For many successful couples, retirement accounts are among the largest assets they will leave behind for their children.
A husband and wife may have spent decades contributing to 401(k)s, IRAs and other retirement plans, ultimately accumulating $2 million, $3 million or considerably more. Most couples understandably name each other as the primary beneficiary of these accounts and their children as the contingent beneficiaries.
That sounds simple and sensible. But there may be a significant weakness in this approach.
If your children inherit substantial retirement accounts directly, the money they receive may eventually become exposed to a divorce, lawsuits, creditors or other financial problems.
For couples with significant retirement assets, a separate Retirement Plan Trust containing carefully drafted accumulation provisions may provide a much stronger way to pass this wealth to the next generation.
The Problem With Naming Children Directly
Consider a married couple with $3 million in combined IRAs and retirement accounts. Each spouse names the other as primary beneficiary. If both parents are gone, their two adult children are named as equal contingent beneficiaries. Eventually, each child could inherit approximately $1.5 million of retirement assets. That sounds like an excellent inheritance. But what happens if one child is going through a divorce when the inheritance is received? What if a child is later sued after a serious automobile accident? What if a child owns a business that fails, has significant creditor problems or simply makes poor financial decisions?
An inheritance that parents spent 30 or 40 years accumulating can suddenly become vulnerable to the legal threats of their children once they inherit them. This is especially important with retirement accounts because, under current federal law, most adult children who inherit an IRA or other defined-contribution retirement account must completely withdraw the inherited account within 10 years following the owner's death.
That means the retirement account itself generally cannot remain intact indefinitely for an adult child. But that does not necessarily mean the money has to be distributed outright into the child's hands.
A Retirement Plan Trust Can Create a Protective Barrier
Instead of naming the children individually as contingent beneficiaries, each spouse can establish a specially designed Retirement Plan Trust and name that trust as the contingent beneficiary of his or her retirement accounts.
The beneficiary designation might generally look like this:
Primary Beneficiary: Spouse
Contingent Beneficiary: Retirement Plan Trust
The Retirement Plan Trust is drafted specifically to receive inherited retirement benefits and comply with the complex rules governing retirement accounts. Most importantly, it can contain accumulation provisions for the couple's children.
An accumulation trust differs from a "conduit" trust. With a conduit trust, retirement plan distributions received by the trustee generally must be passed through the trust to the beneficiary directly. With an accumulation trust, the trustee may instead be permitted to retain distributions from the account inside the trust rather than automatically distributing them to the child.
That distinction can be enormously important.
The Retirement Account May Have to Come Out, But It Doesn't Necessarily Have to Go to the Child
Suppose your daughter inherits a $1.5 million IRA through a properly structured Retirement Plan Trust. Because of the SECURE Act, the inherited IRA generally must be emptied by the end of the applicable 10-year period. Depending upon the circumstances, distributions may also be required during that period on an annual basis as an RMD (required minimum distribution) on the same distribution schedule that the parent over the 10-year period if the parent was older than their required beginning date for RMDs when they passed.
Without a trust, those distributions go directly to your daughter. With an accumulation-style Retirement Plan Trust, however, the IRA distribution can potentially be made to the trust and retained there, subject to the terms of the trust.
In other words: The money may have to leave the IRA, but it does not necessarily have to leave the protection of the trust. That is one of the most important distinctions for families with substantial retirement assets.
Protection From a Child's Divorce
Parents are frequently concerned about what would happen to an inheritance if their son or daughter eventually divorces. California generally treats an inheritance as separate property when it is properly maintained as such. But real life is rarely that simple. Inherited funds may be commingled with marital assets. They may be used to purchase or improve jointly owned property. The child may inadvertently change the character of the property or create disputes regarding tracing and ownership.
A properly drafted continuing trust creates an additional layer of separation. Instead of giving the inherited retirement assets outright to the child, the assets can remain in a trust established by the parents for that child's benefit. The goal is not to prevent your child from benefiting from the inheritance. The goal is to allow your child to benefit from it without unnecessarily giving up the protections that you had the opportunity to create.
Protection From Lawsuits and Creditors
The same concept applies to lawsuits and creditors. Imagine that your son is a physician, business owner, real estate investor or other professional with significant liability exposure. Or perhaps years after receiving his inheritance, he is involved in an accident that results in a substantial judgment. If inherited retirement distributions have already been paid directly to him and are sitting in his personal investment account, those assets may be considerably more exposed.
If the inheritance instead remains in a properly designed trust with appropriate spendthrift and discretionary distribution provisions, the assets may have substantially greater protection from claims against the beneficiary, depending upon applicable law and the circumstances. For a family transferring several million dollars, that distinction can be extremely valuable.
Your Children Can Still Benefit From the Money
Some parents hear "asset protection trust" and imagine that their children will have difficulty accessing their inheritance. That does not have to be the case.
A well-designed trust can permit distributions for the child's needs while keeping assets that are not needed safely inside the trust. Depending upon the family's goals and the trust's design, the child may also have an appropriate role in managing and investing trust assets as a co-trustee or a the sole trustee of their trust share with the right provisions added to the trust.
The objective is to find the appropriate balance between access, control and protection. Giving a child $1 million outright provides maximum control but very little continuing protection. Keeping that same $1 million in a properly structured trust can allow the child to benefit from the money while preserving protections that disappear once the assets are distributed outright.
Why Not Just Use Your Regular Living Trust?
A revocable living trust and a Retirement Plan Trust serve different purposes. Retirement accounts are governed by a complicated combination of beneficiary designation rules, federal tax law and required minimum distribution rules. The SECURE Act dramatically changed the rules for inherited retirement accounts, and the IRS has subsequently issued extensive regulations governing trusts named as retirement account beneficiaries.
A properly drafted trust may qualify as a "see-through" trust so that its beneficiaries are taken into consideration when applying the retirement distribution rules. This is an area where small drafting differences can have significant tax consequences. For that reason, we often prefer a separate Retirement Plan Trust specifically designed to receive retirement assets, rather than relying solely upon the family's general revocable living trust.
For a married couple, that may mean creating a separate Retirement Plan Trust for each spouse and coordinating each trust with that spouse's IRA, 401(k) and other retirement beneficiary designations.
Why Keep the Spouse as Primary Beneficiary?
For most married couples, we generally still want the surviving spouse to have the valuable options available to a spouse beneficiary. A surviving spouse has retirement-planning opportunities that generally are not available to adult children, including the ability in appropriate circumstances to roll inherited IRA assets into the surviving spouse under the spousal rollover rules.
Accordingly, the structure is often:
Spouse first. Retirement Plan Trust second.
If Husband dies first, Wife remains his primary beneficiary. If Wife has already died, or if the trust otherwise becomes the beneficiary under the beneficiary designation and applicable planning, Husband's Retirement Plan Trust can receive the retirement assets for the children. Wife can establish a corresponding Retirement Plan Trust for her retirement accounts. This allows the estate plan to preserve valuable spousal options while creating a protective structure for the next generation.
Importantly, beneficiary designations must be coordinated carefully. If the surviving spouse receives the retirement account and completes a spousal rollover, the surviving spouse's beneficiary designation form will need to be updated to ultimately determine where that account goes upon their death. The couple's overall plan therefore needs to coordinate both spouses' retirement accounts and beneficiary designation forms.
Having a retirement plan trust for your children is a wealth-preservation and asset-protection strategy.
For a family leaving a relatively small IRA, the additional complexity may not be worthwhile. But when a couple has $2 million, $3 million, $5 million or more in retirement accounts, the amount ultimately passing to children can be substantial enough that protecting those assets deserves serious consideration.
Think About What You Are Really Leaving Your Children
If you have accumulated $2 million or more in retirement accounts, you have probably spent decades building those assets.
The estate-planning question should not simply be:
"Who should receive my retirement accounts?"
A better question may be:
"How should my children receive these assets so that the inheritance has the best opportunity to remain protected for them and their families?"
There is an enormous difference between leaving a child a $1 million inherited retirement account outright and leaving retirement benefits through a carefully designed trust that can continue protecting the assets after distributions are made from the retirement account. The SECURE Act shortened the period during which most adult children can maintain inherited retirement accounts. It did not eliminate the opportunity for parents to use thoughtful trust planning to protect the wealth those accounts represent.
For couples with substantial retirement assets, a properly designed accumulation-style Retirement Plan Trust can be an important addition to the overall estate plan, preserving valuable options for the surviving spouse while providing another layer of protection for children against divorce, lawsuits, creditors and other risks that may arise long after their parents are gone.
At Geiger Law Office, we believe estate planning should do more than identify who inherits your assets. A well-designed plan should consider how those assets are inherited, what risks your beneficiaries may face, and how the wealth you spent a lifetime building can be protected for the people you intended to benefit.
One technical nuance I want to point out that is very important: if Spouse A names Spouse B outright as primary beneficiary and Spouse B subsequently rolls over the account, Spouse A's contingent Retirement Plan Trust no longer controls where that money when Spouse B passes. The surviving spouse's beneficiary designation form becomes critical. The beneficiary designation form needs to be updated to name Spouse B’s retirement plan trust. The IRS also confirms that a spouse who is the direct beneficiary generally has rollover/treat-as-own options that are not available when a trust is the named beneficiary.
If you, a friend, or a loved one would like to discuss estate planning and/or Retirement Protector Trusts, contact our Intake Department at 760-448-2220 or visit us online at www.geigerlawoffice.com/contact.cfm. We proudly serve families throughout California from our offices in Carlsbad and Laguna Niguel.
