(Setting Every Community Up for Retirement Enhancement)
In December, 2019, President Trump signed into law the 2019 Secure Act (Setting Every Community Up for Retirement Enhancement). On its face, the Act was a bill to ensure funding for the government for the foreseeable future. Its provisions relating to the taxation of Individual Retirement Account (IRA)(or any deferred income tax retirement account, i.e., 401(k), 403(B) or similar plan) is merely a plan to generate income for the government. The Secure Act applies to any IRA/Retirement Plan when the owner dies on or after January 1, 2020. Further, The Secure Act applies to Roth IRA’s as well as Traditional IRA’s.
Historically, upon the death of a retirement account owner, the beneficiaries of the account have had 1 of 3 to 4 options in receiving distributions from the account. If the beneficiary was a spouse, or a properly drafted Trust for the benefit of a spouse, the surviving spouse could either 1) roll-over the retirement account into their own IRA; 2)take a single, lump-sum distribution, 3) roll-over the retirement account into a beneficiary IRA and withdraw the funds over the five (5) years following the owner’s death, or, 4) roll-over the retirement account into a beneficiary IRA and withdraw the funds over their lifetime, taking the required minimum distribution each year based upon their life-expectancy. A non-spouse beneficiary had the same option as the surviving spouse, excluding the option to roll-over the account into their own IRA.
Under The Secure Act, the above no longer applies as that has changed for any beneficiary other than the surviving spouse or a Trust for the sole benefit of a surviving spouse. For all other beneficiaries, other than for specific categories, the beneficiaries have two (2) options; 1) withdraw the assets in a single, lump-sum distribution, or 2) roll-over the account assets into a beneficiary IRA and withdraw the assets within ten (10) years of the account owner’s death. Unless the beneficiary fits into one of the exceptions, there is no longer an option for withdrawals based upon the beneficiary’s life expectancy. These are called “Eligible Designated Beneficiaries” (EDB). EDB’s include:
A minor beneficiary;
An incapacitated beneficiary;
A beneficiary that is less than 10 years younger than the account owner; or,
A chronically ill beneficiary.
A surviving spouse still has the option to roll the account over to their own, or to stretch out the withdrawals based upon their life-expectancy. A beneficiary, upon the surviving spouse’s death must withdraw the balance of the account within ten (10) years of the surviving spouse’s death. The option for the spouse’s beneficiary to withdraw from the account over the surviving spouse’s remaining life-expectancy (prior to their death), no longer exists.
A minor beneficiary, or a Trust for the sole benefit of that minor beneficiary, can stretch-out the withdrawals based upon their life-expectancy until they reach the age of adulthood. Typically, that is the age of eighteen (18) years; however, that depends upon local law. Once they become an adult, the remaining balance must be withdrawn within the following ten (10) years.
An incapacitated beneficiary, or a Trust for the sole benefit of the incapacitated beneficiary, can stretch out the withdrawals based upon their life-expectancy. Once they are no longer incapacitated or pass away, the remaining account balance must be withdrawn within ten (10) years. Incapacity is defined pursuant to the Social Security Disability rules; however, that does not require a Social Security Administration determination.
A beneficiary that is less than ten (10) years younger than the account holder may withdraw the monies over their life-expectancy, even if their life-expectancy is more than ten (10) years. Upon the beneficiary’s death, the remaining account balance must be withdrawn within ten (10) years of thedeceased beneficiary’s date of death.
A chronically ill beneficiary, or a Trust for the sole benefit of a chronically ill person, can have the withdrawals spread out over their remaining life-expectancy. Upon the death of a chronically ill beneficiary, the remaining balance of the account must be withdrawn within ten (10) years of the beneficiary’s death.
TRUSTS AS BENEFICIARY OF A RETIREMENT ACCOUNT
There are basically two (2) types of trusts for the purposes of receiving retirement account distributions. It is either a “Conduit Trust” or it is an “Accumulative Trust.” A Conduit Trust is one that is there for the sole benefit of a beneficiary, and requires that the required minimum distribution (RMD) withdrawn from the retirement account be distributed to the trust beneficiary in the year of the withdrawal. The purpose of using the conduit trust is to insure that the RMD is calculated based upon the age of the trust beneficiary. An “Accumulation Trust” is any trust that is not a conduit trust. There are typically multiple beneficiaries and the RMD for all trust beneficiaries is based upon the age of the oldest trust beneficiary.
In order for a Trust to be eligible to elect to receive withdrawals from a retirement account based upon the age of a trust beneficiary, the Trust must qualify as a “designated beneficiary.” To qualify as a “designated beneficiary,” the Trust must satisfy four (4) requirements:
The trust must be valid under state law;
The trust must be irrevocable at the time of funding (meaning the owner’s death);
The trust beneficiaries must be identifiable; and,
Documentation regarding the trust must be given to the retirement account custodian by October 31st of the year following the year of death.
There is also, in practice, a fifth requirement; namely, that if there are multiple trust beneficiaries, then ALL of the trust beneficiaries must be individuals. Thus, a charity cannot be a trust beneficiary of a “Designated Beneficiary Trust.”
Problems for Conduit Trusts
If you established a Trust for a child as a “conduit trust” expecting that the RMD would be based upon their life expectancy, and that distribution of the payments would be delayed until the child was older and more mature, then your trust needs to be updated ASAP. For example, if the child is age fifteen (15) years upon your death, and the trust says to distribute at age eighteen (18), but retain the principal until age thirty-five (35), the trust does NOT mesh with the new tax rules. The tax rules would require that all of the Trust IRA accounts be distributed to the child by the 10th anniversary of becoming an adult (i.e., age 18). Therefore, the IRA would have to be distributed to the child at age twenty-eight (28). The result of this situation is that the trust would not qualify as a conduit trust, and would therefore be treated as an accumulative trust. It must now be distributed under different rules; namely, within ten (10) years of the prior owner’s death (i.e. when the child turns twenty-five (25)).
If the trustee does not have the discretion to distribute early, or the trustee simply holds the assets beyond the 10 year anniversary, there are significant IRS penalties that would be assessed against the trust and the trustee. This penalty is an additional tax equal to fifty percent (50%) of the RMD that was not withdrawn from the retirement account.
What Should I, as the Client, Do Now?
It is important to review both the general distribution plan for your trust, along with the trust provisions. However, this is not enough as the beneficiary designations for the IRA, or any other retirement account must also be reviewed for navigating these new rules to ensure maximum efficiency in planning for retirement account distributions to your beneficiaries.
ARE THERE ANY OTHER DISTRIBUTION OPTIONS OTHER THAN A 10 YEAR PAYOUT?
Yes, use a charitable remainder trust. A Charitable Remainder Trust is one in which there is a series of distributions to the grantor or their designated beneficiary (typically their family members) retains an income interest for either a term of years (not to exceed 20 years) or their lifetime, and then at the end of that term the trust principal is then distributed to a qualified charitable organization(s).
If the current beneficiary is old enough, the current trust distributions may be paid to them for their lifetime; otherwise, it is paid for a term of years, not to exceed twenty (20) years. There are two typical situations in which Charitable Remainder Trusts are used for reducing tax consequences in a transaction.
Converting a highly appreciated, low income producing asset into a current cash flow; or
Receiving a tax deferred asset upon the owner’s death, and stretching out the distributions over a period of time for a beneficiary.
What makes the charitable remainder trust work for tax reduction purposes is that because the remainder beneficiary is a charitable organization, the trust itself is treated as a charitable organization. This means that when an asset is given to the charitable trust, and the grantor is still alive, the grantor qualifies for a current income tax deduction on their income tax return based upon the current net present value of the gift to the charity. If the grantor is deceased, and the charitable remainder trust is receiving the proceeds from an IRA or other qualified asset, the grantor does not get a charitable deduction, but the trust does not pay any income tax on the distribution that it receives. In order to qualify for the favorable tax treatment, the following tests must be met:
The trust is irrevocable;
The retained income interest must be in the form of a fixed payment (i.e. Charitable Remainder Annuity Trust) or a fixed percentage (i.e. Charitable Remainder Unitrust), paid out in not less than annual payments;
The income term of the trust can be a fixed period of years, not to exceed twenty (20) years, or for a beneficiary’s lifetime (however long that might be);
The remainder beneficiary must be a qualified charitable organization as defined in the Internal Revenue Code; and
The net present value to the charity must be at least equal to or greater than ten percent (10%) of the value of the assets used to fund the trust at the time the trust is funded.
For income tax purposes, the charitable remainder trust is in part a pass-thru entity, and in part an income trapping entity. What this means is that the trust does not pay any income tax on the sale of an asset, the distributions it receives from a retirement plan or an annuity, or the net income it generates. To the extent that the trust has income, however, it does pass that income, in kind, to the beneficiary, but only as the beneficiary actually receives it.
An example of the use of this trust upon the death of a person with a sizable IRA might look like the following: If they have an traditional IRA worth $100,000, and were leaving it their child or children, the children now only have the option of a lump sum distribution, or to stretch out the withdrawals over a ten (10) year period. Every dollar that is distributed from the IRA will be taxed as ordinary income. If the child or children has taxable income before the distribution of $50,000, they are in a 22% marginal tax bracket for Federal income tax purposes, and a 3.465% marginal tax bracket for State income taxes, the children would only keep a little less than 75% of each distribution, after the payment of income taxes. If the child or children has taxable income before the distribution of $100,000, they are in a 24% marginal tax bracket for Federal income tax purposes, and a 3.96% marginal tax bracket for State income taxes, the children would only keep approximately 72% of each distribution, after the payment of income taxes.
2020 Federal Tax Rates:
For Single Individuals, Taxable Income Over
For Married Individuals Filing Joint Returns, Taxable Income Over
For Heads of Households, Taxable Income Over
2019 State of Ohio Income Tax Rates:
Ohio Taxable Nonbusiness Income Over
Ohio Taxable Nonbusiness Income Up To
Plus % on portion of income above amount in column 1
If that same $100,000 was distributed to a Charitable Remainder Trust, the trust would pay out a fixed percentage of the assets each year, for the term of the trust. Typically, we might set this up with a payout rate of approximately 11%, for a 20 year term. Thus, in the year of death, when the IRA is paid into the charitable remainder trust, the children/beneficiaries would receive $11,000 in the first year. On January 1, the trust would be revalued to take into account any trust expenses, and trust income and growth. If on January 1, the trust is then worth $98,000, then the distribution for the following year would be $10,780. This would repeat itself for all 20 years of the trust. At the end of the 20 years, the remaining trust principal, if any, would then be distributed to the charitable beneficiaries.
There are several advantages to the Charitable Remainder Trust. First, the trust will run for the full 20 years. The children cannot break the trust to get future amounts early. After the first $100,000 is distributed from the trust (usually in year 9 of the trust), all future distributions will be taxed as capital gain distributions and qualified dividends, and little or no ordinary income. Thus, the amount of income tax paid on these distributions will be much less than if they were all ordinary income, such as would occur with distributions from a traditional IRA. Lastly, the net present value of a 20 year Charitable Remainder Trust is about the same as a 10-year stretch out from a traditional IRA, assuming similar growth rates, and combined income tax rates of 25%. If the IRA is withdrawn more quickly than the 10 years, or the beneficiaries are in higher income tax brackets, then the present value of the distributions from the Charitable Remainder Trust for the beneficiaries is higher than the value of the 10 year stretch-out. In addition to the equality or in-equality of the net present values, the Charitable Remainder Trust will allow for a substantial gift to qualified charitable organizations of your choice, rather than the State of Ohio and IRS.