by Michael Kling | January 15, 2015
A recent unanimous Supreme Court decision has rekindled the debate about whether it is better to inherit an IRA in a trust or receive the IRA assets outright. The decision in this case, Clark v. Rameker, in a nutshell, held that an inherited IRA is not an exempt asset. This means inherited IRA assets can be attached to pay a third party creditor’s claim. An “exempt asset” is one that cannot be used to pay a creditor claim. In Nevada, a well-known exempt asset is a Homesteaded primary residence. Under this new Supreme Court case, if you directly inherit IRA assets, the assets are not exempt and can be used to satisfy creditor’s claims.
On the other hand, if you inherit an IRA through a properly structured trust, the trust can protect the IRA assets from creditors. The asset protection feature of a properly drafted trust is not the only reason to consider using an Inherited IRA Trust. Other important scenarios include: when the beneficiary is a minor; if there is a second marriage and the IRA owner wants the spouse to benefit, but also wants to make sure children inherit; ensuring proper management of the assets; controlling the cash flow to children; and, estate tax considerations.
Generally, IRA inheritors must withdraw a minimum amount each year starting on December 31 of the year after they inherit the IRA. If desired, the individual can stretch out these minimum required distributions over their own life expectancy—a tactic often called the “stretch-out IRA.” Stretching out IRA payments gives the account extra years, and potentially decades, of income tax-deferred growth (or tax-free growth in a Roth IRA). Transferring IRA assets through a trust, however, may have income tax consequences by affecting when the beneficiary must take IRA distributions.
A trust, as opposed to a direct inheritance, must meet certain federal regulation requirements to achieve a stretched-out distribution schedule. With a properly drafted trust, the IRS will “look through” the trust and treat the beneficiary as if he or she were directly named the IRA’s beneficiary. This enables the trust to take advantage of the favorable “stretch” distribution rules that apply to individuals. If the trust is not properly drafted and is the named IRA beneficiary, the assets will still be transferred to the trust, but IRA distributions will be required to be taken within as little as five years.
You might think that because you already have a living trust you can simply name that trust as the IRA beneficiary. Beware, however, as the standard living trust may contain boilerplate language that is fine in other contexts, but detrimental when it comes to transferring IRA assets.
If you want to make sure the beneficiary of your IRA achieves the maximum tax benefits while still protecting the IRA assets from creditors or predators, an Inherited IRA Trust would be the answer. Please call Kling Law Offices for a consultation on this important and complex issue. We would be happy to discuss the issues with you so you can make the best decision for transferring your IRA assets.