Madison Eubanks

May 08, 2024

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Retirement Trusts: Are They Right for Your Clients?

As many people age, it’s common for their retirement plan to represent the largest portion of their assets. In estate planning, retirement accounts like 401(k)s and IRAs often require special attention because there are unique rules about how they can be transferred to beneficiaries. 

In some cases, a retirement trust can be a helpful solution. Here, we’ll explore what a retirement trust is, the advantages and disadvantages of using one, how to set up a retirement trust account, and more. 

What is a retirement trust? 

A retirement trust is an estate planning strategy in which a trust is named as the beneficiary of retirement accounts like IRAs or 401(k)s. It’s a standalone trust with the purpose of receiving and administering an inherited retirement account for a beneficiary. 

A retirement trust is intended to shield retirement accounts from creditors, bankruptcy, a lawsuit, divorce, or other threats. When this strategy plays out correctly, the client can enjoy both the benefits of a retirement account and the protection of a trust. 

Just like other types of trusts, the funds from a retirement trust can only be distributed to designated beneficiaries on behalf of them, and payments are overseen by a retirement trustee. Depending on the trust document’s terms, beneficiaries may be able to make additional withdrawals. 

When should a retirement trust be used? 

Retirement trusts may be ideal for clients who have significant funds in retirement accounts like IRAs or 401ks, and want to control how those assets are eventually distributed. For these clients, a retirement trust can shelter the account from creditors, manage income tax liabilities, and provide for young or disabled beneficiaries. 

What are the advantages and disadvantages of retirement trusts? 

Like any estate planning strategies, there are benefits and drawbacks to using a retirement trust, and it won’t suit every client’s financial situation. 

Advantages

Some types of retirement accounts, like traditional IRAs, are funded with pre-tax dollars and taxed on distributions. If a beneficiary doesn’t fully understand this, they may end up in a sticky situation in which they’ve spent the money without accounting for the tax bill. The use of a retirement trust can help ensure proper management of distributions and income tax liability. 

Additionally, as mentioned, a retirement trust can also serve to protect the funds within a retirement account from many types of potential risks, including: 

• A beneficiary’s divorce proceedings
• Bankruptcy 
• A lawsuit against a beneficiary

Additionally, a retirement trust may help: 

• Avoid asset and income limitations for disability assistance
• Restrict a financially irresponsible beneficiary’s spending power

Disadvantages

The primary disadvantage of using a retirement trust is that required minimum distributions (RMDs) to the trust may be taxed at the trust’s income tax rate which is often higher than a beneficiary’s income tax rate. This is often seen if the Trustee is authorized by the trust to accumulate RMDs in the trust rather than to distribute RMDs outright to the beneficiary. Although these accumulation provisions in a trust allow a Trustee to prioritize the goal of asset protection or protection against irresponsible behavior of the beneficiary, it potentially results in a higher income tax rate being applied. 

For example, if an RMD is retained by the trust, then the trust’s income tax rates will apply, which are often higher than an individual’s income tax rate. However, if an RMD is distributed to the beneficiary by the trustee, then the beneficiary’s income tax rate will apply instead. Unfortunately, the distribution means that any protection for the funds may no longer apply. Additionally, the RMD payouts are calculated based on the life expectancy of the oldest beneficiary, which may not be ideal if there are several heirs of different ages. 

It’s also important to note that a retirement trust does not override the SECURE Act, which states that non-spousal beneficiaries of an IRA must fully withdraw the funds within 10 years of receipt. Though there are some narrow exceptions, the 10-year rule applies to accounts held within a retirement trust as well. 

How can you set up a retirement trust? 

The process for setting up a retirement trust is similar to that of other types of trusts. After you and your client determine that a retirement trust is an appropriate strategy for their situation, guide them through key decisions like: 

• Who the beneficiary or beneficiaries of the trust will be
• What the rules of the trust will be (for example, whether beneficiaries can make additional withdrawals outside of the RMD)
• Who the trustee will be (it may be one of the client’s children, a friend, family member, or a third-party like a bank)

Once these parameters have been set, the advisor and client will work with an attorney to draft the trust document. 

Types of retirement trusts

There are four key types of retirement trusts to know, and each comes with its own benefits depending on the client’s financial picture: 

Beneficiary-controlled retirement trust

This type of retirement trust gives the beneficiary (usually the settlor’s children) the power to manage their share of the trust at a designated point in the future. With a beneficiary-controlled trust structure, the beneficiaries can exercise a measure of control over investments and withdrawals from the trust. 

Accumulation-style retirement trust 

An accumulation trust allows the designated trustee to determine whether RMDs from the retirement account should be paid to the beneficiary or kept in the trust. This strategy may be employed when a client wishes to safeguard assets or use the trust for the benefit of a minor, a financially irresponsible beneficiary, or a beneficiary with special needs. Any RMDs held and accumulated in the trust are subject to higher income tax brackets that apply to trusts. 

Conduit retirement trust

A conduit trust is see-through trust and acts as a link between your beneficiary and the IRA. With this strategy, the trust is named as the beneficiary of the IRA, and the client selects the beneficiary of the trust. Any RMDs withdrawn from the IRA that come into the trust must be distributed to the beneficiary in the same year. Essentially, the conduit trust acts like a middleman that transfers the RMDs and protects the remaining IRA assets.

Like with any estate planning strategy, the pros and cons of using a retirement trust should be carefully considered when determining whether it’s suitable for your client. With an estate planning software like Vanilla, advisors can model and visualize how different tools and strategies work together within a client’s estate plan. 

Learn more about Vanilla and get a demo here.