Inheritances are not always the carefree “jackpots” that people often envision. Sometimes they can create problems if the estate planning instrument is not structured properly. Two areas where inheritances can become especially problematic without careful planning are Individual Retirement Arrangement accounts (“IRA’s”) and Special Needs Trusts for beneficiaries who are reliant upon means-tested public benefits such as Medi-Cal or SSI. Exceptional care must be taken when both of these areas are combined.
IRA’s – Preserving “The Stretch”
Traditional IRA’s allow tax deferment in order to encourage saving for retirement. Each dollar that is saved in an IRA creates a tax deduction. The money saved in the IRA grows in a tax deferred manner and is not taxed until it is withdrawn from the IRA. The IRA owner is allowed to withdraw funds from the IRA beginning in the year after the owner reaches age 59.5 without any penalty. However, beginning in the year after the IRA owner reaches age 70.5, the IRA owner is required to make minimum distributions from the IRA and must pay tax on each distribution. Such distributions are often referred to as “Required Minimum Distributions” or “RMD’s.”
If an IRA owner dies while still having funds in an IRA, the IRA owner may designate a beneficiary. If the beneficiary meets certain requirements, the beneficiary is allowed to spread out RMD’s based upon his or her lifetime, thus minimizing the applicable tax on each distribution every year. The concept of allowing a beneficiary to “stretch out” the RMD’s over his or her lifetime is often referred to as a “stretch IRA.” Careful estate plans should allow the beneficiary to “stretch” the IRA over the beneficiary’s life expectancy. Without careful planning, the beneficiary might be forced to withdraw all of the IRA at a much more rapid rate, thus increasing the taxation and depleting the IRA much sooner.
If an IRA designates a trust as a beneficiary, great care must be taken to ensure that the beneficiaries of the trust may “stretch out” distributions based upon their life expectancy. The trust designated as the beneficiary of an IRA must meet specific requirements. Furthermore, the IRA must be based upon the oldest trust beneficiary’s life expectancy. If a charity is named as one of the trust’s beneficiaries, it will usually prevent a “stretch” of the IRA since a charity does not have a life expectancy.
The question becomes whether contingent trust beneficiaries must be counted in determining the oldest trust beneficiary to figure out whether an IRA “stretch” is possible and to determine whose life expectancy can be used. For example, if an IRA designates a trust as a beneficiary that names John (age 35) as the 100% lifetime beneficiary but upon John’s death, any remaining balance is to be distributed to Sally (age 45) and Bob (age 55), Bob might be considered the oldest trust beneficiary and John would have to base his RMD’s on Bob’s life expectancy. If the contingent beneficiaries included a charity, then John might not be able to stretch out the IRA at all since the charity does not have a life expectancy.
One way around this problem is to include “conduit provisions” into the trust. “Conduit provisions” provide that all RMD’s must not only be taken out of the IRA, but that the Trustee of the trust must furthermore distribute the RMD’s directly to the primary beneficiary of the trust. In the example above, if the trust included “conduit provisions” requiring that all of the RMD’s be distributed out of the trust and be given to John, then only John’s life expectancy is considered in determining RMD’s for the trust (Sally, Bob, and the charity do not have to be considered).
The solution of including “conduit provisions” works in the majority or circumstances. However, if the trust designated as the beneficiary of the IRA is a Special Needs Trust, “conduit provisions” are not possible and special language must be included in order to preserve the “stretch” of the IRA.
Special Needs Trusts
If a beneficiary is reliant upon means-tested government benefits such as Medi-Cal or SSI, the beneficiary’s inheritance should be structed as a Special Needs Trust. A Special Needs Trust is a trust that is designed to allow the beneficiary to use and enjoy the inheritance in such a manner that the inheritance does not interfere with the beneficiary’s eligibility for means-tested public benefits. The key with a Special Needs Trust is that a third-party Trustee manages the inheritance for the beneficiary and is careful about the amount, timing, and purpose of each trust distribution.
Because the Trustee of a Special Needs Trust must be careful about the amount, timing and purpose of each trust distribution, “conduit provisions” that require the Trustee to automatically distribute each RMD directly to the trust beneficiary should not be included in a Special Needs Trust. Without “conduit provisions,” the contingent beneficiaries will have to be considered in determining whether and to what extent an IRA can be “stretched out.”
A Special Needs Trust that is designated as the beneficiary of an IRA should not name a charity as a contingent beneficiary and should include special language that under no circumstances shall any contingent beneficiary be born before the primary beneficiary. This often conflicts with the overall intent of the estate plan. In such a situation, it might be prudent to design one Special Needs Trust for all non-IRA assets that might name older individuals or charities as contingent beneficiaries and a separate Special Needs Trust just for the IRA’s that limit the contingent beneficiaries to younger individuals.
IRA’s and Special Needs Trusts both involve careful, nuanced planning that often conflict with each other. Any time you name a Special Needs Trust as a beneficiary of an IRA, special care must be taken with regard to the contingent beneficiaries to ensure that the trust beneficiary is able to “stretch out” the IRA as long as possible, thus minimizing tax on IRA distributions. In many cases, a completely separate trust should be established just to be the designated beneficiary of the IRA.
KRASA LAW, Inc. is located at 704-D Forest Avenue, Pacific Grove, California and Kyle may be reached at 831-920-0205.
Disclaimer: This article is for general information only. Reading this article does not establish an attorney-client relationship. Before acting upon any information contained within this article, you should consult a competent attorney who is licensed to practice law in your community.