Inherited IRA Trusts w/SECURE Act

The following information is intended for educational use only. The reader should obtain personal tax and/or legal counsel before implementing any planning method described in this material. Gender references are not intended to discriminate — masculine shall also mean feminine, and vice versa.

Prior to 2020, taxpayers with Individual Retirement Accounts (IRAs) and certain other retirement plans were able to optimize Minimum Required Distribution (MRD) rules with the recalculation allowances for mandated beneficiary distributions and an appointed trustee to receive and allocate minimum distributions on behalf of a designated beneficiary. By blending those options with a qualified trust, IRA owners were able to employ post-mortem control on beneficiary withdrawal rights not otherwise obtainable without a trust.

However, the SECURE Act of 2020 rewrote that model with significant changes concerning Inherited IRAs. Under the new rules — with certain exceptions — beneficiaries of Inherited IRAs will be required to take all vested IRA benefits within 10 years of the IRA owner's decease.

Custom withdrawal options are still available for the astute planner. Withdrawals can be made (i) in 10 approximately equal portions each year, (ii) at various times and amounts during the 10-year period without minimum or maximum limitations, and/or (iii) as a single lump-sum distribution at the end of the 10-year period.

Understanding Inherited IRA Trusts — also known as Designated Beneficiary Trusts (DBTs) — begins by realizing that a DBT essentially exists as an unfunded Revocable Living Trust (RLT) until the IRA owner dies. With our eStatePlan format, a funded RLT can also serve as a DBT when an IRA is made payable to it, given that the proper Custom Trust Directives are used. As a general rule, making any RLT a primary or contingent beneficiary of an IRA should be avoided without complicit SECURE Act language in the RLT.

A properly drafted RLT/DBT contains language that allows the IRA vendor to distribute portions of the IRA to the trustee according to the terms of the trust, who then distributes to the named beneficiary(s). If the trust contains dispositive language that directs distributions not conforming to the rules of the SECURE Act, it will not work as a DBT and will be set aside for IRA distribution purposes as though it did not exist.

With that said, if an IRA were made payable to a trust which specified that equal shares are to be distributed outright and immediately to the beneficiaries, those beneficiaries would get equal shares with no problems — because distributions through outright allocation clauses in a trust are obviously within the SECURE Act's 10-year depletion rules.

A RLT may neither own nor hold qualified IRA funds — whether during the IRA owner's life or after decease — unless it utilizes a special IRA Administrative Trustee format (see Article #5 on the ITS website / The eStatePlan SuperCharged IRA). Once IRA monies leave the IRA vendor's account, they become immediately taxable to the designated beneficiary(s) identified in the trust, and the trustee would make a K-1 distribution to the beneficiary. If the trust received IRA transfers from the vendor and did not distribute them outright, the trust would need to pay the tax on the IRA distributions at trust income tax rates, which reach the very top of the graduated scale in a short time. (It is quite apparent that Uncle Sam does not like having IRA distributions held in trust.)

When utilizing qualified terms relative to IRA allocations, properly drafted RLTs can serve as qualified Designated Beneficiary Trusts after the death of the grantor/owner of an IRA identifying the trust as the beneficiary. Contrary to popular belief, it is not necessary to establish a separate trust to create a DBT. Qualified RLTs can be used to take advantage of the favorable Inherited IRA rules so that the IRA administrator will be allowed to "see through the trustee" of the RLT as a conduit trust for the purposes of making distributions to the trust's beneficiaries as provided within the trust's terms.

An IRA owner's trust cannot take title to an IRA during the owner's lifetime — unless held within a special trusteed-IRA format — without triggering an income tax liability. Selecting the trust as either a primary or contingent beneficiary of an IRA for the purpose of receiving death-benefit payments turns on the IRA owner's personal estate planning objectives, estate value, etc. Several matters may come under consideration when determining how to allocate distributions, but there are two important issues that should never be ignored — estate taxes and control.

For example, if a couple has an aggregate estate value (including the IRA) less than the value at which federal estate tax rates are imposed, then the likely choice would be for the spouse to be the primary beneficiary and the trust the contingent beneficiary. This would allow the wife — assuming she has not reached her RBD and survives her husband — to roll over his IRA to her own at his death. She could then make their trust the primary beneficiary of her IRA and thus have the trust control the distributions that would be vested to their children at her decease.

Conversely, if the wife wanted to maintain control of her plan to the exclusion of her husband in the event that she predeceases him, then naming a non-spousal credit shelter trust as the primary beneficiary of her IRA — with a specific provision excluding the surviving spouse as a beneficiary of the IRA assets — may be the most appropriate choice. In such event, her interest in the IRA would be funded to the non-spousal credit shelter trust (which becomes irrevocable) at her death, assuring that her interests would ultimately benefit her own children rather than husband's new spouse or his potential creditors.

Trusts offer a combination of versatility and planning capabilities not otherwise available for the IRA owner. Three common examples:

Any RLT can be the beneficiary of multiple plans (including IRAs) belonging to one owner or of separate plans of one or both spouses, helping centralize common planning goals through one structure.

A trustee of a RLT/DBT can be named as the sole beneficiary of a self-directed IRA, which may be important for families with young or incapacitated children, since the imminent death of the IRA owner may otherwise leave the account without an appointed fiduciary.

Most state statutes provide spendthrift-trust judgment protection from creditor claims against non-grantor beneficiaries of a trust. This can lengthen the protection term of the IRA by virtue of the DBT restricting beneficiaries' proclivities to making lump-sum withdrawals.

Through intentional planning, any RLT/DBT can impose age-based allocation restrictions over an IRA in tandem with the current SECURE Act rules. Such strategies fulfill an IRA owner's desire for post-mortem control using payout provisions that enforce the minimal withdrawal terms allowed. When a longer withdrawal period is applied, the funds obviously earn tax-deferred accumulations for a longer period if the money stays in the account.

Trusts created under a statutory legal shield protecting against civil creditor judgments serve as spendthrift trusts. Certain states recognize owned IRAs as spendthrift trusts while under custodial administration and will maintain that status throughout the IRA owner's lifetime. Some states do not. For other states, it depends on the total value of the IRA. The following pertains to ERISA-type plans and not to federal government plans such as IRAs — though some states have applied the same rules to IRAs.

IRC §401(a)(13)(A) provides that "a trust shall not constitute a qualified trust under this section unless the plan of which such trust is a part provides that benefits provided under the plan may not be assigned or alienated."

The Code of Federal Regulations more clearly defines the rule: "[A] trust will not be qualified unless the plan of which the trust is a part provides that benefits provided under the plan may not be anticipated, assigned (either at law or in equity), alienated, or subject to attachment, garnishment, levy, execution or other legal or equitable process" (Treas. Reg. 1.401(a)-13(b)(1)).

Inherited IRAs payable to a trust can enjoy certain asset-protection benefits that may not have applied to the IRA owner. However, if a beneficiary has a right to receive an outright distribution from a trust, that particular distribution value — whether withdrawn or not — would be available to satisfy a creditor claim. The asset-protection feature comes into play by virtue of the trustee holding assets in trust because the language of the trust mandates it that way, and not because the beneficiary simply directs the trustee not to distribute to him.

Until recently, Inherited IRAs were also generally deemed — and treated by most — to have the same level of asset protection as existed when the account owner was alive. That all changed with the Supreme Court decision Clark v. Rameker, 573 U.S. 122 (2014). In reversal of a lower district court case, the U.S. Supreme Court ruled that an Inherited IRA is not a retirement account and therefore cannot enjoy the same status of creditor protection held by the retirement plan when the plan owner was alive. Once an IRA becomes an Inherited IRA, the spendthrift trust status is forfeited and the creditor protection is removed entirely.

There is, however, a remedy. The solution is obtained simply by having the Inherited IRA become payable to a conduit spendthrift trust rather than maintaining the names of natural persons — the ultimate beneficiaries — on the IRA account. That arrangement alone enables any IRA owner to employ the long-standing, federally codified asset-protection benefits of the spendthrift trust as well as the tax-deferred growth aspect allowable to all undistributed assets maintained in an Inherited IRA. This creates a powerful estate planning tool.

A caveat is in play that should have the attention of all IRA owners who want to apply a level of control after their decease. The California Supreme Court recently decided (Carmack v. Reynolds, 2017) to expand the capabilities of a bankruptcy trustee to reach spendthrift trust distributions — at least to the extent that the distributions were not for health, education, maintenance and support (HEMS) purposes. While that case involved a bankruptcy trustee as the plaintiff and not some type of frivolous action, it is still to be noted.

In the Nevada Supreme Court divorce case Klabacka v. Nelson, 133 Nev. Adv. Op. 24 (2017), the court upheld all of the terms and conditions applied with respect to the Self-Settled Spendthrift Trust (SSST) rules directly involved. SSSTs are recent state statutory creatures (Alaska 1997, Nevada 1999, among others) made from the general applications of long-established third-party spendthrift trust law. An Inherited IRA Trust is a classic example of a third-party spendthrift trust.

The court's reasoning included: (1) family courts have subject-matter jurisdiction in divorce proceedings that involve issues otherwise outside the scope of family courts; (2) parol evidence may not be considered to determine party intent to form separate property agreements and self-settled spendthrift trusts where the written agreements are valid and unambiguous; (3) a court order equalizing assets between different spendthrift trusts is improper because the NRS protects against court orders that move assets from trusts in ways that do not benefit trust beneficiaries; (4) spendthrift trusts may not be reached for payment of personal obligations not known at the time the trust is created, such as spousal or child support; (5) a court may not rely on a dismissed unjust-enrichment claim in fashioning remedies; and (6) equitable remedies that impose on spendthrift trust assets are improper, as such trusts are to be protected against court order.

Since SSST law is a recent state statutory design that the Nevada Supreme Court unambiguously upheld, it is common logic to assume that long-established third-party spendthrift trust law would be very secure in any Nevada court. Nevada law reigns supreme as the choice situs for Inherited IRA Trusts as well as for self-settled spendthrift trusts.

Avoiding probate is a worthy objective when transferring any asset. But probate avoidance is not the reason for making IRAs payable to a trust — distributions to designated beneficiaries (exclusive of a trust) usually avoid probate through payable-on-death terms included in IRA contracts. Trust planning with retirement accounts is primarily about the post-mortem control that a trust grantor can obtain.

Preserving managerial control over assets beyond the grave has always been one of the primary reasons for anyone to establish a trust. Naming a minor-aged child or a spendthrift child as a direct beneficiary of an equity account would not be wise planning. If a minor or incapacitated child were vested with a retirement account from a decedent who left no governing instrument, then a guardian's court in the child's state of domicile would likely have to establish a trust instrument — under that state's statutory terms, with a state-appointed fiduciary — to receive the distributions on behalf of the child, even though a guardian had been appointed by the parent.

There are requirements that trusts must satisfy to be deemed a Designated Beneficiary Trust. A DBT will be authorized to receive IRA distributions on behalf of a designated beneficiary but within the terms of the SECURE Act.

Note: Unlike a trust, a probate estate cannot qualify as a designated beneficiary of a qualified IRA (Treasury Reg. §1.401(a)(9)-4 and Private Letter Ruling PLR 2001-26401). If an IRA owner dies before his RBD with a simple will or no will at all, without naming a qualified beneficiary or DBT, the five-year payout rule automatically applies regardless of the ages of the decedent's heirs — because his estate (a non-qualified beneficiary) will become the beneficiary of his IRA by default.

A trust may qualify as a DBT if it passes four tests: (1) be valid under state law; (2) be completely irrevocable (a RLT becomes irrevocable at the death of the grantor) including with regard to beneficiary changes — the trustee cannot be granted powers to sprinkle assets in its discretion or designate other beneficiaries; (3) have natural individuals as beneficiaries who are separately identifiable and thus qualified to receive benefits from an IRA (estates, corporations, partnerships, charities, or other institutions do not qualify); and (4) be presented to the IRA administrator when created — or enforced as an irrevocable trust at the death of the grantor — by October 31st of the year following the owner/grantor's death, in order to certify the beneficiaries as of September 30th of the same year.

Grantors will often name their favorite charities as beneficiaries of their trusts. This can cause a non-qualifying trust problem if not addressed properly, because a charity is not a qualified beneficiary. It is still possible for a grantor to name a non-qualifying beneficiary (e.g., a charity) in his trust and yet enable his RLT to function as a DBT.

A trust containing a charitable allocation may qualify as a DBT if (a) the charitable distribution from the trust occurs before September 30th of the year following the year of death of the grantor and is comprised only of non-IRA assets, and (b) the remainder of the trust — remaining after the charitable distribution(s) — is allocated in definitive shares (but not pecuniary/dollar amounts) to the natural beneficiaries.

Regardless of whether a qualified plan owner designates his trust as a beneficiary of his plan, the value of the plan will be includable in his estate for transfer tax purposes. A prime example of the importance of choosing a proper designated beneficiary is that an IRA can qualify for the marital deduction if transferred to a spouse, or it can be transferred under the shelter of the unified credit (up to a certain amount) when conveyed to non-spousal beneficiaries such as children.

For a married retirement account owner with a large estate, it may make sense to simply name the spouse as the primary beneficiary of the IRA, with the trust as contingent beneficiary. Naming the trust rather than the spouse as the primary beneficiary of a large retirement account could ultimately cause an unnecessary estate tax liability — in addition to the income tax liability — as a result of transferring the plan through the Credit Shelter Trust to non-spouse beneficiaries. Conversely, if the spouse receives a large distribution from the plan through the marital deduction, the participant's unified credit will not be unnecessarily utilized. However, with that method the spouse may acquire an estate tax problem that previously did not exist. For married participants with moderate to large estates, transfer-tax planning with IRAs is important.

One last item: the doctrine of spousal rights. Court cases have surfaced regarding rights over a decedent spouse's IRA. The tax planner would do well to have the participant and the participant's spouse document in writing their intent as to how the IRA should be treated for ownership purposes. The participant cannot expect his IRA to pass entirely through a Credit Shelter Trust when designating his RLT as the beneficiary of his IRA if he did not have outright (sole and separate) interest in the IRA under state law.