After the SECURE Act, most IRA beneficiaries are required to withdraw the balance of the account within 10 years after the owner’s death. The details of those rules can be found in my prior post here. In that post, I also introduced the concept of using an Accumulation Trust (i.e. a trust as beneficiary of an IRA that (1) can accumulate withdrawals from the IRA and (2) has non-individual beneficiaries) as a way to stretch the IRA distributions after the owner’s death beyond the 10-year requirement. Another option to stretch those payments would be to name a charitable remainder trust. Each has its advantages and disadvantages, which are discussed below.
Secure Stretch Trusts as IRA Beneficiaries
Prior to the SECURE Act, naming an Accumulation Trust as the beneficiary of an IRA was usually a bad result. This is because one of two rules would apply: (1) if the owner died before they began taking requirement minimum distributions (RMDs) from the IRA, then the trust would have to withdraw all of the IRA balance within 5 years of the owner’s death, or (2) if the owner died after the owner began taking RMDs, then the trust would have to withdraw the IRA balance over the owner’s remaining life expectancy. The date when RMDs begin is now 72. The remaining life expectancy of a 72 year old is 17.1 years and the remaining life expectancy of an 82 year old is 9.9 years. Therefore, now, if an IRA owner died after age 72 but before age 82, then an Accumulation Trust would be able to stretch out withdrawals from the IRA for more than 10 years. The danger of naming an Accumulate Trust is that it must be carefully drafted to NOT be an Accumulation Trust if the owner dies before age 72, otherwise the more penalizing 5-year rule would apply, rather than the new generic 10-year rule. A properly drafted Accumulation Trust will be referred to as a “Secure Stretch Trust” below.
The federal income tax treatment of an Secure Stretch Trust bears some explanation. As a general rule, an accumulation trust is subject to income tax. To the extent the trust distributes its income (for accounting purposes the income must be “distributable net income”) to a beneficiary during the trust’s tax year, or within 65 days after the end of the trust’s tax year, the recipient beneficiary pays the tax on that distributed income and the trust takes a deduction for the amount it distributed. In that way, the trust is subject to a conduit system of tax where either the trust or the beneficiary pay the tax on the trust income, but not both. This is, admittedly, a very brief overview of a very complex system of taxation, but hopefully you get the general idea.
CRUTs as IRA Beneficiaries
A charitable remainder trust is a trust with two different interests: (1) an annuity or unitrust payment is paid to a specific individual for one or more lifetimes or a term of years, and (2) the balance of the trust after the annuity or unitrust term ends is paid to charity. I previously explained these trusts here, but a few key features are important to emphasize now.
First, if the charitable remainder trust pays an annuity (a fixed amount of money) each year, it is called a Charitable Remainder Annuity Trust, or CRAT. If the charitable remainder trust pays a unitrust amount (a fixed percentage of the value of the trust usually measured on January 1) each year, it is called a Charitable Remainder Unitrust, or “CRUT.”
Second, due to certain valuation rules related to annuities, typically a charitable remainder trust that lasts for the individual beneficiary’s lifetime is structured as a CRUT. See Treas. Reg. 1.7520-3(b)(2); Rev. Proc. 2016-42; Rev. Rul. 70-452.
Third, the trust itself does not pay income tax, unless it has unrelated business taxable income (so called “UBTI”) or is subject to certain charitable excise taxes. UBTI would not usually apply to investments in marketable securities, so that is not typically an issue when CRUTs are beneficiaries of IRAs and the excise tax rules can usually be avoided by diversifying investments and not investing in related businesses of the IRA owner and his or her family members, beneficiaries, and trustees of the trust. The tax treatment of the CRUT means that withdrawals from an IRA can be held and reinvested in the CRUT on a tax-free basis in most cases.
Fourth, the value of the charity’s interest in the CRUT must be at least 10% of the value of the property initially contributed to the trust. This valuation is an actuarial calculation that takes the value of the total property contributed to the trust and reduces it for the present value of all of the anticipated unitrust payments to the individual beneficiary. The net amount in that calculation is the value of the charity’s interest. The present value of the future unitrust payments is discounted at the Code Section 7520 interest rate (the “7520 Rate”). The IRS determines the 7520 Rate each month. In May 2020, the 7520 rate is 0.8% and in June 2020, it is 0.6%. Those are historically low amounts. The lower the 7520 Rate, the smaller the discount on the valuation of the future stream of unitrust payments and the larger the unitrust payment’s value will be (relative to the actual anticipated investment performance of the trust during its term). The lower 7520 Rate also decreases the percentage that can be used as the unitrust payout rate in the CRUT, meaning over a long period of higher growth than the 7520 Rate, the initial individual beneficiary will receive less and the charity more than if the 7520 Rate suggests or would be the case if the 7520 Rate was higher.
Fifth, the term of the trust must be no more than 20 years, or no more than the life of two individuals who are alive when the trust is formed.
Sixth, a CRUT may not pre-pay the unitrust amount, meaning the individual beneficiary receiving the unitrust payment each year is stuck with whatever amount that happens to be, until the trust terminates. There is no way to get more out of the trust to the individual.
With those rules in mind, an IRA owner who wants to “stretch” out the IRA payments after the owner’s death for more than 10 years, thus increasing the tax efficiency of the IRA, could name as a beneficiary of the IRA a CRUT that pays to the owner’s child over the child’s lifetime. The trust could be written in a way that the child’s interest is worth 90% of the value of the IRA balance at the owner’s death and the owner’s estate could be eligible for a charitable income tax deduction for the 10% value going to charity. The CRUT would withdraw the annual RMDs from the IRA, which would likely be based on the 10-year rule, but the CRUT would not pay tax on the IRA withdrawals, and could reinvest the withdrawn amounts within the trust. As the CRUT paid the unitrust amount to the child each year, the child would have to pay tax on the withdrawals at ordinary income tax rates to the extent of the aggregate IRA withdrawal amount (and then may have potential capital gains if the unitrust amount exceeds the aggregate IRA withdrawal and the trust’s investments generate capital gains). If the CRUT pays over the child’s lifetime, this would effectively “stretch” the IRA payments over the child’s lifetime.
Which is Better?
So, which approach is best? As is usual, there is no exact answer. every person’s circumstances are unique and have to be evaluated separately. Solely in terms of flexibility, a Secure Stretch Trust would be better because the Trustee can withdraw and pay to the child more than the RMD from the IRA each year if the Trustee deems that wise and the trust allows it. But, the Secure Stretch Trust does not get tax-free treatment on withdrawn IRA funds held within the trust like a CRUT. Thus, the Secure Stretch Trust must distribute the IRA withdrawals to the child each year in order to push the tax burden to the child (whose tax rate is likely less than the trust’s tax rate).
Another consideration is which option results in the best investment performance. To analyze that, I have assumed the IRA owner’s child is 40 years old at the owner’s death, the withdrawals from the IRA are always taxed at 40% in an individual’s hands, investments always grows at 5% per year, and the investments in the hands of the child (in “taxable” accounts) always has a 5% capital gain churn rate each year taxed at 25%. I also assume none of the distributions are ever spent (perhaps unreasonably so), so that I can control that variable. A 40 year old has about a 38 year life expectancy in this example, and the IRA owner dies at age 72. I also assumed the 7520 Rate would be 4% in the year of the owner’s death (which is close to an historic average of that rate). To summarize–if the trust money (before and after distribution to the child) is always invested and never spent, which option is better purely from an investment perspective?
The last cell in the “Net” category shows the balance that would be in the child’s hands at the child’s death. At $3,928,257, the Secure Stretch Trust is much better than the CRUT’s $2,623,737–again, purely from an investment performance perspective.
There are other factors not included that could increase the drag on the investment performance of either trust. Obviously the spend rate of the child would make a large difference and is controlled in these numbers. Each year of the Secure Stretch Trust or the CRUT has to file an income tax return with the IRS and one of more state tax authorities. Each return increases administrative costs overall, which would increase the administrative cost of the CRUT because it would last for 38 years while the Secure Stretch Trust would last for 18 years. Another big drag on the CRUT is that the charity must be paid at the end of the trust, meaning a large portion of the trust would not be paid to the child at the end of the CRUT term. The child’s tax rate would be heavily influenced by the child’s state or city of residency (e.g. NYC rate of 12.696%, Las Vegas rate of 0%), which could increase not only the tax on IRA withdrawals but the capital gains on investments. The net distributions from the IRA (and Secure Stretch Trust) to the beneficiary and the CRUT (i.e. the gross amount of withdrawals less the gross amount of tax on the withdrawals) is over $300,000 more in the Secure Stretch Trust context, and all of those withdrawals occur by year 18 after the owner’s death, whereas the CRUT payments are stretched out over the life of the child. The higher distribution from the Secure Stretch Trust can then be re-invested earlier and grow longer in the child’s hands. Finally, the final net CRUT number includes distributing the final balance of the CRUT to the charity ($447,981).
If an owner has charitable intent as well as a desire to benefit a child, then it is clear the CRUT would be better. If the IRA owner wanted to benefit the charity immediately after the owner’s death, then the better option might be to leave some or all of the IRA to charity directly at death, and then perhaps leave the rest in a Secure Stretch Trust. For example, using the assumption that money is always invested and grows at 5% annually, $450,000 received 38 years from now would be worth $64,000 today. If the IRA owner left $64,000 of the IRA to charity immediately at death and the balance to a Secure Stretch Trust under the same assumptions above, at the child’s death, the child would have $3,676,849 and the charity would have $450,000.
One advantage of the CRUT is the ability to keep the IRA funds in trust, and out of the child’s hands, if the child is a spendthrift. Both a Secure Stretch Trust and a CRUT could, however, also be structured to control the child’s distributions after they are made. This could be done by making the distributions (1) to a single-member LLC of which the child is the member but that another person manages, (2) to a beneficiary defective inheritance trust (a so called “BDIT”) for the child’s benefit of which the child is not the trustee, (3) to a beneficiary deemed owned trust (as so called “BDOT”) for the child’s benefit of which the child is not the trustee, or (4) to the child’s revocable trust of which the child is not the trustee. Each of these could be structured to be disregarded for income tax purposes, thus making the child the ultimate owner of the trust payments for income tax purposes. Control over the LLC or the revocable trust would need to ensure the child-spendthrift could not just terminate the LLC or the revocable trust without a trusted person’s consent.
Although a detailed explanation of these control options is beyond the scope here, suffice it to say creative planning can be used to piece together a complete structure that meets the IRA owner’s goals while also increasing tax efficiencies.
One warning on using a CRUT (or charitable remainder trust) as the IRA beneficiary is that if the trust lasts for the child’s lifetime, whenever the child died, the trust ends and the charity gets the balance of the trust. Thus, the IRA owner should have charitable intent and understand this possibility before committing to that option.
Though the SECURE Act changed the landscape for IRAs significantly, new planning options are available by taking existing techniques and imagining how they fit into the current tax landscape.