July 26, 2010

ADVICE Column: Estate Planning and the Trusteed IRA

What do money managers need to know now?

Estate planning that contemplates retirement plans is becoming more prevalent and important. As baby boomers age and retire, we frequently find much of their wealth is represented by their qualified plans. It is often a priority to maintain the tax-deferred status of these plans for as long as possible. Wealth managers everywhere know about, understand, and sometimes actively promote the use of strategies designed to "stretch" or extend the tax-deferred nature of these accounts for as long as possible, often through multiple generations. These "stretch IRAs" are not without their drawbacks, however. I will discuss the potentially deceptive promise of the stretch IRA and a potential solution that is becoming more available called the trusteed IRA.

To understand what a trusteed IRA is, you first have to understand the basics of IRA distributions, how "stretching" an IRA changes the distributions from an IRA, and the major issues with a stretched IRA that a trusteed IRA solves. We all know how the "stretch" works. An IRA holder is required to take money out of his/her IRA when they turn 70- 1/2 . The amount he/she needs to take out is determined by an actuarial table provided by the IRS (Publication 590 Appendix C). The goal of these tables is to force the exhaustion of the IRA assets within the actuarial life of the IRA owner!

In other words, if the IRA owner lives until his actuarial life expectancy (as determined by the tables) the distributions are calculated to have the IRA's value be depleted by that life expectancy date. Actually, the tables are even more favorable to owners: to keep surviving spouses from being destitute due to their spouse beating the odds and living longer than their life expectancy, the uniform table takes into account the life expectancy of a hypothetical spouse ten years younger (even if the IRA owner is unmarried). The IRS even provides a separate table for spouses who are more than ten years younger than their mates, to further assure assets remain available for the younger spouse's later years.

For the wealthy, these rules cause problems. There are many affluent people who will not need their retirement assets to meet their cash flow needs. Taking required minimum distributions (RMDs) causes excess liquidity (if RMDs are not taken in kind),

unnecessary income tax (RMDs are taxed as income), and a potential for increased tax rates. Moreover, it removes hard earned money from the tax deferral machine that is the IRA. For these people, the unnecessarily depleted IRA is a wasted opportunity to provide for others.

The "stretching" of an IRA is an intention on the part of the IRA owner to name a younger beneficiary (or having the surviving spouse name a younger beneficiary of his/her inherited IRA), causing the IRA to use a longer actuarial life which is calculated using the younger beneficiaries' life expectancies--aka the "stretch." This causes smaller RMD payments to be made, prolonging tax deferral and compounded growth opportunities in the IRA.

The Problem

The major problem (although there are many) of using the stretch concept is that the IRA owner must actually leave his qualified assets to younger beneficiaries. Once these assets are transferred to the younger beneficiary, that beneficiary can blow up the stretch plan very easily. He/she simply has to withdraw more than the annual RMD amount. They can take out the entire amount if they so desire. Yes they pay income tax, perhaps a lot of income tax, but inheritors of IRAs end up with more money than they started with...and Dad's plan to protect the inheritance and extend tax deferral is history!

This is such a serious problem (one statistic reports the average inheritance being spent in 17 months) that estate planning professionals have devised special trusts that restrict a beneficiary's access to these funds. These trusts, called "see through" trusts, conduit trusts and accumulation trusts, attempt to restrict access to retirement assets while continuing to take advantage of younger beneficiaries' life expectancies. In short, they are attempting to follow through on the promise of stretching an IRA while eliminating the downsides.

Unfortunately, these trusts have downsides of their own. These downsides are complex, and well beyond the scope of this article, but are so serious that many practitioners are uncomfortable drafting these documents (especially discretionary, "accumulation trusts"). As my colleague Ed Morrow, an estate planning attorney at Key Bank, states, "The income-tax rules regarding the use of trusts for retirement benefit bequests are at times illogical, unclear and, even when clear, sometimes problematic."

Sophisticated wealth managers have come up with a solution to many of these issues. The trusteed IRA is a cutting edge tool that more wealth managers will be taking advantage of to assist their clients in controlling the distribution of their wealth after their death. Its beauty and efficacy are in its simplicity, which also makes it easily understandable to clients, a major hurdle for wealth managers dealing with complex issues.

There are two types of IRS-approved individual retirement accounts. Internal Revenue Code (IRC) section 408 (h) defines the "custodial IRA" and section 408(a) defines the "trusteed IRA" as discussed here. Most IRAs use the custodial form. Again, the legal differences are complex, but we all know that custodial accounts traditionally leave the decision-making to the customer or client, while a trust account allows the trustee to

maintain control over the assets, usually guided by a document that determines the trustee's decisions. Taxation of the two types of accounts is identical. In the context of estate planning for IRAs, however, the difference can be important.

A trusteed IRA, by using a carefully crafted beneficiary designation form, emulates the dispositive provisions of a trust with the simplicity of IRA documentation. The beneficiary designation document for a trusteed IRA can control the timing, amount of, and the reasons behind distributions, thus alleviating the biggest problem with custodial stretch IRAs. Some well-crafted trusteed IRA beneficiary designations leave space on

the beneficiary designation form for a client and his/her attorney to add specific distribution language as if they were drafting a trust, yet by using the trusteed IRA, they eliminate most of the drafting issues they would need to deal with to put that same language in a trust meant to control IRA assets. In short, the trusteed IRA allows clients most of the control over their legacy that a complex and sophisticated irrevocable trust offers, with the simplicity of an IRA. As Edward R. Murrow stated: "...an elegant solution...."

Although limiting IRA beneficiaries' access to IRA funds without the use of complicated trusts is a primary goal of trusteed IRAs, there are a number of additional benefits as well. Natalie Choate, in her treatise "Life and Death Planning for Retirement Benefits," (Ataxplan, 2006) listed potential advantages to use a trusteed IRA over a custodial IRA, summarized here:

A trusteed IRA can authorize a trustee to use IRA assets should the IRA holder become disabled. An IRA custodian would not do that.

In a trusteed IRA, the IRA owner can specify successor beneficiaries. This is important because in most cases, the inheritor of a custodial IRA can designate their own beneficiaries once they inherit the IRA. In second marriage situations this can be helpful in maintaining money in a family bloodline.

The drafting of complex trusts to do what the trusteed IRA does can be very expensive, and the complexity can turn off attorneys and clients alike. To review, customize and opine on a trusteed IRA should cost less, and reduce liability for the attorney.

In some states, a trusteed IRA may provide better creditor protection then a custodial IRA.

Is there a downside? Well, nothing is perfect. Clients still need the advice of counsel to make sure their directions are carefully drafted. Clients still need to understand that if they live well beyond their actuarial expectancy, there may not be much to worry about anyway. Wealth managers may be employed by firms that don't have "trust powers" or their broker/dealers with those powers haven't yet pursued developing a trusteed IRA service. Because trusteed IRAs are only recently getting attention, there are not many firms willing to act as trustee, which makes the portability of these accounts a short-term concern, we hope. Finally, not all trusteed IRA's are created equal, so it is up to us, as wealth managers, to act as quality control in our own firms to make sure our clients are well served by this planning tool.

John Bock, JD, CTF, is a senior vice president and regional trust manager at Key Private Bank in Denver, CO. He serves as a fiduciary expert on the relationship management team, and can be reached at john_bock@keybank.com.

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