Why Name a Trust as the Beneficiary of a Retirement Plan
One of the most powerful tools provided to a beneficiary is the ability to “stretch” certain inherited retirement plans. So, when meeting with certain clients, I will often show them the monetary potential that their retirement plans are capable of providing to their beneficiaries, in particular, much younger beneficiaries such as their children, grandchildren and even great-grandchildren. If certain retirement plans are left to younger generations, the benefit to them can be staggering due to their ability to “stretch” the plan over their longer lifetimes than that of the original plan participant. For example, a person who inherits a $150,000 retirement plan at age 30 and withdraws only the RMD each year can stretch that plan into over $1,000,000 by the time that person is in their early 80’s! Obviously, the result is even better if the person is younger. If the person in the same scenario was age 20, the result is over $1,600,000. If that person was age 10, it is over $2,500,000! I have found that many grandparents really like this concept! And, it is even more astounding if the retirement plan is a Roth IRA because no taxes will have to be paid when withdrawals are made! In a way, it is like providing your younger beneficiaries with a pension.
To put it simply, the problem is that most people who inherit a retirement plan that is capable of being stretched will not stretch it. Most will withdraw the entire amount within a short period of time. In the example above, instead of stretching the plan over their lifetime, the 20 year old may decide to just cash out the entire $150k, pay the tax and go on their way.
The beneficiary may do so because they suddenly have “found” money and will just blow through it. Or, the beneficiary may be financially sensible but cash out the plan because they’re uninformed, resulting in taxes being paid on the full amount. Perhaps the beneficiary thinks they can rollover the inherited IRA tax-free to their own IRA – little do they know this is regarded as a taxable distribution of the entire inherited IRA. And, it can be even worse if it’s a Roth IRA. In the eyes of the beneficiary, if they are not required to pay taxes on the withdrawals, there may be less of a reason to not withdraw the entire amount.
Naming a Trust (to be created by the client’s Will or Revocable “Living” Trust at the client’s death) as the beneficiary instead of the individual better ensures that the plan will be stretched. Clearly, if the beneficiary is a minor, it is standard practice to have a Trust established for the benefit of that person. However, a Trust should be considered even if the beneficiary is older, say age 25, because the chances of that person stretching the plan is next to none. Furthermore, if the beneficiary is even older, financially sensible and their life is stable, a Trust is still a safer way to ensure the stretch, because, as mentioned earlier, a beneficiary may withdraw the entire plan through lack of knowledge. Think of it this way – if a retirement plan is left to a Trust with terms providing little restriction to the beneficiary, where the beneficiary of the Trust is also the Trustee, the beneficiary is much more likely to pause and wonder if there is something unique about this asset. They may think to themselves, “So my parents left the retirement plan to this Trust instead of outright to me …. there must be a reason why they did that because my parents knew that I was more than capable of handling the money. I should probably consult my financial advisor or other professional about this situation.” And thus, it is more likely that the plan will be stretched.
For flexibility, the Trust can be designed so that, although it is the client’s intent that only the RMD be withdrawn for the beneficiary, additional amounts may be taken for the beneficiary’s other needs, as determined by the client. The client can actually maintain as little or as much control as they wish regarding distributions from the retirement plan to their beneficiaries. This, along with pitfalls in the drafting of these Trusts and other issues, will be discussed in later parts of this series.
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* Dislaimer - The results above are from Schwab’s Beneficiary RMD Calculator and makes certain assumptions – e.g. an average 6% ROR of the beneficiary. As always, you should not act upon this information without first seeking qualified professional counsel on the specific matter.