The value of a tax-deferred retirement account in its death beneficiary’s hands is maximized when the beneficiary stretches distributions out over his lifetime using required minimum distributions (RMDs). But, many beneficiaries fail to take advantage of stretch distributions. Instead, the account is emptied out soon after it’s inherited. That may be due either to a lack of understanding about the value of taking stretch distributions or to perceived financial exigencies.
Even when stretch distributions are employed, the amounts are uneven from year to year. Distributions are relatively small in the early years and grow quite large later. For example, a 50-year-old taking his initial RMDs from an inherited individual retirement account must withdraw about 3 percent of the IRA’s value as of the beginning of the year; at age 75, nearly
11 percent must be withdrawn; at age 80, nearly 24 percent. In some cases, the inheritor will outlive the stretch.
Use of Trusts
A trust can be established to regulate access to a substantial IRA, but accumulating IRA distributions in a taxable trust often means incurring income taxes at top rates. Trusts pay both the 39.6 percent federal income tax rate and the 3.8 percent Medicare tax on net investment income when taxable income reaches about $12,000. Trust provisions needed to correctly accommodate retirement benefits are extensive, as evidenced in “The Zen of Drafting See-Through Trusts” by Steven E. Trytten, in this issue, p. 45. Such provisions can pose both drafting and administrative risks.
Many trusts are structured to pay only income to the trust’s lifetime beneficiary. The settlor may not understand that retirement account distributions aren’t automatically treated as trust income. Many states have adopted the Uniform Principal and Income Act (UPAIA). UPAIA Section 409 generally provides that 10 percent of such distributions are income, while
90 percent are principal. That means, for example, that if a $1 million IRA distributes a $30,000 death benefit to a trust, the trust’s income beneficiary will be entitled to an income distribution of $3,000—a mere 0.3 percent of the IRA’s value.
There’s a special UPAIA income definition rule for surviving spouses mandating income earned within a retirement account is trust income when an estate tax marital deduction has been claimed under either a so-called “qualified terminable interest property election”1 or a so-called “power of appointment marital trust.”2 Of course, trust drafters can add a provision that overrides the UPAIA rule. For example, the trust may provide that the trustee, in the trustee’s discretion, shall determine the amount of income from retirement account distributions received by the trust.
Advantages of CRT
Leaving an IRA to a charitable remainder trust (CRT) that goes into effect on death has some advantages.3 (For more information on CRTs, see “CRT Basics,” p. 40.) In addition to regulating distributions from the retirement account to the trust beneficiary, a CRT can deliver stable annual distributions to one or more non-charitable beneficiaries, such as a surviving spouse or a child. All CRTs provide charitable benefits. When all payments to non-charitable beneficiaries end, the CRT terminates and pays over to one or more charities chosen by the settlor. The value received by non-charitable beneficiaries from a CRT can compare favorably to carefully managed stretch retirement account distributions.
The best charitable remainder unitrust (CRUT) solution is a 5 percent annual payout percentage (the CRUT minimum). A CRUT payout percentage below the CRUT’s expected total rate of return on its investments will provide a stable lifetime payment stream to the non-charitable beneficiary. For example, a CRUT that can be expected to earn 8 percent per year and that pays its non-charitable beneficiary 5 percent of the CRUT’s value each year might be expected to provide stable, or even increasing, payments. Such a CRUT holding $1 million of trust corpus will distribute $50,000 to its individual beneficiary in the first year. That distribution amount is likely to slowly increase over time because the trust is earning slightly more on its investments than is being distributed to the individual non-charitable beneficiary. But, investment volatility can frustrate that expectation, at least in some years.
On the other hand, while charitable remainder annuity trust (CRAT) payments are fixed, CRATs aren’t permitted to allow adjustments for annual increases to a cost of living index, such as the U.S. consumer price index.
It doesn’t have to be all CRT or none. If, for example, an IRA owner wishes to grant her child direct access to $200,000 of a $1 million IRA, yet wishes to leave the rest to a CRT that makes quarterly payments to the child, she could craft the IRA’s beneficiary form to leave 20 percent of the IRA to her child and 80 percent to the CRT.
Here’s an advantage CRTs have: Neither the income tax nor the Medicare tax applies to retirement account distributions accumulated by a CRT. Avoiding taxes on accumulated retirement account distributions increases lifetime income from a CRUT (but not from a CRAT) during the trust term.
A CRT can also help maximize the value of the estate tax applicable exclusion amount. Each estate is granted an applicable exclusion amount that provides shelter from estate tax in the form of a credit against the tax. The applicable exclusion amount allowed to a decedent’s estate is the sum of the basic exclusion amount ($5.34 million for estates of decedents dying during 2014) and, if present, the unused exclusion amount of the last spouse to predecease the decedent.4
Although the income tax basis of a decedent’s property is, generally, adjusted to fair market value as of date of death, taxable IRAs receive no such adjustment. Instead, income taxes must be paid on IRA distributions after death. Roth IRAs are an exception, not because of basis adjustment but because Roth IRA distributions generally aren’t taxable.
Because income taxes will be payable on inherited retirement account distributions other than Roth accounts, sheltering an IRA from estate taxes through the mechanism of the decedent’s applicable exclusion amount generally isn’t desirable. Here’s how naming a CRT as IRA beneficiary can help. When a CRT is payable to a surviving spouse, the estate tax marital deduction applies to part of the CRT’s value, and the estate tax charitable deduction applies to the rest.5 The combination of the marital and charitable deductions eliminates the CRT from the amount subject to estate tax. That avoids all estate taxes on the IRA, preserving the applicable exclusion amount. For estates that won’t pay estate taxes, the deceased spousal unused exclusion (DSUE) amount is maximized.
When the CRT isn’t payable to a surviving spouse, the charitable deduction still applies—meaning some part of the IRA’s value will escape estate taxes and avoid absorbing DSUE. It would be best for estate-planning documents to provide that estate taxes will be payable from property other than the IRA.
Paying IRA benefits to a CRT will eliminate the hazard of legislative changes to inherited IRA stretch rules. There have been legislative proposals by the Obama administration and some in Congress to force all inherited retirement accounts to empty out in five years, except when the beneficiary is a surviving spouse, is disabled or when other limited exceptions apply.
A 3.8 percent tax is imposed on certain types of unearned income, including interest, dividends and capital gains typically earned in trust investments portfolios.6 Medicare tax regulations provide that CRT distributions carry the distributing CRT’s unearned income out to the CRT beneficiary. Retirement account distributions don’t constitute unearned income for Medicare tax purposes.7 Retirement account distributions to a CRT should be kept to RMDs to minimize the amount of the CRT’s non-retirement account investments that will produce unearned income that the CRT can be deemed to distribute to its beneficiary.
CRT annuity payments aren’t annuities of a type subject to the Medicare tax.8 Rather, lifetime payments to the non-charitable beneficiary potentially carry out unearned income earned within the CRT. The tiered system of CRT distributions generally applies to unearned income. As long as the CRT is holding accumulated taxable retirement accumulations, distributions to the CRT’s lifetime beneficiary will include ordinary income attributable to the retirement account, interest and dividends. Capital gains won’t be taxed to the CRT’s lifetime beneficiary until after the ordinary unearned income has all been distributed.
Medicare taxes will be of less consequence to a trust beneficiary than to a taxable trust because the trigger point for individuals is always higher than for a trust: $200,000 for unmarried individuals; $250,000 for married couples; and $125,000 for married individuals filing separately.
1. Internal Revenue Code Section 2056(b)(7).
2. IRC Section 2056(b)(5). See also Steven B. Gorin and Michael J. Jones, “Rescue Plans for IRAs Left to Marital Trusts,” Trusts & Estates (November 2008), at p. 42.
3. Charitable remainder trusts (CRTs) are authorized under IRC Section 664.
4. IRC Section 2010.
5. A charitable deduction for the remainder interest is provided for in IRC Section 2055(e)(2). Marital deduction for the lifetime interest of the surviving spouse is provided for in IRC Section 2056(b)(8). Note that the interest of the surviving spouse isn’t qualified terminable interest property within the meaning of Section 2056(b)(7), so it shouldn’t be reported as such on the decedent’s estate tax return.
6. IRC Section 1411.
7. IRC Section 1411(c)(5) provides that the term “net investment income” shall not include any distribution from a plan or arrangement described in Sections 401(a), 403(a), 403(b), 408, 408A or 457(b). See also Treasury Regulations Section 1.1411-8.
8. Treas. Regs. Section 1.1411-3(b)(iii) excludes CRTs.