Your clients spend decades building a nest egg that not only ensures their comfortable retirement but also creates financial security for their children.
Unlike many traditional retirement investment products, a retirement trust ensures these assets continue to grow tax-deferred and enjoy numerous other protections.
In this article, we’ll explore why it can be a good idea to speak to your clients about setting up a retirement trust. We’ll also share some best practices for optimally structuring these arrangements.
A trust is a legal arrangement in which assets are transferred to a trustee, who manages them for the benefit of beneficiaries in accordance with the terms set out in the trust document.
Most kinds of assets can be put into a trust, including real estate, investments, bank accounts, items of personal property, and business interests.
A trust is different from a will in that it’s effective during the grantor’s lifetime and can help them actively manage their assets and avoid probate. A will only becomes effective after the person’s death and deals with how assets are subsequently distributed.
Today, retirement plans such as IRAs and 401(k)s are commonplace. The closer someone gets to retirement, the greater the percentage of their assets these accounts typically represent. For many people, their retirement plan is their most significant asset, often worth more than their home.
Unfortunately, most people don’t understand the difference between their estate plans and retirement savings. Most traditional retirement plans aren’t passed on to beneficiaries according to an estate plan, even if a person’s will or trust specifies how “all” their assets are to be distributed.
That’s because most retirement plans have a beneficiary designation. In other words, when the retirement plan account owner dies, the account is passed to the beneficiary stipulated by the deceased owner, often many years or even decades ago when they created the account. This can be problematic if someone has neglected to update their preferred beneficiary.
A retirement trust is a mechanism that allows people to protect their hard-earned assets from creditors, lawsuits, and even unwise financial decisions on the part of beneficiaries themselves. They also open the door to significant tax benefits, as we’ll explore later.
A retirement trust involves a person’s retirement assets being held in an account managed by a trustee. The trustee is responsible for investing these assets and distributing them in accordance with the terms of the trust. The settlor (the person who accumulated the retirement assets) may elect to have the trust pay out benefits during their lifetime or after their death.
In most cases, the named beneficiaries of retirement accounts are the deceased’s spouse, adult children, or other family members. A retirement trust is a standalone mechanism designed to receive and administer an inherited retirement account for the benefit of a beneficiary or multiple beneficiaries.
But why would a client set up a retirement trust rather than simply allowing their beneficiaries to inherit their assets directly?
Retirement trusts can help manage retirement assets and ensure they’re distributed according to the settlor's precise wishes. But there are several other compelling reasons why a person might decide to create a retirement trust as part of their estate plan.
Most retirement accounts funded with pre-tax dollars (like traditional IRAs) are taxed on distributions, i.e., when they’re paid out. Some beneficiaries might not fully understand the amount of tax that they’ll be liable to pay when they receive a distribution. They may spend all the money only to receive a hefty, unwelcome tax bill when they file their next tax return.
With a retirement trust, if someone passes away before they’ve withdrawn all the funds, those funds can be distributed to their beneficiary or beneficiaries without incurring any tax penalties.
Retirement trusts are also a helpful way to protect the trust’s assets from a beneficiary’s creditors. A beneficiary’s creditors can’t access the trust assets unless and until the beneficiary receives a distribution.
Similarly, trust assets aren’t considered marital assets subject to division in a divorce.
A retirement trust is useful for protecting beneficiaries who lack the maturity or responsibility to handle a large inheritance. While the trustee can’t control what the beneficiary does with the funds once they’re distributed, they can control the flow of funds to that beneficiary.
So, to sum up, a retirement trust provides the tax benefits offered by an IRA and the asset protection of a trust.
There are a variety of retirement trusts, each with specific features and benefits:
A conduit trust acts as a link between the beneficiary and the IRA. The trust is named as the beneficiary of the IRA, and the person’s desired beneficiary is designated the beneficiary of the trust. So, the conduit trust essentially acts as the middleman, facilitating the seamless transition of assets while safeguarding the IRA from claims from creditors.
With a beneficiary-controlled trust, the beneficiary (usually the settlor’s children) is granted the power to manage their portion of the trust (i.e., exercise a degree of control over investments and withdrawals from the trust) at a designated date.
This is also known as a “see-through trust”. It allows the trustee to decide whether retirement account withdrawals should be paid out to the beneficiary or remain in the trust.
In addition to the above, retirement trusts may be either revocable or irrevocable.
With revocable trusts, the creator of the trust can manage and control the assets while they are alive and then transfer them to beneficiaries after they die.
Irrevocable trusts, however, cannot be changed or revoked once created. They are generally used for estate planning and asset protection purposes.
Creating a retirement trust is just one strategy for planning for retirement. Many other options and strategies are available to help your clients ensure they don’t pay any more tax than they need to while ensuring their assets are distributed according to their wishes after their passing.
For these reasons, it’s vital they speak with an estate planning professional to determine what's best for them and their family.
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