The overlooked crack in your estate plan

Many families do the hard work of estate planning. They create wills and trusts, name guardians, and carefully structure how assets will pass to the next generation. Then they leave one of their largest assets completely outside of that structure: a retirement account. An IRA or 401(k) built over 30 or 40 years may be worth millions of dollars. Yet it typically passes under a beneficiary designation completed years earlier – a detail that can have significant consequences for the next generation.

For married couples, a common and typically best starting point is to name the surviving spouse as the primary beneficiary. A spouse generally has options unavailable to other beneficiaries, including rolling inherited IRA assets into the spouse’s own IRA or electing to treat the IRA as the spouse’s own, subject to applicable rules.

The next question is what happens to the retirement account when the surviving spouse passes away. Most Americans name their children as contingent beneficiaries. A much better option is to name a properly drafted “see-through” trust as the contingent beneficiary on behalf of the children. This approach can preserve the spouse’s options while providing protection and oversight for the next generation.

This article will detail:

• The hidden risks of leaving retirement accounts directly to heirs
• How beneficiary designations can create unintended exposure for the next generation
• Why a conduit trust may be an effective contingent beneficiary for children

Why the beneficiary designation matters

Consider the real-life estate planning dispute that led to the 2014 Supreme Court case Clark v. Rameker. A parent left an IRA to an adult child, who later filed for bankruptcy. The child claimed that the inherited IRA should receive the same creditor protection as a retirement account owned by the original account holder. The Supreme Court unanimously disagreed.

An inherited IRA differs fundamentally from a retirement account the original owner built. The beneficiary cannot contribute to it, generally must take distributions, and — critically — can withdraw the entire balance at any time without penalty. Those characteristics meant the inherited IRA’s assets were not considered protected “retirement funds” under federal bankruptcy law.

The lesson is clear: the various protections that apply during the original owner’s lifetime do not automatically transfer to a child who inherits the account. The ruling highlights an important distinction though: federal bankruptcy protections for inherited IRAs differ from those available to surviving spouses under the applicable rules.

In addition, some states provide broader protections for inherited IRAs even after Clark, while others follow the Clark ruling. As a result, whether your children’s inheritance is protected may heavily depend on the state they live in when the inheritance occurs. That is a fragile outcome to leave to chance.

Where the exposure exists

The risk arises while an inherited IRA remains in a child’s name and becomes even more direct once your child withdraws those funds and holds them personally. Depending on applicable law, those assets may be exposed to a divorcing spouse, lawsuit, or bankruptcy. Naming the child directly on a beneficiary designation places one of the family’s largest assets squarely within that exposure zone.

Favorably, the SECURE Act of 2019 shortened this exposure period by requiring most inherited retirement accounts to be distributed within 10 years. But this does not eliminate the risk that distributions will become exposed once they reach the beneficiary.

The solution: a properly drafted “see-through” trust

A trust cannot restore the old stretch IRA rules or any other tax laws. Its function is to create a barrier between a non-spouse beneficiary and the inherited assets to manage risks. By naming a designated trust as the retirement account beneficiary, you limit exposure and decide how and when your children receive their inheritance.

These are commonly called “see-through” trusts because tax rules allow the IRS to look through the trust to the underlying beneficiaries for favorable treatment. 

To qualify as a see-through trust, it must meet specific technical requirements:

• Be valid under applicable state law
• Become irrevocable upon your death
• Have identifiable individuals as beneficiaries
• Provide the required documentation to the account custodian on time

These requirements leave little room for error. A trust that almost qualifies does not receive these benefits, which is why this is not a do-it-yourself project.

There are two primary types of see-through trusts. For most families, the conduit trust is the right choice.

Conduit trusts: tax-efficient protection

A conduit trust receives distributions from the retirement account and passes them to your child. Its key benefits are:

• Asset protection: The trust retains control over the retirement account and limits your child’s direct access to funds. This can help protect undistributed assets from creditors, divorce, lawsuits or other risks.
• Individual income-tax treatment: Distributions pass through to your child in the year the trust receives them and are taxed on the child’s individual income tax rate. In contrast, income retained inside a trust is subject to trust income tax rates, which reach the top federal bracket after only a few thousand dollars of income. A conduit trust avoids that disadvantage by design.

The tradeoff is that once a distribution reaches your child, the trust protection ends. Over the ten-year payout period, more of the inherited account reaches your child’s hands. Even so, many families find that the combination of protection during the payout period, favorable individual tax treatment, and trustee oversight provides the right balance between asset protection and tax efficiency.

An alternative is the accumulation trust, which allows the trustee to retain distributions inside the trust rather than pass them directly to the beneficiary. It keeps money shielded for longer, but retained income is taxed at higher trust rates. Accumulation trusts can be appropriate when long-term protection is the priority, particularly for a beneficiary with special needs.

What’s next

A few practical steps worth taking now:

• Review your retirement account beneficiary designations: Your retirement account passes according to these designations, not your will. Confirm that both primary and contingent beneficiaries are named and up to date. For married account owners, consider the surviving spouse’s available options when selecting the primary beneficiary and whether a properly drafted trust should serve as the contingent beneficiary.
• Ask your financial advisor and estate planning attorney if a conduit trust should be your retirement account’s contingent beneficiary: For a large retirement account and children who may face creditor, divorce, or spending risks, a conduit see-through trust may provide a useful balance of protection, oversight, and individual income-tax benefit. The analysis may differ for an eligible designated beneficiary or when family circumstances require stronger protection.
• Review older trusts: Many trusts drafted before 2020 were developed around the old stretch rules. Their beneficiary provisions and payout language should be revisited to confirm they still achieve your goals under today’s rules.
• Focus on what the trust does best: A see-through trust is a protection-and-control tool, not a way to bring back the stretch. Judge it on whether it shields your children’s inheritance and honors your wishes — which, done right, it does.

Estate planning does not end when the will is signed. A single conversation about how retirement assets pass – and to whom – may be one of the most valuable hours you spend on your plan.