Planning with Retirement Accounts

As the Baby Boomers age, the practice of elder law is changing.  One significant change is a result of how the Baby Boomers invest their assets.

The Greatest Generation—the generation who were young adults during World War II and who are the parents of the Baby Boomers—did not invest the bulk of their wealth in retirement accounts, such as 401(k)s and individual retirement accounts (IRAs).  Many of the Greatest Generation subsist on a defined pension benefit and Social Security income.  While they may have IRAs, the value of the accounts tend to be relatively low.

Baby Boomers, on the other hand, tend to have a significant amount of wealth invested in IRAs and other qualified accounts.  While many Baby Boomers do have defined pension benefits, as well, true pension plans were slowly dying out during their adulthood.  They rely more and more on their retirement accounts.

Retirement accounts present unique issues.  Fundamentally, the issue with retirement accounts is that when the owner of the account removes money from the retirement account, the withdrawal is taxable income.

So, if Mr. Smith has an IRA worth $400,000 and he removes $400,000 from his IRA, he would have $400,000 of income in that year and would have to pay tax on that $400,000 of income. This causes issues when people want to qualify for Medicaid or when they want to leave their retirement accounts to their heirs after their death.

Let’s assume that Mr. Smith enters a nursing home costing $12,000 a month.  He wants to qualify for Medicaid benefits, so the Medicaid program will pay for his nursing home stay.

There are a number of techniques that I can employ in order to qualify Mr. Smith for Medicaid benefits, but one of the biggest issues in the planning will be the fact that in order to implement any of these techniques, Mr. Smith will need to remove the assets from his IRA.

When Mr. Smith removes the $400,000 from his IRA, he will have $400,000 of income.  Mr. Smith will have to pay income tax on an additional $400,000 of income.  While he may have some deductible medical expenses to write-off against the $400,000 of income—his nursing home bill for that year—he still has a tremendous amount of income in one year.

If long-term care is a serious concern of yours, you might want to consider removing money from retirement accounts that you own quicker than is required in order to spread the income over several years.  A person has to take a minimum distribution amount from his retirement accounts every year after he attains the age of seventy and a half.  The amount is typically referred to as the Required Minimum Distribution Amount or RMD.

The RMD is a small fraction of the retirement plan, approximately 1/26th every year.  The owner of the retirement account can take more than the RMD in any one year, but he must take at least the RMD.

If Mr. Smith took $50,000 out of his IRA every year for eight years, he could spread the tax liability out over several years, resulting in a lesser income tax liability. Of course, Mr. Smith might never require long-term care, but if he is concerned about needing care some day and wants to plan for Medicaid benefits, he might want to think ahead.

Benefits of a Trust

Lately, I’ve been writing a good deal about trusts.  This past summer, New Jersey enacted its version of the Uniform Trust Code.  The Code is a series of statutes that address the law of trusts.

Before New Jersey enacted the Code, our trust law was a bit of a hodge-podge.  Many of the cases concerning trusts were very old.  Because of their age, the cases are difficult to understand.  When someone tells you that they don’t understand legalese, they should try reading a case from the 1800’s.  Back then, Judges wrote in a manner that is practically incomprehensible.

The Uniform Trust Code is nice because it modernizes the law of trusts and condenses the law into a short series of statutes.  If you have a question about a trust, you can probably find an answer to the question simply by reading the Code.

When it comes to trusts, many people are confused by the very nature of a trust.  What is a Trust?  A trust is a fiduciary relationship.  From a practical standpoint, a trust exists when one person, called the Trustee, holds property for the benefit of another person, called the beneficiary.  The Trustee is a fiduciary to the beneficiary because the trustee owes the beneficiary the duty to hold the property with the utmost care.

So, broken down to its most simple terms, a trust is simply one person holding property for another person.  If Mr. Smith dies and leaves his son John’s share of his estate to a trust, naming his daughter Mary as the trustee of the trust, then Mary is holding John’s inheritance from Mr. Smith for John’s benefit.

Now a trust can have all types of purposes.  Perhaps the beneficiary of the trust is a minor or disabled or has problems managing money or has problems with drugs and alcohol or has a disability.  These are various reasons that Mr. Smith might want to create a trust for his son John.

A trust might only last until the beneficiary attains a certain age—25 or 30 or 35.  Or a trust might last the lifetime of the beneficiary.

A trust can protect the assets being held in the trust from the creditors of the beneficiary.  For instance, if John were ever to be sued or to get divorced, a trust can help insulate the assets being held in the trust from John’s creditors or soon-to-be ex-spouse.  This is accomplished through the use of “spendthrift clause,” which is merely a provision of the trust that says the assets being held in the trust are being held free of the beneficiary’s creditors.

One of the most interesting provisions of New Jersey’s Uniform Trust Code is a provision that says a spendthrift clause is valid even if the trustee is also the beneficiary of the trust.  In other words, Mr. Smith could leave John’s inheritance to John to hold as trustee for John’s benefit and the assets being held in the trust can be protected from John’s creditors by placing a spendthrift clause into the trust.

The reason I find this provision so interesting is this.  Many people come to me and are concerned that someday their son or daughter might die and the inheritance that was left to the child will pass to the child’s spouse.  The concern is, the child’s spouse might remarry and the client’s grandchildren will not get the inheritance the client left to the son.

For example, Mr. Smith dies and leaves his estate to his son John.  John dies two years later and John’s Will leaves everything to John’s wife.  John’s wife remarries.  John’s wife dies and leaves everything to her new husband, which includes Mr. Smith’s inheritance.  John’s children receive nothing from Mr. Smith.

Now, since John could serve as trustee of a trust for his own benefit, Mr. Smith could leave John’s inheritance to a trust that Mr. Smith creates in his last will.  John could be the trustee of this trust.  When John dies, the trust could name John’s children, not John’s wife, as beneficiary.  The trust could even continue until John’s children reach adulthood.

The trust could also have a spendthrift clause in it that protects the assets of the trust from John’s creditors and the creditors of the grandchildren.  Mr. Smith’s money is safe for many decades from creditors and divorce.

Testamentary Trusts

A last will and testament is a document that can accomplish a great deal for the person writing the Will and his heirs.  Through a Will, a person can leave his assets to whom he wishes in the manner of his choosing.

One of the most powerful aspects of a Will can be a trust.  A trust in a Will is called a testamentary trust.  From a practical standpoint, a testamentary trust is merely words in the Will.  For instance, the Will might say, “My executor shall pay any inheritance passing to my son Joseph to my Trustee Mary to hold and administer for Joseph’s benefit.”   Those words contained in the Will create a testamentary trust.

A testamentary trust, as with any trust, is simply one person—in the example above, Mary—holding property for the benefit of another person—in the above example, Joseph.  A trustee holds the property as a fiduciary, meaning that the trustee owes the utmost duty of care to the beneficiary of the trust.

A decedent might wish to create a trust for a beneficiary under his Will for a number of reasons.  A beneficiary might be disabled or might have problems with drugs or alcohol or the beneficiary might have problems managing money.

Sometimes, a decedent wishes to create a trust for a beneficiary simply because he doesn’t want the beneficiary to have unfettered control or access to the inheritance.  The father might fear that if he leaves his son’s inheritance to his son and the son later gets divorced that the son’s ex-wife will lay claim to the inheritance.

A testamentary trust can help protect an inheritance from many issues facing a beneficiary.  When placed into a trust, an inheritance can be protected from a beneficiary’s creditors with a spendthrift clause.

A spendthrift clause is a clause in a trust or a Will that protects the assets held in the trust from the creditors of the beneficiary by preventing the creditors and the beneficiary from encumbering the assets of the trust.  A trust with a spendthrift clause is commonly referred to as a “spendthrift trust.”

If an inheritance is held in a spendthrift testamentary trust, then the assets held in the trust can be insulated from the beneficiary’s creditors.  So, for instance, if a father leaves his son an inheritance and places the inheritance into a testamentary trust with a spendthrift clause, then the inheritance is protected in the event the son is sued or gets divorced.

Recently, our State enacted the Uniform Trust Code.  Pursuant to the trust code, a spendthrift clause is valid.  The trust code also permits a beneficiary to serve as the sole trustee of a trust.  So, if the father leaves his inheritance to his son, the son can serve as sole trustee of the trust for his own benefit and the assets in the trust can be protected from his creditors with the use of a spendthrift clause.

Given these provisions of the law, some people create what are colloquially referred to as “bloodline trusts” in their Wills.  A bloodline trust is a trust designed to hold the assets of a beneficiary for the entirety of the beneficiary’s life then to pass those assets onto the blood relatives of the beneficiary.

For example, a father leaves an inheritance to his son Joseph. The money is held in a bloodline trust for the remainder of Joseph’s life.  The bloodline trust has a spendthrift clause, protecting the assets held in the trust from Joseph’s creditors.  When Joseph dies, the remaining assets of the trust pass to Joseph’s children, the grandchildren of Joseph’s father.