Why use an IRA trust?

Andrew Sykes presents "12 Cool IRA Protection Strategies" to Pittsburgh area financial advisors on October 17, 2013

Andrew Sykes presents “12 Cool IRA Protection Strategies” to Pittsburgh area financial advisors on October 17, 2013

Qualified retirement plans, like IRAs, can have superior advantages when left to a loved one. Chief among those advantages is the ability to “stretch” distributions, which can double or triple the lifetime value to the beneficiaries.

But your plan to leave retirement assets to your beneficiaries may get tripped up in various ways. Here are a few:

Rapid depletion. Rather than carefully stretching distributions over allowable life expectancy, the beneficiary may take down all the money much sooner (perhaps right away). Rapid depletion will foreclose long-term tax deferral, and could very well mean the beneficiary pays more in taxes on the amount distributed. Early depletion can also diminish the chances that proceeds from the inherited IRA will benefit grandchildren or other heirs.

Divorce. Depending on state law, some portion of the distributions could be lost to former in-laws if a beneficiary divorces. (The “lifelong probability of a marriage ending in divorce is 40%-50%,” according to statistics cited in Wikipedia.)

Creditors. Creditors may be able to reach inherited IRAs. A ruling earlier this year in the Seventh Circuit Court of Appeals for the Seventh Circuit held that inherited IRAs do not fit the Bankruptcy Code’s exemption for “retirement funds.” Other appeals courts have held the opposite. But unless the Supreme Court overrules the Seventh Circuit’s ruling, creditor protection for inherited IRAs will depend on where your beneficiaries happen to live.

A well drafted IRA trust can mitigate the effects of these pitfalls by controlling how and when distributions are taken from the trust, and providing an additional layer of protection from the effects of divorce, creditors, and other unexpected occurrences.

A pet trust for Fluffy

You don’t have to be Leona Helmsley to set up a trust for a beloved pet.

After the billionaire Helmsley’s death, her white Maltese lived in the lap of luxury on its multi-million dollar trust fund. But Pennsylvania law allows people of even modest means to provide for a dog, cat, or other animal that is as dear as a family member (or, let’s face it, more dear than that nephew who drops by only when he needs help paying his bar tab).

Suppose you’re concerned about Fluffy, who greets you with wild tail-wagging each morning, listens attentively to everything you say, and never talks back. What will become of Fluffy when you die or go to a nursing home? Who will walk him and buy him his favorite smoked pig ears?

In recent years, Pennsylvania joined about 40 other states that have passed laws to make pet trusts valid and enforceable. Such statutes are important because pets (otherwise considered property by law) cannot inherit from their owners.

Under a pet trust, you give Fluffy, along with enough money to pay for his care, to a trustee. The trustee, usually a trusted friend or bank, has a duty to arrange for the proper care of the pet according to your instructions.

You can establish a pet trust for Fluffy during your lifetime (called an “inter vivos” trust), or by means of a clause in your will.

One advantage of an inter vivos trust is that it can go into effect as soon as you become unable to care for your pet. A clause found only in your will may not be discovered until after Fluffy has gone hungry or been given away.

Your pet trust should contain specific instructions about Fluffy’s care, such as the type and amount of food (and any specific brands) he eats, medical care (including preferred veterinarian), grooming needs, daily routine, favorite treats, toys, and so on.

Determine who the trust should name as Fluffy’s caretaker. The trustee will deliver Fluffy to the caretaker for care according to your instructions.

Check to make sure the caretaker you name is willing to take on the responsibility. That will put you one step ahead of Leona Helmsley, whose proposed caretaker reportedly had no interest in the post. Be sure to name a substitute caretaker in case your first choice dies, or is unable to provide care.

You can fund the trust up front, or provide for funding through a bequest in your will. The funds can come from your estate, or from some other arrangement such as life insurance, a “pay on death” account, annuity, or retirement plan. Depending on your pet’s needs, the trust may require as little as $200 to $2,000 a year.

If you set up an inter vivos trust, you may also need to change your will to make reference to the trust and perhaps provide additional funding.

Under Pennsylvania law, the trust lasts until the end of your pet’s lifetime. If you have set up the trust for more than one pet, it will last until the death of the last surviving animal. Any remaining funds will then return to you, if you’re still alive, or can pass to a beneficiary you name.

You will probably also want to leave instructions about disposition of the pet’s remains after its death, such as burial or cremation.

An attorney knowledgeable about estate planning, and pet trusts in particular, can help you set up a pet trust that complies with Pennsylvania’s trust laws.

Fluffy might not eat hand-fed meals from a silver serving set like the Helmsley dog, but you can rest easy knowing Fluffy will have his smoked pig ears even when you’re gone.

Why an irrevocable trust can be superior to gifting

Wise use of an irrevocable trust can be a powerful way to protect assets as one gets older. One use is to avoid the need to spend down assets in order to qualify for certain benefits, such as veterans benefits and Medicaid.

But why use a trust? Why not just give the money away?

If a client is trying to protect assets and still qualify for government benefits, one strategy is to gift away excess funds to someone outside the household, typically children or other family members. The client then applies for veterans benefits, or in the case of Medicaid, waits five years before applying for benefits.

That strategy poses a number of significant risks. The person to whom it is gifted could die, become divorced, spend the money, invest the money in an unwise way, lose the money to creditors, and so on.

Even if the person making the gift were healthy when the gift was made, a health crisis could bring about the need for nursing facility care during the five years following the gift. If the gifted funds have been lost or spent, there could be no way to cure the gift. Without Medicaid benefits, there may be no way to pay for care.

An irrevocable trust has a number of advantages over an outright gift.

Control

Simply having the funds in a trust provides a superior amount of control over an outright gift.

In addition, the person who creates and funds an irrevocable trust (called the “grantor”) can make a number of important decisions about how the funds are held, managed, and disbursed.  The grantor can name trustees, and decide whether to have a single trustee, followed by successor trustees, or co-trustees. The grantor can name beneficiaries and retain the right to change beneficiaries through a power of appointment in the grantor’s will.

A trust protector can be named, with the power to approve or disapprove distributions during the grantor’s lifetime. The grantor can decide whether there will be one trust or a number of trusts, and can stipulate what assets will be used to fund each trust.

Income

The grantor can decide to receive income from the trust, even if there is no access to principal. Having income makes grantors feel as if the money is still theirs in some way, thereby easing some concerns about establishing an irrevocable trust in the first place.

Income can also help the client make it through a five-year look-back period by providing a means to help pay for care.

Protection from loss

By far one of the biggest concerns about gifting away funds is that the recipient (or “beneficiary”) will lose it in some way. With the right drafting, though, the funds placed into an irrevocable trust will not be available to be lost in a beneficiary’s divorce or bankruptcy proceeding.

Using a trust avoids the risk that a beneficiary will die and that the funds will be distributed to the beneficiary’s heirs.

Spendthrift language can help prevent the money from going to a beneficiary’s creditors, or from being squandered by a beneficiary who cannot handle money due to bad decision-making, gambling problems, addictions, or other reasons.

Tax advantages

An irrevocable trust offers some tax advantages over an outright gift, primarily in the area of capital gains tax. If the trust is structured as a grantor-type trust, then appreciated assets, such as a stock portfolio, can receive a favorable step-up in basis upon the death of the grantor. If such an asset were merely gifted, the recipient would have the same basis as the donor, and in many cases owe much more in capital gains tax.

Using a grantor-type trust provides a similar tax advantage for a homeowner’s principal residence. The estate can take advantage of the grantor’s capital gains tax exclusion under 26 U.S.C. § 121, which would not be available to heirs if the residence were gifted during the lifetime of the owner.

Weighing the options

Whether to create an irrevocable trust in any particular situation requires a careful assessment of the client’s objectives, assets, income, health and care needs, family dynamics, and other considerations. It can work well in the right circumstances, but it’s always best to consult with experienced legal counsel to make an informed decision.

Can you undo an irrevocable trust?

“Irrevocable.”

That word concerns many people, despite the effectiveness of irrevocable trusts in protecting assets and avoiding probate.

It’s true that, in general, an irrevocable trust cannot be entirely undone by the person who created it (called the “settlor”), acting alone. But under the laws of many states, even an irrevocable trust can be modified or terminated if the settlor has the consent of other interested parties. (Most states have adopted a version of the Uniform Trust Code (UTC), which has provisions for modification or termination.)

In Pennsylvania, where I practice, the rule is: “A noncharitable irrevocable trust may be modified or terminated upon consent of the settlor and all beneficiaries even if the modification or termination is inconsistent with a material purpose of the trust.”

Here’s an example. Bob creates an irrevocable trust naming his son and daughter as beneficiaries, and funds it with $300,000 for the purposes of protecting assets from scam artists, designing family members, possible future creditors, and long term care costs; having help managing the funds as he ages; and avoiding probate.

Bob cannot unilaterally change his mind and take all the money back. Without the consent of his children, he cannot stop the money from being distributed at the time of his death. But if Bob and his two children all agree, they could terminate the trust altogether.

Why might they terminate the trust? Circumstances may have changed drastically or unforeseen events may have arisen. Despite Bob’s best planning, things will not work out the way he originally intended and it now makes sense to switch to another plan. But it could be for any reason. According to the rule, as long as the settlor and beneficiaries agree, they can change or end the trust even if doing so is inconsistent with the purposes of the trust.

If the trust is terminated, what happens to the money? Under the UTC and Pennsylvania law, the beneficiaries determine where the money will go. It could go back to Bob if the beneficiaries agree, but the beneficiaries have the final say in a termination by consent.

What if Bob loses his capacity to make decisions? Can someone else consent for him? Often, the answer is yes, depending on state law and on the arrangements made for Bob. In Pennsylvania, consent can be exercised by a guardian, or by Bob’s agent under power of attorney if it is a general POA or if the POA specifically provides the power to consent.

Can Bob retain rights short of modification or termination? Settlors of irrevocable trusts often do retain certain rights, such as the ability to remove trustees, change distributions to beneficiaries, and so forth. Retaining such rights often affects taxation of the trust’s income, so you need to know what you’re doing or have the advice of competent legal counsel. Frequently, rights are retained for the precise purpose of affecting taxation in a favorable way.

IMPORTANT NOTES: Under the UTC, these rules apply only to a non-charitableirrevocable trust. Modifying or terminating an irrevocable trust with a charitable component may require court action. The rules discussed above may be different in your jurisdiction, so check with legal counsel.

Who should you name as your trustee?

Trusts are increasingly common – even in middle class estate planning – for their effectiveness in avoiding probate, protecting assets, helping minor children, and serving the disabled.

If you’re not the trustee of your own trust, who should you name? Even if you are the initial trustee, who should you name to succeed you if you become incapacitated?

These questions are important but the answers are not always easy.

A family member often serves as trustee for a number of reasons. First, there is often a trusted family member, such as an adult child, who already helps out with financial matters. Using that person fit naturally into the current family scheme. Second, the client usually has a high degree of trust in a close family member. Their goals may be very similar, and a family member often knows a great deal about the intentions of the person who created the trust. Third, the family member may perform as trustee for little or no compensation.

It is important to note that the trustee has important responsibilities and fiduciary duties. Reliability and trustworthiness are therefore crucial. Many family members are honest and trustworthy enough to perform this task, but keep an eye out for indications of family disharmony, addiction problems, and mismanagement in other areas of life.

Naming co-trustees can address concerns about the ability of any one trustee to serve competently and responsibly. I have found that clients often wish to name co-trustees for other reasons, such as not wanting to single out any individual child. Whenever a trust names co-trustees, it should specify whether each co-trustee may act independently, without the signature or consent of the other co-trustee, or not. Having non-independent co-trustees can help ensure responsible action, but clients must balance that goal against the burdensomeness of always obtaining two signatures to take any action.

A corporate trustee can often be a good choice. While generally more expensive, a corporate trustee can bring professionalism and expertise that are well worth the cost. Trust officers have experience making distributions, filing tax returns, and keeping accurate accounts of their activities. A corporate trustee also offers longevity – the bank or trust company will likely be around in 25 years and able to serve, while a family member may not.

Many of these trusts will remain in place for 5, 10, 20 years or more. Spend some time at the beginning making a good choice about who can serve effectively during that time.