Many people own a trust as part of their estate plan. Prior to 2020, it was common to have the beneficiary of an IRA be a trust. A See-Through Trust allows individuals to pass IRAs, via a trust, to their trust beneficiaries.
There are several reasons to name a trust as the beneficiary of an IRA. The most common is to avoid a lump sum disbursement while maintaining control post death.
There are two types of See-Through trusts that qualify as designated beneficiaries: Conduit Trusts and Accumulation Trusts.
Conduit Trusts are designed to force out all IRA Required Minimum Distributions (RMDs) to the trust beneficiaries. Prior to the SECURE Act (which became law on December 20, 2019), when an account owner died, the trust would distribute RMDs ”stretched” over the beneficiary’s life.
The SECURE Act eliminated the ”stretch” and instituted a new ten-year rule unless the beneficiary qualifies as an Eligible Designated Beneficiary.
The Planning Problem
The SECURE Act created multiple obstacles for estate planning. Two problems with Conduit Trusts occur due to the language in the trust documents:
Scenario 1 – Verbiage that states that the Trustee shall withdraw RMDs and is authorized to make distributions in excess of RMDs
In a Scenario that could have one of two negative outcomes, this could be the better choice between the two. While the account still needs to be liquidated by the end of the tenth year, the Trustee can help manage tax consequences by controlling the distributions over the following decade.
Scenario 2 – Verbiage that states that the Trustee shall withdraw only RMDs
It’s possible that the Conduit Trust was set up to protect your beneficiary from creditors, a future divorce, or themselves because they are spendthrifts. But the SECURE Act throws a wrench in these plans.
Not only does the Act negate the reason you created the trust in the first place, it also raises a new tax concern. Instead of being able to spread the beneficiary’s tax liability over ten years, like in Scenario 1, the beneficiary in Scenario two will end up with one large tax bill in the tenth year.
Scenario 1 – You died with $1 million in an IRA. Your Trustee disbursed ten equal payments to your married beneficiary. Simplifying the tax code and assuming a 22 percent tax bracket, your beneficiary would owe $220,000 in federal income taxes spread over ten years.
Scenario 2 – Because of the verbiage of your Conduit Trust, the Trustee is not able to make any discretionary distributions. Using the rule of 72 (The Rule of 72 is defined as a shortcut or rule of thumb used to estimate the number of years required to double your money at a given annual rate of return, and vice versa) and assuming a seven percent return, over ten-years, your $1 million IRA doubled. At the end of the tenth year, the Trustee distributes the required minimum distribution and instead of paying 22 percent on $1 million, the beneficiary pays 37 percent on $2 million. This equates to a tax bill of $720,000 in a one-time payment.
If you created an estate plan prior to 2020 with the intentions of using the stretch IRA provisions, you need to update your estate plan. You have time to make adjustments if your beneficiaries don’t qualify as Eligible Designated Beneficiaries.
There are additional planning issues I didn’t cover in this blog that should be considered. Work with your estate planning attorney and financial advisor to ensure that your estate plan reflects the recent changes resulting from the SECURE Act that might affect your final wishes.
While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. Any opinions are those of the author, and not necessarily those of Raymond James. The case studies presented are for illustrative purposes only. Individual cases will vary. Any information is not a complete summary or statement of all available data necessary for making an investment or financial decision and does not constitute a recommendation. Prior to making any decision, you should consult with the appropriate professional about your individual situation. RMD’s are generally subject to federal income tax and may be subject to state taxes. Consult your tax advisor to assess your situation. The Rule of 72 is a hypothetical illustration and is not intended to reflect the actual performance of any particular security. Future performance cannot be guaranteed, and investment yields will fluctuate with market conditions. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. All investments are subject to risk. There is no assurance that any investment strategy will be successful.