Naming a trust as a beneficiary of your retirement plan can be a good idea in some circumstances, but it can be dangerous if you have potential creditors against your estate.  You also need to be aware of the rules surrounding the beneficiary’s distribution period or you may inadvertently subject a beneficiary to paying more tax than necessary.

When to Name a Trust

There are a lot of good reasons to name a trust as beneficiary of a retirement plan, whether it is a 401(k), a 403(b), or an IRA. If the IRA beneficiaries are young, disabled, or for other reasons shouldn’t be managing the asset themselves, the trust provides that management. People in a second marriage or relationship may want their spouse or partner to benefit from the funds, but not be able to deplete them entirely, and trusts provide protection from the beneficiary’s creditors. A trust can also lay out multiple contingent beneficiaries that many retirement account beneficiary forms cannot.  However, the trust may not protect your retirement funds from your own creditors.

Creditor Protection for Retirement Plans

IRAs enjoy substantial creditor protection during your life. If you get sued, your IRA will be subject to claim, but you can protect it by declaring bankruptcy. Under the federal bankruptcy code, the first $1,362,800 of retirement assets are protected from having to be paid to creditors. Most cases settle, so you can generally get this protection without having to go through the bankruptcy process, but it’s there if necessary.

But Only During Life

However, that protection ends at death. It does not apply to inherited IRAs, those you leave to others or that you have inherited from others. Inherited IRAs are subject to creditor claims. However, your heirs are not liable for your debts. So, if your retirement plans pass directly to them, the plan assets will be protected from your debts.

By way of example, let’s assume an individual dies owing $400,000 to various creditors, with a total estate of $500,000 divided between a house with a market value of $250,000, savings of $100,000, and retirement plans holding $150,000. If the retirement plans are paid directly to this individual’s heirs, they will not be subject to the person’s debts. The rest of the assets will have to go to pay off debts, leaving nothing in the estate for the heirs, but also leaving the creditors short $50,000.

Revocable Trusts Subject to Claim

But what if the IRAs were payable to the individual’s revocable trust? Then they very well may be subject to claim. If there are not enough funds in the decedent’s probate estate to pay his or her debts, Indiana law allows the creditors to go after a revocable trust. In at least one case in Kansas, the court ruled that this right of creditors to go after the decedent’s revocable trust applied to an IRA payable to the trust.

Life insurance, similar to IRAs, have a beneficiary designation and Indiana law does not allow creditors to go after life insurance proceeds paid to individuals.  However, creditors can go after life insurance proceeds payable to an estate or trust.  Consequently, there is reason to think that an Indiana court would conclude that IRAs payable to a revocable trust are subject to the decedent’s creditor claims.

You should use caution before naming your revocable trust as beneficiary of your retirement plan.  To review your retirement account beneficiary options, contact the Stinson Law Firm at 317-622-8181.

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