How to Protect Inherited Retirement Assets

A qualified domestic relations order, or QDRO, allows a divorcing spouse to receive benefits from a qualified retirement account tax-free and roll them over just as if they were a participant in the plan.

"Unless you're Paul McCartney with a huge estate, in most divorces both spouses inflict a certain amount of emotional, economic and legal pain on each other and then it settles," Goralka said. "If they're able to get their hooks into [an inherited IRA] through that settlement process, then all that tax-free growth goes with it. So with that $200,000 account that's going to grow to $1 million, say the spouse takes half of that, now all that's left is the $100,000 for the child, and the other $100,000, which is going to grow to $500,000, is now taken by the ex-spouse."

Because these assets tend to appreciate more quickly than others, they're high on the list of things that a spouse will try to get through divorce proceedings, he added.

Goralka said using a retirement trust as a designated beneficiary isn't necessarily a well-known strategy among financial advisors. "A lot of times, because the rules regarding qualified plans are very technical," advisors may not know how to best use a trust as a designated beneficiary for their clients' specific situations. "Again, this stretch is designed on what the age of the beneficiary is, so how do you know what that age is? What if the trust is providing for five beneficiaries?"

In that case, the separate shares for each beneficiary should be referenced on the beneficiary form itself. "We want to make sure each child's age can be used" for the stretch-out, Goralka said.

He added that the trust itself can cause it to be disqualified if "you're not able to show that all of the funds are going to be going to the designated beneficiary during their lifetime. It can be disqualified if they're being used to pay estate taxes, for example; even if it's hypothetical it can create a disqualification."

For that reason, "it's very hard for a regular trust to qualify, but a retirement inheritance trust is designed specifically to hold only retirement accounts, and it's carefully drafted to include the specific provisions required in the Internal Revenue Code for it to qualify," he said.

It's important to note that whether assets will qualify for tax deferral isn't decided by the IRS, but the plan administrator. "When there's a death, the plan administrator is going to review [the plan], and decide whether that trust meets those requirements. A regular living trust often does not."

When an IRA is inherited by a child, cashing the check will prevent them from ever getting access to that tax-deferred growth. IRAs inherited by a spouse have a grace period, when they can return funds to the account, Goralka said.

He suggested using a team approach and working with clients and their estate planning attorneys to make sure clients' desires are being carried out. He also stressed the importance of making sure beneficiary designations have actually been made.

"It sounds silly, but often these beneficiary designations, because they're so simple, they're overlooked."

In that case, the assets could be subject to taxation and probate fees, as well.

That means keeping a copy, as well. "More firms are using online designations. The concern I have with that is being able to show what you've done. If you're doing an online designation, you want to make sure you can do a 'print screen' or get a copy of that," he advised.

— Read RMDs From Client IRAs: An Unconventional ESA Funding Tool on ThinkAdvisor.