Estate Planning Essentials Part 3: Protecting Beneficiaries from Themselves

Other posts in this 3-part series: Part 1, Part 2

Sudden wealth is easily mishandled. Studies have shown that some heirs ultimately end up in worse financial shape after receiving an inher­i­tance. This is so common that psychol­o­gists call it sudden wealth syndrome, although it is not an actual psycho­logical diagnosis. It can afflict lottery winners, first-round NBA draft picks, and heirs of sizeable estates.¹

Trusts could protect the accumu­lated wealth and heirs alike. 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 the heir(s) may spend the money irresponsibly.

Spendthrift Trust

This type of trust restricts the amount of money spent by the benefi­ciary. The trustee has 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 allowing payments for the health, education, and mainte­nance of the beneficiary.

A spend­thrift 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. 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 estab­lished in such a way that the benefi­ciary cannot antic­ipate or encumber their interest in the trust. This helps to ensure that the benefi­ciary cannot borrow against the trust. The income received from the trust cannot 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 can even be preserved through a 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 essential to have the trust drawn up properly. This requires using an attorney that thoroughly under­stands the complex trust laws unique to the state where the trust is domiciled. If the spend­thrift clause is defective under state law, it becomes unenforceable, and the creditors of the heir can access the assets.

IRA Protection Trust

With the exception of Roth IRAs, assets left to heirs as benefi­ciaries under an IRA are subject to income taxes when withdrawn. One of the most important aspects of an IRA is 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 of an IRA received from a decedent who passed away after December 31, 2019 are generally required to liquidate the account by the end of the 10th year following the year of death of the IRA owner. The benefi­ciary may take distri­b­u­tions of any amount at any frequency. There are excep­tions for certain eligible desig­nated beneficiaries:

• The IRA owner’s minor child (they become subject to the 10-year rule at the age of majority)
• The benefi­ciary is not more than 10 years younger than the IRA owner
• The benefi­ciary is disabled (as defined by the IRS)
• The benefi­ciary is chron­i­cally ill (as defined by the IRS)

These eligible desig­nated benefi­ciaries can choose to use either the 10-year rule or the lifetime distri­b­ution rules that were in effect before 2020.

Distri­b­ution decisions are the beneficiary’s to make—unless the benefi­ciary is a trust, and the terms of the trust make the election for them. Trusts are not living people, but trusts can be treated as desig­nated benefi­ciaries provided they meet four requirements:

1. The trust must be valid under state law.
2. The trust must be irrev­o­cable upon the account owner’s death.
3. All applicable trust benefi­ciaries must be identifiable.
4. A copy of the trust, or a certified list of trust benefi­ciaries, must be provided to the IRA custodian or plan admin­is­trator by October 31 of the year following the account owner’s death.

There are two ways you can set up IRA Protection Trusts: conduit and accumulation.

Conduit Trust: The Internal Revenue Code’s 10-Year Rule still applies: all distri­b­u­tions from an inherited IRA must be made by December 31 of the 10th year after the year of death. Accord­ingly, the entire inherited retirement account is emptied within 10 years after death. A Conduit Trust requires all distri­b­u­tions to be passed through to the Income Benefi­ciary, and the trust must be empty by the end of the 10th year after death.

Accumu­lation Trust: Those who want to maintain post-death control over retirement assets for longer than 10 years after death could create an accumu­lation trust as the benefi­ciary of the retirement account. The trustee would hold assets within the trust after they are distributed from the inherited retirement account. The terms of this trust could contain any of the protection aspects previ­ously discussed.

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There is no one-size-fits-all solution when planning an estate. Each situation is unique. Trusts can be an essential part of the estate plan. However, they are often complex and time consuming to set up. Be sure to work with an attorney that specializes in estate planning to ensure your documents are correctly drafted after you’ve decided the direction you want to take.

Insights

• Anyone who has concerns about how heirs will handle money could consider taking steps to control distri­b­u­tions through trusts.
• Estate planning is unique to every family.
• Work with an attorney who specializes in estate planning to help ensure all documents are correctly drafted.