Stretch IRA / Family IRA Trusts
The IRA distribution rules offer major planning opportunities for IRA accounts. To take advantage of these opportunities, we have developed a planning strategy we call the Family IRA Trust™. This memorandum explores and explains how this special type of trust works.
A Brief Description of a Family IRA Trust™
This is a trust that is specifically set up to be the beneficiary of an IRA account1. It pairs the many significant benefits of trust planning with maximizing the time period for distributions from IRA accounts.
Trusts can be beneficiaries of retirement plans but there are several rules that have to be followed to maximize the stretch rules for these accounts. The Family IRA Trust™ complies with these rules as of the time of the creation of the trust. However, this trust needs to be monitored for any future changes in IRA rules.
Stretch IRA planning can extend the life of an IRA by many decades in some circumstances, which in turn maximizes the benefits of tax-deferred growth. The use of a trust as a beneficiary is meant to capture the many planning benefits and options that are available by using a trust.
There are a number of important benefits that can be obtained by naming a trust as an IRA beneficiary compared to naming an individual. These are the most important:
- Control of assets otherwise payable to a minor or to a person who is incompetent or who cannot handle his or her finances.
- Properly structured assets in a trust are not attachable by creditors nor are they marital property of the beneficiary.
- Property in a trust can avoid probate on the death of a beneficiary
- There are important estate tax planning benefits with potentially large tax savings.
- The trust solves the problem of a successor beneficiary where the initial trust beneficiary dies before complete distribution of an inherited IRA account.
The Family IRA Trust™ is designed to achieve all of these benefits and more.
The Family IRA Trust™ and Providing for Grandchildren.
The goal of the Family IRA Trust™ is to combine the benefits of retaining inheritances in trusts with "stretch" IRA planning. Here is one situation particularly suited for this strategy.
John, age 65, has a son, Dennis, age 40 and a granddaughter, Robin, age 10. John is widowed and wealthy. His current estate plan provides that everything is to go to his son. There is more than enough property in his estate to provide for the financial security of his son and his son's family and John wants to maximize tax deferral of his $500,000 IRA. We advise him to consider naming Robin as the beneficiary.
Dennis's life expectancy is 43.6 years and Robin's life expectancy is 72.8 years. We ask John to assume that something happens to him in 2006. If Dennis is the beneficiary, his first required distribution is by December 31st of 2007 and will be 2.29% of the trust balance or $11,250 (100 divided by the life expectancy of Dennis of 43.6 years equals 2.29%).
If Robin is the beneficiary, the required distribution is $6,850 (100 divided by 72.8 years). This is $4,400 less than the distribution required to be paid to Dennis, leaving more money to grow longer.
The foregoing shows the immediate consequences of "stretching." Now suppose that instead John lives another 15 years to age 80, which is a more likely occurrence. What are the financial consequences to the family from "stretching" the IRA distributions beginning at the death of John. The following compares the use of Dennis's life expectancy to Robin's.
|Distribution to each beneficiary for first year after death of John (2021)||$30,748||$16,841|
|Cumulative distributions to each beneficiary over that person's life expectancy (2049 for Dennis and 2073 for Robin)||$2,910,456||$9,224,336|
Exhibit A is a summary of the distributions where Dennis is the beneficiary and Exhibit B is where Robin is the beneficiary. Full detailed illustrations are available by contacting Smith and Condeni.
In 2021, Robin as beneficiary is taking out almost 50% less than Dennis is required to withdraw. This feeds the cumulative benefit and results in the total payouts to Robin being more than triple those that would be made to Dennis.
Once a client determines that he or she wants to pursue this strategy, we then evaluate the use of the Family IRA Trust™ to be the beneficiary of the IRA. In our example, we advise John to set up a Family IRA Trust™ and name Robin as the beneficiary of the trust. All of the benefits of "stretch' planning and the Family IRA TrustTm are secured.
Life Insurance and the Family IRA Trust™
Assume, however, that the client does not want to by-pass his children and feels they may need the financial security the IRA provides. The solution is for the client to buy a life insurance contract on his life with a death benefit equal to the value of the IRA, the projected value of that account or another value he selects that is appropriate for the financial resource that he wants to have available for his children. How does this work2? Using John and his family, this is what occurs:
- John is the insured on an insurance contract with a $500,000 death benefit. The annual cost of a universal life contract for that amount is about $10,5003.
- He makes a gift of that amount each year to an insurance trust that owns the contract and the trust uses this gift to pay the premium. This is a tax-free gift because the trust beneficiary, Dennis, has Crummey withdrawal powers.
- The cost to fund the insurance contract is only about 2% of the value of the IRA.
- At John's death at age 80, the $500,000 death benefit is paid to the trust. Dennis receives trust distributions as the beneficiary.
- Robin is the beneficiary of the $500,000 IRA and the IRA Family Trust™ begins distributions based on her life expectancy.
- There is an enormous financial benefit to the family from this strategy including (but not limited to) the following:
- The wealth left for Dennis and Robin is $1,000,000 not $500,000.
- The $500,000 death benefit paid to the trust for Dennis is income tax free.
- The principal of this trust will pass free of estate taxes at Dennis's death and will be held for Robin.
- The stretch of the IRA account using Robin's life expectancy will create an enormously larger pool of assets in the Family IRA Trust™ using Robin's life expectancy as compared to Dennis's.
Second Marriage Situations
This strategy is also very useful in second marriage situations. Typically, each spouse wants to provide for the economic security of the other but wants his or her assets to ultimately go to the children from the first marriage or to other family members. The fact patterns in these situations quite commonly look like this.
Dave is married to Trish and has a child from a prior marriage, Joe, who is 30. Dave's largest asset is his IRA account with a balance of $500,000. Dave is 65 and Trish is 60.
Dave wants to provide for the financial support of Trish if something happens to him, but upon her death he wants to make sure that whatever is left over in his retirement account will pass on to Joe. The Family IRA Trust™ provides a perfect solution. The following is one approach, among several, that illustrates the strategy.
Dave determines that he would like Trish to receive $3,000 per month ($36,000 per year). This is slightly more than 7% of the IRA balance. He wants to maximize tax deferral of the IRA and to make sure that the IRA ultimately goes to Joe.
Assume for purposes of evaluating the following choices that Dave dies fifteen years later at age 80 at which time Trish is 75.
Choice #1: Trish is beneficiary of the IRA.
Trish rolls over the IRA to her name, remarries and names her new husband as the beneficiary. This is not a good outcome and we may safely assume that Trish and Joe no longer share Thanksgiving dinner as a family.
Choice #2: Dave names his trust as the beneficiary of the IRA.
Following his death, the trustee makes withdrawals based on the minimum required distributions. At this point, Trish is age 75. Under the single life expectancy table, her life expectancy is 13.4 and the required distribution for the first year is 7.46% or $37,300.
Each year thereafter, the life expectancy is reduced by 1 year. Five years later, the remaining life expectancy is 8.4 and the required distribution is $59,500. Eventually, the account value of the IRA reaches zero.
Choice #3: Dave names his Family IRA Trust™ as the beneficiary.
The beneficiary of this trust is his son, Joe. To provide the income benefit of $3,000 per month that he wants for Trish, he does the following:
• He purchases a life insurance contract on his life. The premium for the contract is $8,000 per year and the death benefit is $380,000.
• At his death, the death benefit is used to buy a single premium immediate annuity that pays Trish $3,000 per month for her life. Not coincidentally, the cost of the annuity is $380,000.
At his death, Trish gets guaranteed income of $3,000 per month. The IRA is kept intact and the Family IRA Trust™ uses Joe's life expectancy to determine the required distributions.
Are there other benefits? Yes. As one example, the illustration used for this analysis has an exclusion ratio for the annuity payment of 84.1%4. $2,523 of the monthly payment is income tax free. Income taxes are only paid on $477.
If instead, $3,000 per month is withdrawn from the IRA, then income taxes are due on the entire amount. This can be solved by taking out additional funds from the IRA to pay the taxes but this in turn increases the income taxes that are currently paid. It also leaves fewer assets in the IRA that are growing tax deferred.
The Family IRA Trust™ is also useful for aunts, uncles or other family members who do not have their own children. Quite frequently, these persons want to name their nieces and nephews as beneficiaries. This may be because they believe their siblings have enough money and/or because of their strong attachment to their siblings' children.
When a Family IRA Trusrm is used to accomplish this, there are a number of benefits beyond those already discussed. One is that there will be a permanent memory of the gift that was made. It is in a trust and you will not be forgotten.
Another reason that cannot be overlooked is keeping the parents of the children in control. A gift of a large IRA account to a young person can lead to family conflict. At age 18, or at age 21 if the beneficiary was a custodian for a minor child, the child gets control of the asset and can do whatever he or she wants. Parents may find this to be an uncomfortable situation. With a Family IRA Trusrm that names the parent as Trustee, this can be avoided.
Asset Protection Planning Benefits of a Family IRA Trust™
The Family IRA Trusrm will provide significant asset protection planning for its beneficiaries. This is because of its "spendthrift" clause that insulates the trust assets from claims against the trust beneficiary. The beneficiary of the trust does not legally own the trust property and has only a "beneficial interest" in the trust property that a creditor cannot attach. This makes trusts useful for protecting the assets from claims of creditors of the beneficiary.
Ohio, and many other states, also protects assets in IRA's from attachment from creditors. However, what is not generally appreciated is that this protection only applies to the original owner of the IRA and not the beneficiary.
To remedy this limitation, IRA assets payable to a trust are protected because of the terms of the trust and are not subject to attachment by creditors of the beneficiary. If asset protection planning is an important objective of an estate plan, the Family IRA Trust™ should be used.
Divorce and the Family IRA Trust™
Assets in a Family IRA Trust™ are not marital assets and are not divisible in a divorce situation. With divorce rate of about 50%, this is probably the most significant risk that beneficiaries will face. The Family IRA Trust™ protects family members from losing part of their inheritance in a divorce proceeding.
Applicability to Retirement Plans Other Than IRA's
This plan works best with IRA accounts because those accounts will always have the maximum stretch opportunities. Other retirement plans such as profit sharing plans and 401(k)'s do not necessarily have the same distribution options. This is because the plan sponsor may not have chosen the maximum tax deferral periods that are available. To learn more about this very important planning issue, read our article, Company Plan Rollovers to IRAs. It is available under Library at our website, www.smith-condeni.com. The distribution options for these plans has to be reviewed before creating a Family IRA Trust™.
Tax Consequences Of Using A Family IRA Trust™
The IRA distributions are taxed to the trust since it is a separate tax entity. The trust pays taxes on its income and reports this on a 1041 income tax return. Many states, including Ohio, now tax trust income so there may also be some state income tax.
Trusts are subject to a compressed tax rate schedule, meaning they get to the higher tax brackets much more quickly than individuals do so trust income and distributions frequently need to be managed if income tax issues are of primary concern.
However, the Family IRA Trust™ gets a tax deduction for any income it distributes and this income is then taxed to the beneficiary of the trust at that person's tax rates. This allows the Trustee and the beneficiary to manage income tax planning, keeping these taxes to a minimum.
Some Final Thoughts
There are many situations where the use of a Family IRA Trust™ would be very valuable and this article only identifies several common planning situations.
Keep in mind also that this strategy is not an all or nothing proposition. You can designate only part of the IRA to go to a Family IRA Trust™ with other portions for a surviving spouse, other family members or other beneficiaries for whom you want to provide. To do this, we prepare a custom IRA beneficiary designation form designating the portions of the IRA that are allocated to the Family IRA Trusfrm and other beneficiaries.
There are many variations on this strategy and a lot of bells and whistles that can be added. However, this article is long enough and our fingers are getting tired. To learn more about this important planning strategy and how it can be used effectively to create, maximize and protect wealth, contact your Smith and Condeni attorney.
Thank you very much to our good friend, Bill Davis at NorthCoast Brokerage, a Capitas Financial Partner, Cleveland, Ohio for his technical assistance, insurance and annuity illustrations as well as his thoughtful comments.
1 The beneficiary designation must be carefully drafted when a trust is named as a beneficiary. This is handled as part of the creation of a Family IRA Trust™.
2 The examples used and discussed in this article do not take into account either inflation or growth in the value of the IRA account and assumes that required withdrawals are offset by growth of the IRA account. This is done to isolate the significance of the planning choices.
3 Insurance and annuity illustrations are courtesy of NorthCoast Brokerage, a Capitas Financial Partner, Cleveland, Ohio.
4 Payments under an annuity contract are part a return of the money used to buy the contract and part is interest or other earnings on the money deposited with the purchase of the contract. The portion of the payment that is a return of the purchase money is not taxed. In the above example, about $84 of each $100 is tax-free and the balance of $16 is earnings on the money deposited.