Where living trusts and retirement meet: Asset Protection and Income Tax Ad-vantages for Your Retirement Plan Beneficiaries

 In Trusts

Already have a living trust? Find out why a Retirement Trust Account gives you the best of both worlds.

In the estate planning worlds of asset protection for beneficiaries on the one hand, and income tax advantages for beneficiaries on the other, the conventional wisdom that asks one to choose between the two when it comes to your retirement accounts, is no longer relevant. The solution has been found in the Retirement Trust Account, which offers the best of both worlds. Before we get to the solution, however, let’s examine why it’s needed to begin with.

The Issue

Before the Retirement Trust Account, we only had traditional trusts to work with in estate planning. And traditional trusts do – as conventional wisdom tell us – make bad retirement account beneficiaries, primarily for tax reasons; that’s why naming an individual as a retirement beneficiary has historically been the best option for maximizing your retirement assets and minimizing your beneficiary’s income tax. But why?

To understand, it helps to know a little bit about federal income tax law and actuarial tables. Simply put: the IRS allows an individual to inherit retirement benefits, but it bases the mandatory payouts from the retirement account on the life expectancy of the beneficiary. This allows a beneficiary to inherit over the course of his/her life expectancy (taken from the IRS actuarial table). Therefore, the younger the beneficiary, the more years the retirement benefit distributions will be “stretched”. You can see, then, the inverse relationship between the age of the beneficiary and the amount of required annual distributions. This arrangement holds great value in terms of tax advantages and wealth protection/management when the beneficiary acts wisely:

  • Immediate Tax Benefit:Because the beneficiary can choose to not to receive the retirement funds in a lump sum, he/she can avoid a 40% loss right out of the gate. Instead, the individual may opt to allow the funds to continue their tax-deferred growth, and receive an annual distribution as explained above.
  • Modest Annual Distributions Yield Long Term Tax Benefits & Immediate Financial Benefit:The beneficiary’s annual distributions received will count towards their income tax purposes, and so smaller, modest amounts will be much less likely to hoist that individual to a higher tax bracket.
  • Long Term Security:When opting to take only the mandatory payouts and allowing the funds to continue their tax-deferred growth, the beneficiary can count on continuous and increasing distributions over the course of his/her lifetime.
  • Long Term Growth Potential:When only mandatory distributions are made annually, the bulk of the benefit will be allowed to continue growing, tax-deferred; this can turn an average retirement account into a small fortune.

At this point you may be wondering…if all this is available to my beneficiary now, why would I need any kind of special trust? First, it’s important to note that while the beneficiary has the option to opt for “stretch”, he/she can choose to receive the sum of the account in one lump-sum. And second, this arrangement offers no trust protections. Such outcomes have consequences; let’s take a closer look at why we like trusts, and what we risk in naming an individual beneficiary.

Why We Like Living Trusts in Estate Planning

Trusts find their appeal in the asset protection they can offer to you and your beneficiaries. For example, a trust can insulate assets from creditors, a lawsuit judgment, irresponsible financial management, a careless spouse, harmful addictions, divorce, and making unwise investments. Assets left outright provide – including retirement accounts – have none of those protections.

However, naming a traditional trust as a beneficiary can have devastating tax consequences. This is for two reasons:

(1) Shorter distribution periods, and

(2) Compressed Tax Brackets

Remember the inverse relationship between the length of the distribution period and the amount of required annual distributions? Because naming a trust will most likely have a shorter distribution and because trusts are taxed at the top income tax brackets, the potential for immediate, drastic loss of wealth is simply too much to ignore.

Many of us take great care to properly manage our assets with trust planning. But if the trust (and all of its protections) that was created doesn’t apply to retirement accounts, that’s potentially a real problem; this vulnerability can greatly undermine the goals and desires of an otherwise solid plan. What’s more, retirement accounts are often a great asset for individuals. In fact, it is not uncommon to find one’s dominant source of wealth in these accounts – whether an IRA, 401(k) or other. In other words, a lot is at stake.

Much to gain, much to lose

If going without these inherent trust protections doesn’t concern you, perhaps this will: while it’s true that retirement account beneficiaries have the option to inherit retirement benefits over the course of their life expectancy to avoid the huge income tax loss and allow tax-deferred growth, they do not have to. Before you get too comfortable in thinking that your beneficiary would never act unwisely here, consider this: roughly 90% of beneficiaries choose a lump-sum cash out. When one really ponders that number, leaving a retirement account to an individual beneficiary tends to feel less like good planning, and more like gambling.


A Solution: The Retirement Trust Account

There is no longer any reason to take unnecessary risks. A solution is found in the Retirement Trust Account, the see-through trust exception to traditional rule. When properly drafted, we can “see-through” the trust to identify its beneficiaries and thereby determine the applicable distribution period. Consider the benefits this provides:

  • Be certain that the assets you leave behind will be protected from huge income tax loss
  • Be assured that your wealth won’t be cut nearly in half overnight, but will instead grow exponentially for years to come
  • Be confident that your assets will give bothlong term financial security and valuable trust protections for your loved ones


The solution to accomplishing all of these goals is the Retirement Trust Account; and the difference it can make is quite staggering. Consider the following case study for added perspective:

John is divorced with two grown children: Jack is 19 and Jill is 24. John has an estate valued at 1.5 million dollars, with $750k in retirement accounts. In this scenario, 50% of the value of his estate will go directly to his named beneficiaries: Jack & Jill. Jack is in his first year of college and still very immature when it comes to finances. Jill is currently studying to be a doctor, a profession with greater potential for lawsuits.

Scenario 1: If John names Jack and Jill as co-beneficiaries with equal shares, Jack and Jill each stand to take 375k. At John’s death, Jack and Jill both decide to take a lump-sum payout. Jill has been burdened with school bills, while Jack is anxious to pursue his dreams of travelling abroad while he’s young. After accounting for a 40% income tax loss, each child has $225k.

Scenario 2: If John created a Retirement Trust Account, the outcome is quite different. Instead of leaving each child 225k, the money will continue to grow, tax-deferred, to over 2.7 million dollars. In addition, each child will begin receiving annual distributions based on Jill’s age at the time of John’s death. The first year, Jill and Jack will share over $13k, with each receiving roughly $6800. This number will increase each year. So when Jill is 40, the two will split about $40k, when Jill is 60 – $111k, and when Jill is 82, distributions reach their peak in the amount of nearly $483k.

The Retirement Trust Account ensures these goals are met because all of the protections you desire in a traditional trust can now be applied to your retirement wealth AND your beneficiary can still benefit from the tax-deferred growth. It really is the best of both worlds, don’t you think? If you are interested in learning more, schedule a visit at our office to discuss your personalized Estate Plan.

If you need a  living trust set up, our attorneys in Plano can help you. Contact us for more information today.

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