(Dow Jones) Many parents want to control how quickly their children can draw down the retirement accounts they inherit-and are fixating on trusts as the answer. But setting up such a trust can be a complicated and risky process.
This area of estate planning "is a minefield," warns Jay Starkman, a certified public accountant in Atlanta. Recent rulings by the Internal Revenue Service and various courts have raised more questions than they have answered. Still, he understands why parents put up with the hassle.
"Every tax practitioner has seen parents leave a lot of money that took a lifetime to save, and then watched the children go through it in less than five years," Starkman says. Such profligacy can be especially galling when parents have paid taxes upfront to convert a traditional individual retirement account to a Roth IRA so their children's future withdrawals-and any future gains-are tax-free.
The big concern is adult children with spendthrift ways, contentious marriages or careers that leave them vulnerable to lawsuits. Bankruptcy and civil courts, which generally shield IRAs from creditors for their original account holders, have been divided over the treatment of such accounts when they are inherited.
Seymour Goldberg, a lawyer and CPA in Woodbury, N.Y., points to conflicting court rulings as another reason to use trusts. In a Texas case, a bankruptcy judge ruled in March that federal law doesn't protect inherited IRAs as retirement accounts, because their owners can't use those accounts to save for retirement.
A Florida state court ruled last year that inherited IRAs aren't sheltered from creditors in civil lawsuits outside of bankruptcy court. But recent bankruptcy cases in Minnesota, Idaho and Pennsylvania resulted in judgments preserving inherited IRA assets.
The upshot: It could be years before the courts, or Congress, make it clear whether inherited IRAs are protected from creditors.
Annual distributions. As a result, some estate lawyers and accountants are advising parents to name an irrevocable trust as the IRA beneficiary-and to name their heirs as beneficiaries of the trust.
One downside with such a trust: You have to spread the required annual withdrawals across the life expectancy of the oldest heir, rather than using each heir's individual life expectancy. That means that your heirs could lose the opportunity for a longer period of tax-free growth. Given that, you might want to name a young trust beneficiary in order to spread those distributions over a longer time period, says Goldberg.
A second pitfall: The IRS seemed to indicate in a so-called private-letter ruling issued in March that the opportunities for trustees to tweak the language in such trusts is limited. In this case, a trustee wanted to clarify in the trust's wording who the designated beneficiary was supposed to be-after the original IRA owner had died. A state court order allowed the change-but the IRS said it wouldn't.
"The moral of the story is, we have to get these [IRA trusts] right the first time," says Robert S. Keebler, a CPA in Green Bay, Wis.
Conduit trusts. What if your kids have low-risk, stable jobs and happy marriages, and your main concern is simply making sure they stretch out their inherited-IRA withdrawals? One option is a lower-maintenance "conduit" trust.
Say you want to leave your IRA to your three children. You could set up a conduit trust for the benefit of each child, and then name those trusts as the beneficiaries of the account. Each year, the required distributions from the IRA, divided into separate inherited accounts, would be based on each child's age, would go into his or her individual trust and then be paid out to the child. You can set it up so the child can't take out more than the minimum each year.
But what if you aren't sure what the future holds for your children? Keebler is increasingly advising clients to set up a conduit trust with a "toggle switch," he says. With a conduit trust, the IRA distributions have to be paid outright to the trust beneficiary. But by including special language when the trust is set up, the trustee could have a one-time option to switch to a more protective trust, as described above, between the IRA owner's death and Sept. 30 of the following year.
In a private-letter ruling five years ago, the IRS said that a trust with that option met its standards. "This gives you the chance to take a second look at the trust and decide what's more important"-simplicity and the potential for a longer distribution period, or creditor protection, says estate lawyer Philip Kavesh in Torrance, Calif., who requested the ruling.