Taxation - Income, Estate, & Gift
By Robert Keebler, CPA/PFS, MST, AEP® (Distinguished) - Special guest author
One of the key changes made by the SECURE Act is a new 10-year rule for distributions from most non-spousal inherited IRAs.1 All distributions from these accounts must now be distributed to beneficiaries within 10 years after the IRA owner dies. This eliminates the "stretch IRA" which allowed non-spousal beneficiaries to stretch out distributions over their lifetimes. A young beneficiary could be named, allowing the account assets to grow at their pre-tax rate of return for a long period of time. For beneficiaries who didn't need the money, stretch IRAs could be used as an inheritance vehicle to accumulate large amounts for future generations of the family.
This review of suggested strategies that owners of large IRAs might use to maximize the wealth that can be accumulated from their IRAs for their families following enactment of the SECURE Act looks at:
- Charitable remainder trusts,
- Multi-generational accumulation trusts,
- IRC Section 678 trusts,
- Incomplete gift non-grantor trusts,
- Life insurance, and
- Roth IRA conversions.
Charitable Remainder Trust as IRA Beneficiary
The stretch IRA was the ideal method for maximizing the time during which IRA assets could grow tax-free for non-spouse beneficiaries. Although the SECURE Act eliminated this strategy, its long tax deferral period can still be replicated to a large extent by transferring IRA assets to a charitable remainder trust (CRAT or CRUT).
Spreading out distributions
If a charitable remainder trust (CRT) is named the beneficiary of a traditional IRA, there is no tax when the funds in the IRA are distributed to the trust.
Tax is only payable when the beneficiaries receive distributions from the CRT. These distributions can be spread out over a term of years not to exceed 20, or for the life or lives of a named individual or individuals, creating a long deferral period.
Internal Revenue Code Sections 664(d)(1)(D) and 664(d)(2)(D) require that the present value of the charitable remainder interest must be at least 10% of the initial value of the trust assets. Thus, charitable intent might be necessary to make this strategy work.
Multi-generational Accumulation Trusts
If an accumulation trust is named the beneficiary of an IRA, all the IRA funds would have to be paid to the trust by the end of the 10-year period, but the trustee would have the discretion to decide how much, if any, to pay to the beneficiaries and how much to keep in the trust.
Although accumulation trusts increase costs and add complexity, they also create important non-tax advantages for a family. They limit beneficiary access to funds, protect assets from creditors, provide professional management of trust assets, and may enable the trustee to manage tax brackets. They also may provide divorce protection and dead-hand control and facilitate estate planning and planning for beneficiaries with special needs. The trust would be structured as a spray trust, naming a broad group of family members as beneficiaries and spraying distributions across the group according to instructions provided by the grantor to the trustee. These beneficiaries could include more than one generation of the IRA owner's family. This would give the family the flexibility to vary the amount of income in respect of a decedent (IRD) distributed to minimize income tax obligations. Thus, a spray trust could be used to combine the tax benefits of low tax rates with the non-tax advantages of an accumulation trust.
IRC Section 678 Trust
As noted above, accumulation trusts can provide important non-tax benefits for a family. To get these advantages, however, the assets must stay in the trust instead of being distributed to the trust beneficiaries. Unfortunately, any amounts retained in the trusts would ordinarily be taxed at the high trust tax rates. For 2020, all trust income above $12,950 is taxed at the top individual income tax rate of 37%. By contrast, if the required minimum distributions (RMDs) are distributed to the trust beneficiaries, they will be taxed at the beneficiaries' individual tax rates, which might be substantially lower. Under IRC Section 678, a person other than the trust's grantor is treated as the owner of a trust if that person is given a power to withdraw trust assets without the consent of any other person. If a trust beneficiary is treated as the owner of a trust under Section 678, all items of income, deductions, and credits against tax of the trust would be reported on the beneficiary's Form 1040 instead of on the trust's tax return. This would enable the trust to retain and accumulate the RMDs in the trust without paying the high trust rates. The family of the IRA owner would get the best of both worlds, the advantages of leaving the assets in the trust with the lower tax rates of the individual beneficiaries.
Incomplete Gift Non-Grantor (ING) Trusts
The benefits of using an accumulation trust as a beneficiary of an IRA can be enhanced by making the trust an incomplete gift non-grantor trust in a state that doesn't tax trust income. The leading states for creating these ING trusts are Delaware, Nevada and Wyoming. They also can be created in several other states.
Beneficiaries who don't need the required minimum distributions they receive from their inherited IRAs during the 10-year SECURE Act period may be able to increase the amounts that can be accumulated for heirs by using some or all of the distributions they receive from the IRA to buy life insurance, provided they have an insurable need. The proceeds of the policy would be paid income tax-free to the beneficiary's heirs or to a trust for their benefit.
Life insurance has two advantages: First, assuming that the contract meets the definition of life insurance, there is no tax on the build-up of the policy's cash surrender value. Moreover, there is generally no income tax payable when the insured dies. Thus, as a general rule, the insurance proceeds are never subject to income tax.
Key factors when considering whether life insurance is a favorable strategy include tax deferrals and longevity of the insured.
Roth IRA Conversions
An important advantage of a Roth IRA is that there are no RMDs. This enables the entire value of the IRA to grow tax-free until the beneficiary's death, facilitating accumulation of wealth for the family.
If the beneficiary doesn't need distributions, the Roth IRA could be viewed more as a wealth transfer tool than as a retirement income vehicle.
Roth IRA conversion vs. other strategies
An advantage of a Roth conversion over a transfer to a CRT is that there is no need to transfer 10% of the value to charity. The full value can go to heirs.
The advantage of transferring the IRA assets to an irrevocable non-grantor trust would be that distributions to beneficiaries could be spread out and state income tax could be avoided. The Roth IRA could not only avoid state income tax, but also federal income tax.
There are many strategies to consider when it comes to IRA distributions. Unique personal and financial objectives must be considered in light of ever-changing legislation. Individuals are urged to consult with financial professionals who can provide the expertise necessary to help them choose the best course to navigate this complex arena.
Robert S. Keebler, CPA/PFS, MST, AEP® (Distinguished)is a partner with Keebler & Associates, LLP, and a recipient of the prestigious Accredited Estate Planners (Distinguished) award from the National Association of Estate Planners & Councils. He frequently represents clients before the IRS in the private letter ruling process and in estate, gift and income tax examinations and appeals, and has received more than 250 favorable private letter rulings including several key rulings of "first impression." Keebler has been speaking at national estate planning and tax seminars for over 20 years and is a frequent presenter for New York Life's advisor webinars and company training conferences.
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