Using Trusts to Protect Inherited IRAs

Many clients have large IRAs and retirement plan accounts and need special estate planning for these assets. A 2009 study by the Investment Company Institute found that retirement plans account for 34% of all household financial assets, up from 14% in 1978; IRAs alone account for more than 10% of all household financial assets; and 47 million U.S. households have IRAs.

Compare these numbers to the approximately 4,000 estate tax returns that will be required to be filed annually under the new “permanent” estate tax exemption of $5 million adjusted for inflation, and it is easy to see that planning for retirement accounts presents a more significant opportunity for the estate planning advisory team than does estate tax planning.

Clients want to protect their IRA and retirement plan assets for their families, but most do not understand what can happen to those accounts after they die. And, unfortunately, much of the information plan owners and beneficiaries receive from family members, other lay sources, and, surprisingly, even some advisors is outdated or incorrect.

Without proper planning, trillions of dollars in IRAs and qualified plans that are passed down to clients’ beneficiaries upon death could be exposed to the beneficiaries’ creditors and other beneficiary-associated risks. By using specially designed IRA trusts, the plan owner’s beneficiaries can be protected from creditors, predators, and the temptation inherent in “found” money and thus ensure that the beneficiary achieves the maximum tax deferral that the client intends.

In this issue of The Wealth Counselor, we will explain some of the rules about retirement plans that every member of the advisory team must know and how a properly prepared retirement plan trust (which we will here refer to as an “IRA trust”) can protect the plan assets after the owner’s death.

Problems with Inherited IRAs and Retirement Assets
Impact of Income Taxes
Unless the client’s retirement plan assets are in a Roth IRA or other Roth vehicle, income taxes must be paid whenever assets are withdrawn from these accounts. The top federal income tax rate is now 39.5% and state income taxes, where applicable, are in addition. (The 3.8% Medicare surcharge does not apply to retirement account withdrawals but the withdrawals from non-Roth accounts do get counted in determining if and by how much the taxpayer has exceeded the applicable threshold amount for the surtax.)

Impact of Income Tax Deferral
Different Levels of Protection for IRAs and Inherited IRAs
Qualified retirement plans, including SEP and Simple IRA plans, are protected under ERISA, but traditional, Roth, and inherited IRAs are protected under state laws, which vary greatly. For example, during the original IRA owner’s lifetime, protection can range from unlimited protection to a specified dollar amount or, as in California, to an amount reasonably necessary for the owner and any dependents. Protection for inherited IRAs may be different than that provided to the owner. This varies from state to state and is determined by the beneficiary’s state of residence when the protection question arises. Therefore, only the surest result is obtained through good, proactive planning.

Planning Tip: It is critical to understand how the laws in your state apply to an original owner and to someone who has inherited an IRA. You cannot assume that the beneficiary residing in another, often currently unknown state will have the same asset protection as the owner or a beneficiary residing in your state.

“Found” Money Is Extremely Slippery
We have all heard of the result of studies of how fast the average beneficiary goes through life insurance proceeds. Spending “found” money simply does not carry the significance of spending one’s own hard earned money. An IRA or other retirement account passing to an individual beneficiary is also “found” money and just as slippery.

IRAs and other retirement plans offer the substantial tax benefit of income tax deferral. Stretching out the inherited retirement plan’s distributions over a beneficiary’s actuarial life expectancy yields a much greater return than if the beneficiary cashes out the plan and pays taxes immediately on the full distribution plus on any future earnings on those assets.

Planning Tip: It can be very helpful to have a chart or calculator that illustrates to clients the benefits of income tax deferral based on his/her actual account balance, actuarial life expectancy, and beneficiaries’ ages.

Divorce and Unintended Beneficiaries
Although an inherited IRA is not a marital asset, it is “on the table” in a divorce because it can be transferred as part of a divorce settlement. Also, the beneficiary of an inherited IRA will make his/her own beneficiary designation in case of death before the account is depleted. Most clients do not want a child’s ex-spouse to get their IRA or a child’s new spouse to inherit because both carry the risk that the client’s grandchildren will be disinherited.

Loss of SSI/Medicaid
Any inheritance, including assets in an inherited IRA, are considered “resources” for determining SSI/Medicaid eligibility. At least temporary loss of SSI/Medicaid or other government benefits by a disabled beneficiary is hard to avoid if there is more than $2,000 in the inherited IRA.

Planning Tip: Assets held in a properly drafted IRA trust can provide much better protection and ensure maximum stretch out.

Basic Retirement Plan Concepts
A major advantage of qualified retirement plans and IRAs is that the income tax on plan earnings is deferred until withdrawal. With the exception of a Roth IRA or plan account, the account owner (referred to herein as “the owner”) must commence Required Minimum Distributions (RMDs) by his or her Required Beginning Date (RBD). The owner is never required by tax law to make withdrawals from any Roth account but the Roth account beneficiary is.

Required Beginning Date (RBD)
Generally the RBD is April 1 in the year following the calendar year in which the owner reaches age 70 ½ or, for a qualified plan, the calendar year in which the owner retires from employment. There is a qualified plan exception for less than 5% owners. In each year beginning with the year of the RBD, the owner must withdraw at least the Required Minimum Distribution (RMD).

Calculating Required Minimum Distributions (RMDs)
RMDs are calculated by dividing the prior year’s 12/31 account balance by the applicable life expectancy factor as provided by the IRS.

Life Expectancy Factors
There are different life expectancy factors for different account holders. That from the Uniform Table is used for an owner’s lifetime distributions. (This table recalculates life expectancy every year so that even someone age 110 has a life expectancy and will not be required to empty the account.) However, if the owner’s spouse is the owner’s sole beneficiary and is more than ten years younger than the owner, the Joint & Last Survivor Table is used instead of the Uniform Life Table during the owner’s life. The Single Life Table is used by all qualified beneficiaries after the owner’s death.

Planning Tip: When working with a qualified plan, be sure to read the plan agreement and become aware of optional plan provisions. If the custodian is not willing to do what the client wants, consider changing to a new custodian where possible or rolling the account assets into an IRA.

Spousal Rollovers
Only a surviving spouse can rollover an IRA (or qualified plan) into his/her own IRA. Once rolled over, the IRA is treated as if all contributions to it had been made by the surviving spouse. In other words, the surviving spouse uses the Uniform Table to determine RMDs, which must begin by the surviving spouse’s RBD.

Planning Tip: A surviving spouse can defer a rollover indefinitely. If the surviving spouse is younger than 59 ½, rolling over before attaining age 59 ½ risks incurring the 10% early withdrawal penalty. In such cases, consider establishing an inherited IRA and rolling over when the surviving spouse attains age 59 ½. If the surviving spouse is the sole beneficiary, his or her RBD from the inherited IRA is the same as was his or her deceased spouse’s RBD.

Qualified Plan Rollovers by Non-Spouse Beneficiaries
A non-spouse beneficiary is now allowed to do a trustee-to-trustee rollover of a qualified plan to his or her own Inherited IRA.

NOTE: All inherited IRA accounts must be titled in the original owner’s name for the benefit of the beneficiary (e.g., Mary Smith, Deceased, IRA f/b/o Jim Smith). Anything else is considered a 100% taxable distribution.

Designated Beneficiary
If there is a designated beneficiary of the inherited IRA or plan account, the designated beneficiary’s life expectancy is used to determine RMDs in years following the year of the owner’s death. This allows the inherited account to be distributed over the beneficiary’s actual life expectancy, resulting in maximum stretch out and tax deferral.

*    If there is not a designated beneficiary and the owner died before his or her Required Beginning Date, the account must be completely distributed by the December 31 following the fifth anniversary of the owner’s death (the “five-year rule”).
*    If there is not a designated beneficiary and the owner died on or after his or her RBD, the RMD is determined using the Single Life Table as if the owner were still living (the “ghost life expectancy rule”).

A designated beneficiary (as defined by Treas. Reg Section 1.401(a)(9)-4):
*    Must be named a designated beneficiary under the terms of the plan or by an affirmative election by the employee;
*    Need not be specified by name but must be identifiable on the date of death;
*    May be a class of beneficiaries capable of expansion or contraction (e.g., my children or grandchildren);
*    Must be an individual alive on the date of the owner’s death;
*    May be a trust if all of its beneficiaries who have to be considered are individuals alive on the date of the owner’s death, the oldest of whom may be determined (a “qualifying” trust).

A designated beneficiary is NOT:
*    an estate;
*    a charity;
*    a non-qualifying trust;
*    any non-individual other than a qualifying trust; or
*    an individual born after the date of the owner’s death.

The IRA Trust
The advantages of using trusts in general include spendthrift protection, creditor and predator protection, beneficiary divorce protection, special needs planning, consistent investment management, estate planning, and exercising control over the trust assets after the death of the trust maker.

Disadvantages of trusts include greater complexity; legal, accounting and trustee fees; and for trusts that are not required to distribute all their taxable income, greatly compressed income tax brackets (the 39.5% top income tax bracket for individuals begins at $400,000, for such trusts it begins at $11,950).

To be a qualified trust, and thus qualify as a designated beneficiary of an IRA or retirement plan account, an IRA trust must:
1.   Be valid under state law;
2.   Be irrevocable not later than the death of the owner; and
3.   Have beneficiaries all of whom are individuals who are identifiable from the trust instrument when considered on September 1 of the year following the owner’s death.

In addition, the documentation requirement for a trust beneficiary must be satisfied.

Planning Tip: A single revocable living trust would meet requirement #2 because it becomes irrevocable upon the trust maker’s death. However, unless it contains a “conduit” provision, discussed below, a single RLT is unlikely to satisfy requirement #3. A joint revocable living trust would not satisfy requirement #2 because it continues to be revocable until the death of the second spouse. For these and many other reasons, a specialized IRA trust is a preferable IRA beneficiary.

Planning Tip: The documentation requirement is fairly easy to satisfy, but it is vital not to miss the documentation deadline. The trust document must be provided to the account custodian by October 1 of the year following the owner’s death.

Types of IRA Trusts
Conduit Trust
The IRS regulations for IRA trusts provide an example that is commonly referred to as a “conduit” trust. This is a trust in which all distributions from the IRA are required to be immediately distributed to the trust’s beneficiary(ies). With a conduit trust, identification of countable beneficiaries and qualifying the trust as a designated beneficiary is easier because “downstream” and contingent beneficiaries are not considered. On the other hand, because all distributions, including RMDs, must be immediately distributed to the beneficiary(ies), those distributions are not asset protected as they would be if they could stay in the trust.

Accumulation Trust
An accumulation trust is one in which distributions from the inherited IRA may be kept within the trust rather than being distributed to the beneficiary(ies). That way, the trust assets have more protection against creditors and predators. This also more easily allows the beneficiary(ies) SSI/Medicaid eligibility to be preserved. On the other hand, an accumulation trust is a separate taxpayer and is subject to the compressed income tax brackets for undistributed income. Plus, the risk of the trust not being a designated beneficiary (and thus able to take advantage of the stretch) is greater because all beneficiaries have to be considered except those who are “mere potential successor” beneficiaries.

Example: The owner’s child is the primary beneficiary and a charity is the contingent beneficiary. With a conduit trust, the charity would not be counted and the child’s life expectancy would be used to determine the trust’s RMDs, which would produce maximum stretch out and tax deferral opportunity. With an accumulation trust, the charity would be counted and the trust would not be a “designated beneficiary.” That would cause the trust’s RMDs to be determined using the five-year rule or the owner’s ghost life expectancy, depending on whether the owner’s death occurred before or on/after his or her RBD.

In PLR 100537044, the IRS permitted a one-time “toggle” from conduit to accumulation trust. Having such a provision could be important if there is a change in circumstances of a beneficiary (disability, drug problems, etc.) between the time the owner set up the trust and September 1 of the year following the owner’s death. In the “toggle,” any general power of appointment given to a beneficiary must be converted to a limited power of appointment, which can create a Generation-Skipping Transfer Tax issue.

Planning Tip: Consider giving the Trust Protector the “toggle” power in any IRA trust to provide flexibility to deal with possible future events.

Separate IRA Trust vs. Trust in a Revocable Living Trust or Will
A separate IRA Trust is more likely to qualify as a designated beneficiary than is either a non-conduit RLT or trust established under a will.

Commonly encountered issues with using RLTs and trusts in wills as IRA/retirement plan beneficiaries include the possible adverse effects of formula funding clauses; pecuniary clauses and recognition of income; powers of appointment (can expand the class of potential beneficiaries); adoption effect clauses; provisions for payment of debts, taxes and expenses; apportionment language/firewall provisions; older or unidentifiable contingent beneficiary(ies), and non-individual remote contingent beneficiaries.

Drafting Issues and Beneficiary Designations
Revocable vs. Irrevocable
A revocable IRA trust allows for changes to be made easily, but it may open the IRA to the account owner’s creditors at death. See, Commerce Bank v. Bolander, 2007 WL 1041760, Kan. App. 2007. Making the IRA trust irrevocable will protect against the Commerce Bank case problem. Making the IRA trust irrevocable does not have to be a final decision by the IRA owner. While an irrevocable trust may not be changed by its maker, a competent IRA owner can always create a new IRA trust and make a new beneficiary designation pointing to the new IRA trust.

Beneficiary Designations—Separate Shares
If an IRA is payable to an IRA trust rather than the separate beneficiaries’ shares of the trust, the trust’s RMD will be determined by the life expectancy of the oldest trust beneficiary (problematic if one beneficiary is age 60 and another beneficiary is age 2). By contrast, if multiple sub-trusts of an IRA trust are allocated shares of an IRA in the beneficiary designation form, the IRA share of each sub-trust will be paid over the life expectancy of the oldest beneficiary of that sub-trust.

Disclaimer Planning
IRA trusts can contain credit shelter and QTIP trusts for the benefit of the surviving spouse. Proper structuring of the beneficiary designation allows for disclaimer planning for the spouse and other beneficiaries. Note that no further stretch is allowed after the death of the spouse with regard to IRAs not rolled over to the surviving spouse’s own IRA by instead going to a credit shelter or QTIP trust established by the IRA owner.

Planning Tip: The general treatment for disclaimer planning is 1) spouse; 2) if spouse disclaims, IRA trust (for funding of credit shelter/QTIP); 3) if spouse is deceased, to the separate IRA sub-trusts for descendants, per stirpes. Also, children can be given the power to disclaim so that IRA distributions can be stretched out over the owner’s grandchildren’s lifetimes.

Custom-drafted beneficiary designations are required to allow proper disclaimer planning and separate share treatment. (See planning tip above.) However, some IRA custodians will not accept custom beneficiary designations and insist on using their own forms, especially for “smaller” accounts (those under $500,000). In such cases, giving the custodian a choice between losing the account to a more reasonable custodian and accepting the proposed custom beneficiary designation may produce the desired result.

Naming a separate IRA trust as designated IRA or retirement plan beneficiary is preferable to naming beneficiaries outright. It ensures that the client’s goals are carried out, including that the client’s beneficiaries will use the IRA stretch out potential. It provides asset protection against predators, the beneficiaries’ creditors and loss upon divorce. It can provide bloodline protection, preventing unintentional beneficiaries and disinheriting of descendants. It provides for beneficiaries who have or later develop special needs without jeopardizing their valuable government benefits. And it can even keep the IRA assets under the client’s current advisor’s management.

Each client’s situation is different. For IRA trust planning, individual, case-by-case analysis with input from all advisors is essential.

With so much outdated and incorrect information about IRAs and IRA planning being tossed around, current and knowledgeable advisors will stand out and prove invaluable to both clients and the other members of the advisory team.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax adviser based on the taxpayer’s particular circumstances.

Healthcare Cost Lifecycle

Healthcare costs vary widely from person to person, and from household to household. While this is the case, there still exists a general cycle of healthcare expenses that follows the overall life cycle of many individuals. For financial planning purposes, this is very helpful to consider when estimating future cash-flow needs and retirement expense projections

During the earliest phase, full-time employees are often covered by their employer’s health insurance plan. Normally the employer does not cover the spouse or children of the employee. The expense of providing health insurance and care for these family members falls on the family. In this phase, a financial shock, such as loss of employment would have two effects. First, it would increase family healthcare expenses by the cost of insurance and care for the terminated employee (since employer would no longer be providing coverage as a benefit). Second, lost income here would be likely to strain the ability of the family to continue to pay for family coverage.

In the next phase, kids grow older and begin to leave to home. If they go obtain their own full-time employment, they will likely be covered by their employer’s health insurance plan, and will no longer be a health expense for the family. If, alternatively, they go off to college, they may remain on the parental/family health insurance plans. In California, there is a special health insurance program for college students. Upon graduating or upon obtaining their own employment, their healthcare expense burden will be shifted onto the children themselves (or onto their employers).

In the final phase, working adults are usually covered by employer plans and kids are out of the house. As the empty nesters age, they will usually see increasing personal healthcare needs. When they are old enough to qualify for Medicare, some healthcare expenses will be offset. Since only two, and eventually, only one person in the household will need healthcare, this phase often actually requires even less expense than in previous phases. Naturally, near the time of death, healthcare expenses often are significantly higher for a given person than at any previous period of their individual life. Careful planning in earlier years can allow for the retirement income needed to provide coverage for healthcare and even long-term care needs.

Overview of Captive Insurance Companies

For the small business owner, captive insurance companies may provide several advantages in risk-management, income taxation, and generational wealth transfers.

Background on Insurance Companies

Insurance companies make money by pooling premiums in excess of underwriting costs and investing them for the company’s profit. The principal belongs to the insured premium-payers (it is what is used to pay claims for loss). The profits go to the insurance company.

What is a “Captive”?

A captive is an insurance company that is wholly owned by a parent company.

What are the Benefits of Establishing a Captive?

  • If there are not claims, uncollected proceeds are not lost premiums by the parent company as they would be if the premiums were paid to a third-party insurance company.
  • Captives may insure against risks that are generally uninsurable or which are hard to cover commercially.
  • The cost of insurance can be lower due to individualized, catered coverage that exactly matches the parent company’s risk profile and experience.
  • Premiums paid are still deductible.
  • Premiums paid and investment earnings on those premiums (float) are kept among the parent-company owners and their families.
  • Captive can earn an underwriting profit from a portion of premiums.
  • Allows companies to retain more, if they so desire.
  • Captives that qualify under I.R.C. §831(b) are exempt from income tax on the first $1.2 million of premiums received. (However, the IRS “red flags” captives that just happen to charge exactly $1.2 million in premiums… as they might be shams trying to exploit this advantage).
  • Parent company essentially gets to use pre-tax dollar for self insurance (because of the deduction for premiums paid to the captive). Ordinarily, cash-reserves held by a company to cover uninsurable risks, or to self-insure, are after tax dollars.
  • A captive may remain “in the family.” The value in unused premiums transferred to the captive is transferred to succeeding generations along with the closely held parent company.


Under some circumstances, establishing a captive insurance company can provide numerous financial benefits to parent companies, their owners, and successors in ownership.

What are Some of the Risks of Investing in Directly Held Real Estate?

Directly held real estate, owning rental properties in your own name, can expose you to various types of risk.

There is legal risk: potential law suits by tenants or other people who fall or are injured on the premises.

There is financial risk: real estate is not liquid which means that if you need to access the money in an emergency you may be forced to sell at a loss, especially if the reason you need the money is because of a downturn in the economy (when real estate prices may have suffered a decline along with other assets). When people most want to sell, it may be at a time when there are fewer buyers (and fewer lenders who are willing to finance them).

Another risk arises from leverage. Often the highest returns that people can find in real estate come from borrowing as much as possible, but leverage is always a two-edged sword. If renters dry up, massive mortgage payments can accumulate and drain your liquid cash reserves.

As people age, they should carefully consider their tolerance for risk. Generally, the older you are, the less you should leverage, the more liquid you should be, and the less risk you should take (after all, you would have less time to make up any adverse investment outcomes).

Many of these issues go away if real estate is invested in by Real Estate Investment Trusts (REITs), instead of by directly holding real estate.

Medicare Benefits Abroad

Does your Medicare Coverage cover you while you are living or traveling abroad? Unfortunately, the answer is most likely going to be no. Original Medicare Coverage includes all 50 states, and U.S. territories (U.S. Virgin Islands, Guam, American Samoa, and the Northern Mariana Islands), but outside of those locations, your medical care probably will not be covered. While you are living abroad, if you remain current on your Medicare Part B premium payments, you can maintain your coverage, but again, that is only for medical care provided in the United States.

In certain cases, Medicare will cover hospital expenses in Canada and Mexico. If you are living in the United States and the hospital in Canada or Mexico is closer than a hospital in the United States, your medical care will be covered. Also, if you have an emergency while traveling in a direct route from Alaska, through Canada, to another state, without unreasonable delay, you can treat the emergency at a Canadian hospital if it is closer than the nearest U.S. hospital. If you do receive health care in a foreign hospital under these circumstances, that hospital can, but is not required to file Medicare claims for you. If the hospital does not file the claim for you, it is your responsibility to have an itemized bill submitted to Medicare for the services you received.

Another possible exception is if you are covered by Medicare Part B while on a cruise ship. If the cruise ship is within six hours of a U.S. port, and the doctor is allowed to provide medical services under certain laws, then your care will be covered.

There is one option that you have for coverage while you are abroad, and that is Medigap. Medigap Plans C, D, F, G, M and N will cover emergency health care coverage when you are traveling outside the United States. Plans E, H, I, and J also provide foreign coverage; however, these plans are no longer for sale. So what coverage do these plans provide? They will cover 80% of medically necessary emergency care after a $250 annual deductible is met. Note that there is a lifetime limit of $50,000 for this foreign travel emergency coverage, and for the care to be covered, it must begin within the first 60 days of your trip. If you would like medical coverage while living abroad, you will need to obtain such coverage through a different provider.

When Might Life Insurance Be Necessary… And What Type?

Whether one needs life insurance at all, whole life, or term depends on one’s circumstances.

There are specific circumstances that would dictate a need for permanent insurance — which includes whole life, universal life, variable life, etc.  Here is one example.  Consider a person whose estate consists of one asset: a business worth $10 million.  Clearly, this person’s estate will have an estate tax liability.  But, if the only asset is the business itself, there is no cash to pay the estate tax.  In this circumstance, the heirs would have to sell the business simply to get the cash needed to pay the estate tax.  In cases like this, the family would obtain a permanent life insurance policy in an amount to cover the likely estate tax liability.  There are a range of other examples in which permanent life insurance makes sense.  That being said, we would like to think that good estate planning can sidestep the estate tax liability in the first place.

Other that these specific circumstances, we believe most individual’s life insurance needs are temporary.  We refer to something called the “window of risk”.

When an individual is young and single, generally, there is no need for life insurance at all.  When a couple gets married but rents and has no children, still, there is no need for life insurance.  When a couple owns a home and two incomes are needed to pay the mortgage, now the window of risk opens.  When the couple has kids, the window is fully open.  As time goes on and the children finish college, the window of risk begins to close.  During this same time, the couple’s assets grow and the balance on the mortgage declines.  At some point, the couple’s assets are substantial enough and the mortgage balance is low or zero that the window of risk closes.  Typically, by the time one reaches retirement, the window of risk is closed and there is no need for life insurance.

We believe that absent one of the special circumstances that would require permanent life insurance, for most individuals, term policies for their specific window of risk are the best course of action.

One word of caution, stick with the higher rated insurance companies and have a non-salesperson review your policy prior to purchasing it.

Do I Need Umbrella Insurance Coverage? If so, How Much?

An umbrella policy is a personal liability policy.

As a general rule, it should at least cover your net worth. It is best to round up to more fully protect your assets. For example, if your net worth is $2.5 million, you’ll want a $3 million policy. As a general exception to the rule, some assets may not need to be covered by an umbrella policy because state and federal statutes may provide for certain creditor exemptions (some assets, like qualified retirement accounts, are outside the reach of most liability creditors).

To qualify for an umbrella policy one must have the maximum liability coverage required by their underlying homeowner and auto insurance (this varies from company to company). Umbrella coverage brings does not “add to” auto and homeowners coverage, but rather increases them to the limit of the umbrella. So if your auto coverage was $500k and your umbrella was $2 million policy, you would have $2 million of liability protection, NOT $2.5 million.

For those whose net worth exceeds $5 million, there is probably need for additional, non-insurance asset protection planning with the help of an attorney.

At Integrated Wealth Counsel we work with our clients’ attorneys to prepare comprehensive risk management plans.