For individuals with substantial IRA or 401(k) balances, estate planning requires careful consideration to ensure that wealth is preserved, protected, and transferred efficiently. Traditional trust structures, while useful for asset protection, often create unintended tax burdens under current federal tax laws.
A Beneficiary Deemed Owned Trust (BDOT) presents a strategic alternative, allowing for the protection of inherited retirement accounts while also minimizing tax liability. This structure can eliminate the need for ongoing trust tax returns and prevent excessive taxation, potentially saving beneficiaries tens or even hundreds of thousands of dollars over time.
The Challenge: Taxation and Asset Protection in Traditional Trust Structures
A common concern among individuals with large retirement accounts is ensuring that inherited wealth remains protected—not only from potential creditors, lawsuits, and divorce proceedings but also from unnecessary tax erosion.
Consider the following example:
Vito Corleone, a single individual, has an IRA worth $2 million and no significant additional assets. His primary concern is that if he leaves this wealth to his son, Michael, it could become vulnerable in the event of divorce, lawsuits, or financial liabilities.
To protect these assets, Vito could establish a spendthrift trust as part of his estate plan. Upon Vito’s passing, the IRA would be transferred into this trust, ensuring that the funds remain secure from creditors while allowing Michael to access distributions for specific purposes (e.g., health, education, maintenance, and support).
However, this traditional structure introduces a serious tax complication.
The SECURE Act and Its Impact on IRA Distributions
The SECURE Act significantly altered the taxation of inherited IRAs by eliminating the lifetime “stretch” provision for most non-spousal beneficiaries. Under current law:
Mandatory Distributions – Non-spouse beneficiaries must withdraw the entire balance of an inherited IRA within 10 years of the account holder’s death.
High Tax Exposure – These distributions are taxed as ordinary income, often pushing beneficiaries into higher tax brackets and accelerating tax liability.
For instance, if Michael inherits the $2 million IRA outright, he must withdraw the full balance within 10 years, equating to approximately $285,000 per year in taxable income.
However, if the IRA is placed in a traditional irrevocable trust, an additional issue arises:
Tax Disparities Between Individuals and Trusts
Traditional irrevocable trusts are subject to highly compressed tax brackets:
Trusts reach the maximum federal tax rate (37%) at just $15,201 of income.
Individuals (e.g., Michael) do not reach the 37% tax rate until income exceeds $731,201 (married filing jointly, 2024).
Comparison of Tax Rates
This means that if Michael’s spendthrift trust retains any income rather than distributing it, the trust will be taxed at the highest possible rate on nearly all of its earnings.
The Financial Impact: A Costly Choice
If Michael takes all distributions from the trust to avoid excessive tax rates, he loses asset protection and exposes his inheritance to creditors, lawsuits, or future estate taxes.
If Michael does not take distributions, the trust pays taxes at the highest marginal rate, resulting in substantial tax erosion.
In Michael’s case, this difference amounts to approximately $30,000 in excess taxes per year—resulting in a total tax liability of $414,000 over ten years and additional losses due to foregone investment growth.
The BDOT Solution: Maximizing Tax Efficiency Without Sacrificing Asset Protection
A Beneficiary Deemed Owned Trust (BDOT) is a sophisticated trust structure designed to circumvent the tax pitfalls of traditional spendthrift trusts while preserving key asset protection benefits.
Key Advantages of a BDOT
Taxation at the Individual Level – Unlike traditional irrevocable trusts, a BDOT is structured so that the beneficiary (Michael) is treated as the owner for tax purposes. This allows the IRA’s required minimum distributions (RMDs) to be taxed at Michael’s individual rate rather than the trust’s compressed rate.
No Separate Trust Tax Return – Since the trust’s income is taxed directly to the beneficiary, a BDOT eliminates the need for separate trust tax filings, reducing administrative burdens.
Maintains Asset Protection – While providing tax efficiency, a BDOT retains creditor and divorce protections, ensuring that inherited assets remain secure.
Long-Term Wealth Preservation
By implementing a BDOT, Michael could:
Reduce tax liabilities by over $30,000 per year
Preserve an additional $414,000 in investment growth over 10 years
Ensure his inheritance remains protected from external claims and potential financial risks
Additional Considerations
Beyond income tax savings, BDOTs also provide:
Estate Tax Benefits – Assets placed in a BDOT may be excluded from the beneficiary’s taxable estate, reducing potential estate tax liability.
Step-Up in Basis at the Beneficiary’s Death – Certain BDOT structures can enable a step-up in basis for capital assets, further minimizing future tax burdens.
Flexibility Through Trust Protectors – A trust protector provision allows for adjustments to the trust’s terms to adapt to future legal or tax changes.
Is a BDOT Right for Your Estate Plan?
For individuals with substantial retirement assets, a Beneficiary Deemed Owned Trust is a highly effective tool for:
Minimizing tax exposure on inherited IRAs
Ensuring long-term asset protection
Eliminating the need for trust tax returns
Determining whether a BDOT aligns with your estate planning goals requires careful legal and financial assessment.
Take the Next Step
At Harrison Estate Law, we specialize in advanced estate planning strategies designed to protect wealth while optimizing tax efficiency. Contact us today to learn how a BDOT can safeguard your family’s financial future.
