Estate Planning - Spendthrift & IRA Trusts - Part 3 of 3

Estate Planning Considerations — Spendthrift and IRA Trusts — Part 3 of 3

Previous posts in this series: Part 1, Part 2


I want to wrap up my series on leaving wealth to your heirs by looking at two more types of trusts. Leaving assets in trust can protect the wealth you have accumu­lated but also protect your heirs. People that have never handled a sizable amount of money often mishandle it. It’s not unusual for them to be in worse financial shape after receiving the money than they were before. One important aspect of a trust is the ability to control the distri­b­ution of income and principal. This first type of trust is designed for those situa­tions when you think your heir(s) may spend the money irrespon­sibly.

Spend­thrift Trust

This type of trust restricts the amount of money that may be spent by the benefi­ciary. The trustee has the sole authority to make distri­b­u­tions from the trust either to the benefi­ciary directly or to make payments on behalf of the benefi­ciary. The trustee must follow the terms of the trust. Typically these terms are defined as the health, education and mainte­nance of the benefi­ciary. You can leave the defin­i­tions broad to give your trustee some discretion or keep the terms strict.

This type of trust is often used when the parent is concerned about a child’s ability to handle financial affairs. The parent may have observed that the child mismanages their own money. You don’t want to leave them a large amount of money when they can’t handle what they have now. The child may live an extrav­agant lifestyle that the parent doesn’t want to help support. A child that is living in constant financial turmoil is a good candidate for this type of trust.

The trust is written in a way that the benefi­ciary cannot antic­ipate or encumber their interest in the trust. It is written this way so that the benefi­ciary cannot borrow against the trust. The income they receive from the trust can also not be counted on which means the benefi­ciary can’t use it to qualify for a loan. Generally the trust contains specific language stating the Trustees will not be liable for, or subject to, the debts, contracts, oblig­a­tions, liabil­ities or torts of any benefi­ciary.

A spend­thrift trust will even be preserved through the beneficiary’s bankruptcy. Most state laws will include a trust as property of the bankruptcy estate, unless the trust contains a spend­thrift clause enforceable under that state’s law. Therefore, it is very important to have the trust drawn up properly. This requires using an attorney that thoroughly under­stands the complex trust law unique to the state you live in. If the spend­thrift clause is defective under your state law, it becomes unenforceable and the creditors of your benefi­ciary can access the assets.

IRA Protection Trust

Assets left to benefi­ciaries under an IRA are subject to income taxes when withdrawn. One of the most important aspects of your IRA is the tax deferral. The longer the money stays in the IRA, the more the assets can grow compounded on a tax deferred basis. Non-spousal benefi­ciaries must begin taking distri­b­u­tions from the IRA and are given two options:

  1. The five-year rule — Take a lump sum payment no later than the end of the fifth year following the IRA owner’s death. The benefi­ciary can allow the assets to remain in the IRA until the end of the fourth year. Distri­b­u­tions must begin on or after January 1st of the fifth year following the year in which the IRA owner died and be completed by the end of that year. None of these payments are eligible for rollover.
  2. Stretch IRA payments — Take regular distri­b­u­tions over the remaining life expectancy of the benefi­ciary. The distri­b­u­tions must begin before December 31st of the year following the IRA owner’s death. This option decreases the amount required to be withdrawn each year, while allowing the account balance to continue to grow tax-free.

This decision is up to the benefi­ciary to make unless the benefi­ciary is a trust where you have already made the election for them. The IRS requires the trust to have desig­nated benefi­ciaries to allow the election of stretch payments. If the IRA owner properly plans for his heirs to be a desig­nated benefi­ciary, they will have the oppor­tunity to use each of their own life expectancies to maximize distri­b­u­tions. The terms of the trust ensures and enforces that the stretch payments actually happen.

The IRA Protection Trust is an estate planning technique intended to coordinate the admin­is­tration and distri­b­ution of IRA assets after death. There are two aspects of the trust. First, it allows each benefi­ciary to qualify as a desig­nated benefi­ciary as required by the IRS. Second, it enforces your goals of requiring the benefi­ciaries to stretch distri­b­u­tions from the IRA preventing them from taking money out of the IRA earlier than required. Because the trust restricts distri­b­u­tions, it serves as a barrier from creditors, claimants, and court actions.

There are two ways you can set up IRA Protection Trusts: conduit and accumu­lation. The conduit trust form takes the minimum distri­b­ution from the IRA each year and passes it through to the benefi­ciary. The trust serves merely as a flow-through, or conduit, for paying out the annual distri­b­ution. The trustee is not given discretion over the distri­b­u­tions. A conduit trust requires the trustee to disperse the minimum distri­b­ution each year.

The accumu­lation trust retains the distri­b­u­tions inside a separate account owned by the trust to secure the funds from creditors or spend­thrift benefi­ciaries. The trustee of this type of trust can use discretion when choosing whether to distribute trust funds to the benefi­ciary for reasons such as the health, education and mainte­nance of the benefi­ciary.

There is no one size fits all solution when planning your estate. Each situation is unique. Trusts can be an important part of your estate plan when leaving assets to benefi­ciaries is involved. However, they are often complex and time consuming to set up properly. I hope this newsletter series has given you some ideas to consider for you own estate plan. Be sure to work with an attorney that specializes in estate planning to make sure all your documents are properly drafted after you’ve decided the direction you want to take.

Rick’s Insights

  • If you have concerns about how your heirs will handle the money you leave them, you can take steps to control that even after your death.
  • There are no one size fits all solutions to estate planning. Each situation is unique.
  • Be sure to work with an attorney who specializes in estate planning to make sure all your documents are properly drafted.