Estate Planning and Asset Protection for Retirement Accounts

For many estate planning clients, their retirement account represents the majority of their wealth.  Typically these accounts are held in “tax qualified plans” such as a 401(k), or an IRA.  Because they are not subject to income tax until withdrawn — typically at age 70 1/2 — they provide the ability to accumulate large amounts of wealth during one’s lifetime.  In addition, they are generally unreachable by creditors of the plan holder.  But  what happens to your retirement account if you die prematurely?  In that event, substantial assets may be available for your beneficiaries.

Consequently, In designing your estate plan, two things become critically important.  First, you want to ensure that your retirement account assets inherited by your spouse and children — known as Inherited IRA’s — continue to accumulate for the maximum time period allowed without payment of tax. This period of time before taxable distributions must begin is referred to as the “stretch-out” . A longer stretch-out can make a huge difference in the amount of funds available to your beneficiaries later in life. Second, you want to ensure that these assets are protected from lawsuits, creditors, divorce or financial mismanagement. Until the landmark case of Clark v. Rameker, it was thought that the protections afforded to a plan holder’s retirement account extended to inheriting beneficiaries. But in Rameker, creditors of an estate were allowed to reach the retirement assets inherited by a child beneficiary. In making its finding, the court determined that funds in an inherited IRA are not considered retirement funds.

Creating an estate plan that accomplishes both the stretch-out and asset protection can be complicated. Two types of trusts can be used, but each can achieve only one of the two desired objectives. A conduit trust is best suited to ensure the maximum stretch-out because the life expectancy of the primary beneficiary is used as the measuring life. For example, if you have two children, ages 6 and 14, you can set up separate trusts so that each becomes the primary beneficiary of their own trust.  In that case, each child can use their own life expectancy as the measuring life in determining the length of the stretch-out. All distributions made from the retirement account, however, must be distributed to the beneficiary. They cannot be held by the trustee. Once distributed, these funds are no longer protected.

An accumulation trust allows distributions from the retirement account to be held by the trustee inside the trust. Accordingly, it provides for greater asset protection than the conduit trust. The downside is that rather than using the life expectancy of the primary beneficiary alone to determine the length of the stretch-out, all potential beneficiaries must be considered.  Exactly who that includes is not completely clear, but if an older person such as a parent, or grand-parent, could possibly become a beneficiary then that person’s life expectancy must be used. Using the older beneficiary’s life expectancy would shorten the stretch-out, and create substantially less future asset value. Furthermore, if required distributions from the retirement account are held by the trustee, income from the retained money could be taxed at a significantly higher rate.

So what do you do? The conduit trust is easier to draft. If your beneficiary, at the time of drafting,  is young and has no asset protection type issues, then the longer stretch-out and greater future growth offered by the conduit trust may be most important to you.  But what if things change. For example, your son starts a business that goes bankrupt, or he gets married and then divorced, what then?

The solution may be what’s known as a standalone retirement trust (“SRT”). An SRT can be drafted to achieve both the benefit of asset protection and the stretch-out. A third party non-beneficiary (known as a Trust Protector) is typically designated in the trust document with authority to alter the distribution provisions, for a limited period, after the death of the plan holder.  Effectively, this allows a conduit trust to later become an accumulation trust, or an accumulation trust to become a conduit trust, based on the future needs of the beneficiary. Although increasingly recognized as a cutting-edge estate planning tool, not all estate planning attorneys adhere to the legal soundness of this approach. In any event, if your retirement account represents a substantial percentage of your assets, it should certainly be considered.

At the Law Offices of Clifford M. Cohen, we keep up with the most current estate planning and asset protection techniques. Please contact our office at (202) 895-2799 for a free telephone consultation concerning how we can assist you in planning for the future of those you love the most.