By Jessica L. Estes
Most people with individual retirement accounts (“IRAs”) name their spouse and children as the primary and contingent beneficiaries, respectively, of their IRA. Or, if they are not married or do not have any children, their siblings and nieces or nephews. For the reasons outlined below, this may not be the best decision. Though, to understand why it may not be the best decision, it is important to understand the basics of IRAs and required minimum distributions (“RMD”). Generally, an owner’s funds in an IRA will be protected from his or her creditors, but a RMD will not be protected. A RMD is the distribution that must be taken starting at age 70 ½, which is based on one’s life expectancy. Once the distribution is made, that income is not protected unless state law provides otherwise. When the owner of the IRA dies, his or her beneficiary receives an inherited IRA.
In 2014, the U.S. Supreme Court’s decision in Clark v. Rameker sent shock waves through the legal and financial planning industries. The Court was asked to decide whether funds held in an inherited IRA were “retirement funds” within the meaning of the bankruptcy statute and thus, exempted from an individual’s bankruptcy estate. The Court answered this question with a resounding “no” and specifically held that funds in an inherited IRA are not “retirement funds,” rendering those funds available for payment to creditors. The Court reasoned that “retirement funds” are monies set aside for a day when one stops working; whereas, an inherited IRA consists of funds that may be used for immediate consumption. Prior to this decision, an inherited IRA was considered “retirement funds” and protected from the reach of one’s creditors. After this decision, though, that is not necessarily the case.
If one’s spouse inherits the IRA, they can: (1) create a new IRA in their name; (2) roll the inherited IRA into an existing IRA already in the spouse’s name; or (3) they can leave the inherited IRA in the deceased spouse’s name if the deceased spouse was younger than the surviving spouse so the payments can be stretched out for a longer period. If the spouse chooses option 1 or 2, the funds in the account will be protected; however, if the spouse chooses option 3, likely the funds would not be protected.
Moreover, if a child inherits the IRA, they could stretch out the RMD’s based on their life expectancy rather than their parent’s life expectancy, or the child could take the money all at once. Either way, though, the funds would not be protected from the child’s creditors, which may include a bankruptcy court, general creditors, lawsuits and judgments entered against them. Additionally, the Supreme Court decision opens the door for Medicaid to recover against an inherited IRA since the federal law allows recovery against beneficiary- designated accounts.
Another reason to name a trust as the beneficiary of your IRA is to protect government benefits for a spouse who may require or is currently receiving long-term care Medicaid benefits, or a disabled child receiving benefits. If those individuals were to inherit even a small IRA, it could disqualify them from continuing to receive benefits. Depending on the amount of the IRA, that may or may not matter, but one should be aware of the consequences of such action.
Similarly, if a designated beneficiary (1) is a spendthrift, (2) has a drug, alcohol or gambling addiction, or (3) has creditors, or any number of other issues, naming a trust could be beneficial to preserve the funds so it is not depleted quickly.
The trust must be drafted carefully so as not to trigger a five-year payout. If the Internal Revenue Service (“IRS”) considers the trust as the owner or beneficiary of the IRA, the trust must liquidate the IRA and distribute it within 5 years of the decedent’s death. However, the IRS will not consider a trust the owner or beneficiary of the IRA if four requirements are met: (1) the trust is irrevocable as of the decedent’s death; (2) the trust is valid under State law; (3) the trust identifies “human” beneficiaries; and (4) the trustee provides a copy of the trust to the plan administrator or custodian within 9 months of the date of death. If there is the possibility that a non-human can become a beneficiary (e.g. ultimate beneficiary is a church or charity), then the 5-year payout rule applies. As long as the above requirements are met, the trust will be considered a “see through” entity and any distributions paid to the beneficiary of the trust, will be taxed at that beneficiary’s income tax rate.
Also, the trust can be drafted in a way that maximizes the payout to the beneficiaries. Likewise, it is important to decide how the RMD’s payable to the trust will be handled. Giving the trustee the authority to decide whether to make distribution to the beneficiary or to continue to hold the RMD’s in trust provides more flexibility and creditor protection for the beneficiary. Depending on your situation, a trust might be the better choice for your IRA beneficiary designation.