Today I will conclude our five part series on the five threats to qualified accounts. In our first four blogs we outlined the threats to IRA’s from income taxes, excise taxes, long-term care costs, and estate taxes. Today we will focus on the final threat, the risk of loss to beneficiaries and/or their creditors. The U.S. Supreme Court in June 2014 in Clark v. Rameker held an inherited IRA is not a “retirement account” for purposes of the protection under the Bankruptcy Code. This threw the financial and estate planning industry into turmoil, but those of us who stayed abreast of the legal arguments, were not surprised by the courts decision had planned that way for many years. A second and often overlooked threat is by the beneficiary themselves. Not all beneficiaries are equipped to receive assets and properly manage or protect them. So let’s look at these dangers more closely.
As outlined in our first part of this series, qualified funds are inherently protected under ERISA and the Bankruptcy Act. The challenge however, is the U.S. Supreme Court now has ruled inherited IRAs (the IRA after the death of the owner) is not protected. This is a major threat to qualified accounts. The most strategic way to protect against this threat is to ensure an individual's IRAs is beneficiary designated to a "see through” asset protection trust. For a trust to be qualified as a designated beneficiary under the Internal Revenue Regulations it requires it is irrevocable at death, it is valid under state law, the beneficiaries are "identifiable" and a copy of the trust is provided to the plan administrator. Once these four conditions are met the IRS will look “through” the trust at the beneficiaries of the trust to determine the designated beneficiary to determine the required minimum distributions. This can be an exceptional planning tool to protect the qualified account from the reach of the creditors, divorce, lawsuits, nursing homes, or other predators of the beneficiary, who now owns the IRA. For a complete review of using a trust as a beneficiary of an IRA and all its benefits register for our FREE Clark v. Rameker Webinar.
The second major risk to qualified accounts is that while we can protect the IRAs from the predators and creditors of the beneficiary, we cannot protect it from the beneficiary them self. How often do professionals get the call from the child, that inherited an IRA who says, “I need $70,000.00 out of my inherited IRA”, then the advisor discovers it is to buy a $50,000.00 car ($20,000.00 needed for income taxes) that's worth $40,000.00 when it’s driven off the lot. For individuals who are concerned about spendthrifts as beneficiaries, qualified accounts can be protected from abuse by the beneficiary themselves by creating an accumulation trust as beneficiary. An accumulation trust allows the trustee to hold the IRA required distributions made from the IRA in the trust and are not required to be distributed out to the beneficiary. This would typically be done if there's a risk of the distribution being lost to the beneficiary’s creditors or predators. The principal argument against accumulation trusts is that the income not distributed is taxed at the higher trust tax rate. True, but the question becomes would you rather pay the highest trust income tax rate of thirty nine point six percent or give it to a beneficiary who is subject to a judgment in which case the beneficiary would receive zero. In addition, to avoid the higher income tax, the distributions would be made to other beneficiaries named in the trust. So planning to protect an IRA from your beneficiaries and for your beneficiaries is not difficult, but does require planning during the life of the IRA owner to ensure the beneficiary does receive the qualified account outright but through the form of a trust which sets all the protections the client desires.
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David J. Zumpano, Esq, CPA, Co-founder Lawyers With Purpose, Founder and Senior Partner of Estate Planning Law Center