allows you to elect into community property for property held in a community property trust. Other states may follow Alaska’s lead and legislation is pending elsewhere to do so.