When to Avoid Naming a Trust as Beneficiary of Your Retirement Plan

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 are worried about creditors coming after your estate. 

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. 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, states often allow the creditors to go after a revocable trust. In at least one case in Kansas, which like 34 other states and the District of Columbia has adopted the Uniform Trust Code, the court ruled that this right of creditors to go after the decedent's revocable trust applied to an IRA payable to the trust. There's no reason to think that other courts would not come to a similar conclusion.

Conclusion
So, if your debts exceed your non-retirement plan assets, don't make your retirement plan payable to your revocable trust. Either make it payable directly to beneficiaries or, if a trust is necessary, to an irrevocable trust. If your assets far exceed your debts, or possible lawsuit claims against you or your estate, then don't worry about any of the above.