It is not uncommon for clients to show me balance sheets which hold a few primary large dollar assets – these are usually real estate, life insurance policies, and retirement accounts. Because of the specific rules which govern inherited retirement accounts, and in the wake of Congress passing the SECURE Act, advanced planning with retirement accounts has gotten more complicated.
The simplest route remains using the account’s beneficiary designation to allow the entire account to go directly to the beneficiary. Changes to federal law via the SECURE Act have limited the ability of the owner of an inherited IRA or 401(k) to stretch taxable distributions, however. Unless the account beneficiary fits into a limited category of “eligible designated beneficiaries”, the beneficiary will be required to withdraw the entirety of the account balance within ten years. Taxable distributions will be treated as ordinary income to the beneficiary when they are withdrawn and taxed at the individual’s income tax rate.
It remains possible to make the beneficiary of a retirement account a trust, but that trust cannot be an “eligible designated beneficiary.” A trust beneficiary will either be subject to the 10-year distribution requirement, or an even more limited 5-year rule. In addition, the income tax impact of a trust beneficiary can be significant. Unless the trust is structured to pass out all distributions received by the trust each year, distributions will be taxed as income to the trust. Trusts reach the highest federal marginal income tax rate at much faster than individuals or joint filers, so accumulating distributions within the trust is rarely the best choice to maximize the value of a retirement account. In 2021, trusts reach the maximum federal marginal income tax rate (37%) after only $13,050 in income, as opposed to $523,600 in taxable income for a single filer. For all these reasons, under the SECURE Act, this route has become much less attractive to those with large retirement accounts.
There is one avenue that remains for trust planning which achieves a similar result to the old “stretch” treatment and provides an opportunity for charitable legacies at the same time. Charitable Remainder Trusts (CRTs) are an IRS sanctioned trust vehicle which allows you to provide cash benefits to a human beneficiary over a defined period of time and a remainder gift to a designated charity.
Here’s how it works:
When the account owner dies, the retirement account goes to the CRT. The CRT is permitted to cash out the entire balance of the retirement account income tax-free. The CRT then pays the designated human beneficiary distributions over a defined period. Depending on the age of the individual and the balance of the account, this may be structured as an annuity or a percentage of the trust principal and may last for the beneficiary’s lifetime or a term of years. There are Annual distributions remains taxable at the income tax rate of the human beneficiary, but at the end of the trust term, the remainder of the assets are distributed to the chosen charitable beneficiary, tax free. The deceased account holder’s estate will receive a charitable deduction for the portion of the account which is deemed to make up the remainder interest under IRS rules.
There are some caveats to this type of plan. In order for a CRT to work properly, at least ten percent of the actuarial value of the trust must go to charity. Distributions must be made at least annually and must be in an amount of at least 5% and no more than 50% of the trust assets. A CRT which does not meet the IRS requirements will not be a qualified CRT and will not receive the tax benefits inherent in this kind of plan. A CPA, financial advisor, or estate planning attorney can run formulas to determine whether the assets are sufficient to meet these tests and provide the kind of distribution stream desired, and what kind of term and annual distribution amount will qualify under the rules.