Asset Protection for IRAs How can I protect an inherited IRA? What is a Standalone Trust?

Asset Protection

A determination of this issue by the US Supreme Court is forthcoming in 2014.

The WA statute protects a participant’s IRAs from creditors’ attacks (personal injury lawsuits, divorcing spouses’ property division lawsuit (other than the Community Property exception, etc.) and the Federal Bankruptcy Act protects a Washington participant’s IRAs up to $1 million (indexed with an inflation). However, such a protection is not accorded to an Inherited IRA when the beneficiary is not a surviving spouse. Recently, there are more than a few bankruptcy court cases wherein this creditor attack of an inherited IRA was an issue, and the beneficiary lost in all cases and all inherited IRAs were subject to creditors’ attachment. The reasoning behind this decision making is that the purpose of the statutory protection of an IRA is solely to protect a participant’s retirement needs. Therefore, when a beneficiary (usually a child) is supposed to work and make his/her own living, the statutory protection does not extend to such a beneficiary. Therefore, when a child beneficiary goes through a divorce proceeding, his/her divorcing spouse might be able to successfully attach the child beneficiary’s right to an inherited IRA. A plaintiff in an auto accident might be able to successfully attach the child beneficiary’s right to an inherited IRA, too.

Then how can you protect an inherited IRA for your beneficiary (non-spouse)?

The answer is that you should use an asset protection mechanism built in a Standalone IRA trust. If you use a Standalone IRA trust, the asset protection of an inherited IRA is not derived from the statutory exemption. Instead, the trust law provides asset protection. A Standalone IRA trust provides asset protection that cannot be obtained by designating an individual beneficiary. It can also provide an income tax deferral benefit by stretching out required minimum distributions over the longest possible period, thereby creating further economic benefits.

A Standalone IRA Trust

For income tax purposes, there are more economic benefits to beneficiaries if distributions from an IRA can be stretched out over the beneficiary’s life expectancy by deferring the payment of income tax within the IRA. From an IRA participant’s perspective, the longer the IRA distributions can be deferred over a young beneficiary’s life expectancy, the more wealth is transferred to the participant’s beneficiaries. Such a goal can be achieved by establishing a Standalone IRA Trust.

There are four basic requirements for a Standalone IRA trust to achieve the above goal:

  1. The trust is a valid trust under a state law;
  2. The trust is irrevocable or become irrevocable upon a participant’s death;
  3. Beneficiaries must be identifiable from the trust agreement itself; and
  4. The documentation is provided to the plan administrator.

A Conduit Trust and An Accumulation Trust

A Standalone IRA trust can be either a conduit trust or an accumulation trust.

A conduit trust requires that as an IRA distribution is received by the trust, the same amount must be distributed to the beneficiary. Therefore, the trust does not accumulate excess IRA distributions inside the trust. If the beneficiary of the Standalone IRA Trust lives up to the life expectancy, the trust will not hold any accumulated IRA distributions inside the trust. However, if you establish a conduit trust, you do not have to worry about remainder beneficiaries or contingent beneficiaries to satisfy the 3rd requirement that I stated above (identifiable beneficiaries). That avoids a big surprise that the IRS might assert that the beneficiary’s 90 year old aunt’s life expectancy will be used for the income tax purposes if your lawyer makes a mistake in the document. Drafting an accumulation IRA trust requires extremely advanced tax knowledge.

An accumulation trust, unlike a conduit trust, allows IRA distributions to be accumulated in the trust. In order to determine the designated beneficiary of an accumulation trust, all the potential beneficiaries (except mere potential successors) are considered for the determination of the life expectancy for income tax deferral purposes. As I stated before, the younger the beneficiary, the more income tax benefit can be obtained because the distributions must be made according to the beneficiary’s life expectancy which is very long for a young beneficiary.

If you want a stronger asset protection feature in the Standalone IRA trust, the accumulation trust makes more sense than the conduit trust because the conduit trust requires a distribution to be made to the beneficiary each year, and such a mandatory distribution is subject to creditors’ attachment, although the principal of the trust assets are protected from such creditors. Especially, when you have a special needs (disabled) beneficiary who receives needs-based government benefits and if you want to use a Standalone IRA trust for the beneficiary, the accumulation Standalone Trust will be more attractive. Also, for a beneficiary who is engaged in a high risk profession or in a troubled marriage, you probably want to establish an accumulation Standalone IRA trust.

If you are interested in establishing a Standalone IRA trust, please contact our office.

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category: Asset Protection

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