Reproduced with the expressed written consent and permission from Robert L. Moshman, Esq., author of the The Estate Analyst. To contact Bob Moshman to be included on his distribution list of his monthly newsletter, e-mail Bob at firstname.lastname@example.org.
A Baby Boomer with an otherwise unremarkable estate could leave behind a supercharged IRA that empowers beneficiaries.
Philip J. Kavesh, a veteran estate planning attorney who has trained thousands of financial professionals, took part in designing the IRA Inheritance Trust® and successfully obtained a Private Letter Ruling for the technique in 2005.
Although several variations of “stretch-out” or “see-through” trusts have performed well and gained popularity among practitioners, the original IRA Inheritance Trust® is poised for a star turn that perfectly anticipates a significant demographic event.
We caught up with Mr. Kavesh to learn how the IRA Inheritance Trust® works and why it may turn IRAs into the focal point of millions of estate plans for the next generation.
Here Comes the Boom
The staid trappings of diplomas and desk protectors belie the true adventurous hearts of estate planning professionals.
Truth be told, we would prefer to confront danger like Ernest Hemingway in the pursuit of big game. We are romantic heroes who would challenge the IRS and employ bold (yet prudent) plans to protect our clients from significant Federal estate tax…if only they still needed such assistance.
Alas, the Golden Age of estate tax planning is fading from memory. The vast national herd of upper-middle-class clients with taxable estates has vanished like the buffalo. Tycoons in need of estate planning are an endangered species.
Yet there is a vast wave of economic power on the horizon that should captivate our imagination for financial planning purposes. Between 1946 and 1964, about 76 million Americans were born in a period known as the Baby Boom.
This group—by the way, don’t call us “boomers” because we hate that—may control as much as 80% of personal financial assets and 50% of all consumer spending. In 2014, the members of this group will be between the ages of 50 and 68—prime time for freshening up estate plans.
While only a small percentage of the group will have significant estate tax exposure, a much larger number will have retirement assets with tremendous potential for future income tax savings. About 6% (or 4.5 million members) of the group will have very large IRA funds to work with.
Once upon a time, America was a land of big companies with big pension plans that were “top heavy” in favor of top management. Defined benefit pension plans were once the main retirement mechanism for American companies.
In 1974, the Employee Retirement Income Security Act (ERISA) was enacted to democratize the use of tax-deferred benefits. ERISA imposed minimum standards for participating, vesting, and funding on U.S. plan sponsors and gave rise to the beginning of alternative retirement plans, such as Individual Retirement Accounts (IRAs).
For top management to exploit tax-deferred benefits, pension plans would have to cover the rank and file. Companies adapted. They shifted from defined benefit plans, the Cadillac Deville of retirement plans ($11,900 in 1979), to defined contribution plans, which were more of a Chevy Caprice ($4,800 in 1979).
In other words, companies still wanted to provide a full-size vehicle but with less luxury and a much lower upfront commitment. Companies would make contributions, and, with enough time and favorable investment rates, the employees would get whatever the funds grew to. Generally speaking, more companies wanted to avoid guaranteeing a particular benefit and then getting caught short of funds in the future. Congress continued to encourage self-reliance. Many companies then shifted emphasis to 401(k) plans, in which employers would match employee contributions.
And Then Came the IRA
The most significant development for self reliant retirement planning was the IRA. It was a radical conceptual shift that altered the entire paradigm of personal finance. An individual could have the same tax-deferred power as a mighty corporation. And because individuals had IRAs, they became investors.
Originally, the IRS had a contribution limit of $1,500 for those who qualified. Employees covered by company plans could not contribute to IRAs. It was a good start, but by saving $1,500 per year an employee could retire…never. Still, the new concept demonstrated raw economic power. Initially, $1.4 billion was contributed to IRAs in the first year (1975). By 1981, annual contributions reached $4.8 billion.
Over time, IRA contribution limits were increased and rules were relaxed. The biggest change came with the Economic Recovery Tax Act of 1981, which increased the contribution limit to $2,000, allowed participation by those covered by employers, and provided $250 contributions for a non-working spouse.
Dazzling IRA Statistics
Prepare to be impressed by the IRA’s growth.1 Following ERTA ’81, banks began marketing IRAs aggressively, and competitive interest rates were offered.
- By 1985, there were 16.2 million taxpayers deducting $38.2 billion.
- By 1986, there were 40 million Americans with $256 billion invested in IRAs.
- By 1999, there were $2.7 trillion invested in IRAs, with 92% invested in traditional IRAs. This level of assets was at a high point of a bull market.
- By 2004, IRA assets in America reached $3.5 trillion. This exceeded the $2.6 trillion in defined contribution plans and the $1.9 trillion in defined benefit plans. Source: GAO.
Meanwhile, traditional employer plans were in decline. Between 1980 and 2005, the Pension Benefit Guaranty Corporation witnessed the number of qualified defined benefit plans decline from 250,000 to 80,000. The Government Accountability Office reports that only 14% of businesses with less than 100 employees now offer retirement plans.
Bear in mind, however, that many retirement plan assets will be rolled over into IRAs. So, in summation, an incredible amount somewhere north of $8 trillion in qualified retirement assets will be pouring through IRAs during the next several decades.
Mr. DeMille, the IRA Inheritance Trust® is ready for its close-up.2
An Interview with Philip J. Kavesh, Esq.
Q: What kind of reaction did you get when the IRA Inheritance Trust® was first introduced?
A: Private Letter Ruling 200537044was obtained in 2005. Once we got it, there was a lot of initial buzz, and then it gradually calmed down. But the technical understanding of the Trust has trickled down to estate practitioners. This process is similar to what living trusts went through in the early 1980s. When living trusts became popular, many professionals were initially skeptical, and it took living trusts about 8 to 10 years to become popular.
Q: Is the IRA Inheritance Trust® dormant or gaining in popularity?
A: There is momentum for the IRA Inheritance Trust® lately; interest can be gauged on The Ultimate Estate Planner’s website (www.ultimateestateplanner.com), where there is an increase in people wanting to read about it.
Q: Why is a trust useful for retirement assets?
A: IRA trusts aren’t for everyone with retirement assets but can be useful instead of—or in combination with—testamentary trusts. With the right IRA trust, income tax savings can be maximized while also providing protection from creditors.
Q: Is it preferable to utilize a stand-alone trust to receive the IRA assets?
A: There is some risk involved in doing it wrong and ending up with a five-year payout. The objective is to defer income tax by maximizing the “stretch-out.” Setting up a beneficiary sub-share trust inside a living trust that lacks firewalls against bad provisions elsewhere in the living trust may cause it not to qualify for the stretch-out under IRS regulations. To ensure the stretch-out, we use a stand-alone trust that has already been approved by the IRS.
There are also some practical benefits. Beneficiaries are less likely to empty out a separate IRA trust designed to maximize stretch-out. Beneficiaries often run to the custodian and withdraw all of the funds without realizing they’ve wasted the stretch-out ability. That is a tragic mistake. There is no 60-day “put-back” provision to save it. I’ve heard that as many as 85% of IRAs get inadvertently cashed out in the first year after the owner’s death.
Q: Is there any downside to having the IRA within a trust, such as administrative costs?
A: Very little. There is very little extra work for the tax preparer or trustee. In most cases, the trust beneficiary is also the trustee, so there isn’t going to be an additional fee for the trustee. In most cases, and wherever a conduit trust is involved (and the IRA withdrawals are paid out to the beneficiary), there is little or no extra cost at all. In an accumulation trust, paying a trustee a 1% fee to save 100% of assets from creditors becomes worthwhile. For accounting, the return involves about one transaction per year for the distributions. These are very small costs compared to the protection and stretch-out benefits.
Q: Should planners resist the temptation to combine all assets in a living trust after death?
A: A lot of practitioners have little experience with custodians after people die. Having a separate trust allows the custodian to review it and promptly determine on the face of the trust that it is designed to qualify for stretch-out and then implement it. If the IRA trust is buried in a living trust with 60 pages, the custodian is less likely to work with the trust and the estate.
Q: If there are several beneficiaries, must the trustee create sub-trusts so that each beneficiary can utilize his or her own life expectancy for RMDs?
A: Yes. This is a major item. A lot of practitioners don’t understand this. Our PLR requires that the trust not only divide into sub-shares to use each beneficiary’s life expectancy, but also the beneficiary designation form must name the designated beneficiaries’ sub-shares and not just the master trust. If you just name the trust, the oldest beneficiary’s life expectancy will be used for everyone. When we do an IRA beneficiary trust, we assist the clients with the exact language to use on the beneficiary designation forms and the trust. We must avoid having the clients and the custodian ruin the plan by filling out forms incorrectly. Attention to detail is required.
Q: You have steered potential users toward conduit trusts rather than accumulation trusts to avoid taxation inside the trust. Is there a downside?
A: Conduit trusts can’t be relied on for creditor protection. With a conduit trust, all of the required mandatory distributions or withdrawals have to be paid out to the beneficiaries of the trust. As a result, there is no asset protection on the withdrawals. There is also very little asset protection on the principal, depending on the state law. If there are regular withdrawals, then the principal of the trust has only nominal protection. This is one reason we pioneered the use of the toggle switch to allow the trustee or trust protector to switch from a conduit trust to an accumulation trust if it is more appropriate for protection against creditors.
Q: How does the toggle option work?
A: Practitioners are reluctant to set up a long-term trust if they aren’t sure if beneficiaries will need it for asset protection or stretch-out purposes. Having a toggle switch gives us the ability to customize each beneficiary’s sub-trust in the future. This built-in flexibility is what makes the trust more palatable to potential clients.
Q: If a “trust protector” has been appointed and is allowed to exercise one toggle option within nine months of death, what kinds of contexts would warrant the use of the toggle?
A: The toggle option allows the trust protector to reset the asset protection level for each beneficiary with 20/20 hindsight after the IRA owner has died. One of the challenges for estate planners is to predict way down the road what problems—alcohol, drugs, bankruptcy, divorce, etc.— will affect family members later in life. The accumulation trust is the higher level of asset protection that can be toggled in by the trust protector.
Q: How is an IRA trust going to look now that investment returns are lower in the marketplace?
A: Lower returns probably won’t affect the popularity, and attorneys are drafting more of these for clients. Many clients with sizable IRAs only intend to take minimum distributions, and there will be a lot of assets left at death, so the stretch-out is especially desirable. Many parents are realizing that their children have little or no retirement plans. Many companies have cut back. So to protect a parent’s inherited IRA is more important than it has been in the past.
Q: A single member conduit to a young beneficiary with a long life span will provide the most tax deferral. Are there still benefits if the intended beneficiary is somewhat older, such as a surviving spouse?
A: Yes, there can be a decent life expectancy and stretch-out for someone who is 65 or 70 years old. But every context has to be evaluated. For an older beneficiary, the benefit is more focused on the asset protection. For a spouse, a QTIP trust allows the RMDs to come out but restricts the spouse from withdrawing the rest, so it helps protect the balance in a second marriage, for example. But, clearly, the younger beneficiaries get the most stretch-out benefit. An IRA now worth $200,000 can be turned into a $1 million legacy when it is combined with a trust that preserves tax-free compounding for decades after the IRA owner has died. For someone with $200,000 but 10 beneficiaries, maybe the trust doesn’t make sense. For someone with less than $150,000 but a beneficiary who is in need of asset protection, an IRA Inheritance Trust® can make sense. For example, a direct inheritance doesn’t help someone with special needs who is receiving government benefits—that’s where a trust would protect assets.
Q: Should the IRA Inheritance Trust® be a more mainstream option?
A: Yes, definitely. As a rule of thumb, where there is a minimum of $150,000 in retirement assets, that is about the level where an IRA Inheritance Trust® is worthwhile for the beneficiaries. The stretch-out allows the account to compound tax-free. At the $150,000 level, the stretch-out can be worth, over the beneficiary’s lifetime, $450,000 to $750,000. Growth depends on how long the owner and the beneficiaries live. A lot of analysis concludes that if beneficiaries live 15 to 20 years after the IRA owner’s death, then the stretch-out is a big benefit. When RMDs are calculated, they only become large when people turn 80, so accounts still grow. Many people with a simple 401(k) and who aren’t particularly wealthy—very middle-class people—may have substantial retirement assets that could be worth more with stretch-out. As more people understand the significant benefits of stretch-out IRA trusts, more and more will be utilized.
- A number of statistics were gathered from articles found on the Internet: Accumulation And Distributions Of Retirement Assets, 1996-2000—Results From A Matched File Of Tax Returns And Information Returns, Peter Sailer and Kurt Gurka, Internal Revenue Service; Sarah Holden, Investment Company Institute. Presented at the 2003 American Statistical Association Meetings; 40 Million Americans Can’t Be Wrong: Save the IRAs, By Peter J. May 27, 1986. Heritage Foundation; Individual Retirement Account, Wikipedia; History of the Individual Retirement Arrangement (IRA) (2009) by jblankenship; Siedle, Ted. The Greatest Retirement Crisis in American History, Forbes (2013).
- “You see, this is my life! It always will be! Nothing else! Just us, the cameras, and those wonderful people out there in the dark!… All right, Mr. DeMille, I’m ready for my close-up.”—Last lines of Norma Desmond in Sunset Boulevard (1950).