The Demise of the “Stretch” IRA: How Does the SECURE Act Affect Trust Planning for Retirement Benefits? A Step-by-Step Approach to Offer Your Clients a TaxWise Solution

The Demise of the “Stretch” IRA

The Setting Every Community Up for Retirement Enhancement (SECURE) Act was enacted on January 1, 2020. This is the most significant retirement plan legislation since the Pension Protection Act of 2006. As a result, we wanted to share with you what has changed and options available for advisors to discuss with their clients.

This article will focus on estate planning techniques that are now available for retirement plan assets because the SECURE Act essentially requires all IRAs, Roth IRAs, and qualified plans to be distributed within ten years of the owner’s death. The option to “stretch” the required minimum distribution payments is now available only to a limited class of eligible designated beneficiaries:

• Spouses
• Minor children of the decedent (note: minor children who are eligible will become non-eligible when they reach the age of majority)
• Disabled beneficiaries
• Chronically ill beneficiaries
• Individuals not more than ten years younger than the IRA owner

Beneficiary Designation Options

In light of the new legislation, what options are available and who should one choose as beneficiary?

Spouse. A spouse will become the owner, and Required Minimum Distributions (RMDs) commence at the mandatory at age of 72. A spouse should also designate beneficiaries of the inherited IRA.

Non-spouse/child. The non-spouse beneficiary must withdraw the entire balance over ten years. Exceptions are made for “eligible designated beneficiaries,” and this minority group of beneficiaries can still use the pre-2020 rules allowing a life expectancy “stretch” from an inherited IRA. One question that arises is whether taking the distribution forces the beneficiary into a higher tax bracket. Perhaps the most important question of all is “how does an IRA owner now leave his or her retirement benefits under the oversight of a trust to support the needs of various loved ones?”

Charity. One can designate a charity as the beneficiary of the IRA, but this tactic circumvents the decedent’s children or grandchildren as beneficiaries. Are there charitable options that can provide income to heirs and in effect “stretch out” the payments and the tax liability for them? Let’s look at a viable option that accomplishes three key planning objectives:

• Allows all beneficiaries the ability to “stretch” inherited retirement benefits.
• Mitigates the loss of retirement benefits to taxes.
• Provides a charitable legacy for an IRA owner, while not reducing the after-tax value of his or her retirement assets left to children or other loved ones.

Traditional Trust Planning with Retirement Assets

Because retirement assets are typically the largest asset in an individual’s estate, special planning is required to ensure beneficiaries inherit these assets in the most optimal way, customized for each beneficiary. Before 2020, retirement assets could be payable to a “see-through” trust. These IRA trusts were known as either “conduit” trusts or “accumulation” (or discretionary) trusts.

Under the old rules, if the IRA trust qualified as a see-through trust, the trust beneficiaries were treated as if they were named directly, and the “stretch” payout was permitted. With a conduit trust, RMDs were paid from the inherited IRA to the trust and distributed to the trust beneficiaries annually. The beneficiaries paid tax on the RMDs at their own tax rate.

With an accumulation trust, the trustee had the discretion to decide whether to pay out the RMDs immediately to the trust beneficiaries or instead retain the assets in the trust to preserve the funds. Unfortunately, when the RMD funds were kept in the accumulation trust, they were taxed to the trust at the high trust tax rates instead of being taxed to the beneficiaries directly.

In 2020 and beyond, the problem with the conduit trust is there are zero RMDs, and at the end of the ten years, the entire balance in the inherited IRA would be paid out to the beneficiaries. This results in no funds remaining protected in the trust after the ten years and leaves recipients with a mega tax bill.

If an accumulation trust is a beneficiary, then again, all of the inherited IRA funds would have to be paid to the trust by the end of the ten years. Since this is an accumulation trust, the trustee does not have to pay out all of the funds to the trust beneficiaries, so the funds could remain in the trust and be protected, but at a cost. After those ten years, the entire trust would be taxed at federal trust tax rates, which, in 2020, is 37% for income over $12,950.

Testamentary Charitable Remainder Trust

For donors who wish to provide for charity with an estate gift and establish a reliable income stream to one or more heirs, using retirement plan assets to fund a testamentary charitable remainder trust (TCRT) can be an effective way to accomplish both goals. In a series of positive private letter rulings, the IRS determined that such a transfer would not trigger federal income tax on the entire balance. Instead, the income tax is applied only as the income is distributed individually to the income beneficiaries of the TCRT.

At the passing of the IRA owner, all the money is transferred from the IRA to the TCRT, and no income tax is paid. Before the charity receives the funds, the donor’s loved ones will receive income for the rest of their lives based on the reinvestment of the entire value of the IRA.

Ideally, the IRA owner interested in this technique will leave the account directly, making the TCRT the beneficiary. Leaving the IRA first to a living trust, then making distributions directly to charity or to a charitable remainder trust requires adroit drafting to ensure an optimal income tax result.

The Economics of the Testamentary CRT

When beneficiaries who inherit an IRA are between the ages of 25 and 45, there is a high likelihood that the amount the beneficiaries receive in life income payments from a TCRT is actually equal to or greater than if there was no TCRT and the beneficiary deferred for ten years and invested the after-tax amount for the rest of their lives. (See Appendix A)

For donors who have significant charitable intent, a beneficiary with an average life expectancy of 20 years is still a viable option, but as we get down to a ten-year life expectancy of the beneficiary, the economics indicate the beneficiary would have been better off inheriting the IRA and deferring for the ten-year period.

Combining the IRS-Approved Sample Trust Instruments for the Most Optimal Testamentary CRT Document

In 2005, the IRS approved sample trust instruments for charitable remainder unitrusts, which are much more likely to be utilized than annuity trusts. Unfortunately there is not one specific sample document that completely covers leaving a retirement account directly to a qualified TCRT through a beneficiary designation. Rev Proc. 2005-56 through 2005-59 can be used accurately if the TCRT will be established from the donor’s dispositive document, such as a last will or living trust. However, these specimen documents must be slightly amended if the TCRT will be funded directly through a beneficiary designation.

Case Study

In 2020, Vivian Smith, age 80, is revising her estate plans for her son, Tom, age 45. Unfortunately, Tom is going through a divorce at this time and has been between jobs. Vivian’s largest asset is her IRA, and she named Tom as the IRA’s only designated beneficiary. When Vivian passes away in 2025, the value of Tom’s inherited IRA is $1,000,000. Let’s look at three potential outcomes that Vivian can control as she reviews her estate plans in 2020. (See Appendix A for assumptions)

Scenario One: Assume first that Tom is not financially sophisticated, and in 2025, he immediately withdraws the funds in the IRA account and pays income taxes at an effective rate of 45% (federal and state combined). His net after-tax value is $571,175. Even worse, assume that Tom has serious debts from his divorce, and his creditors are able to take the entire retirement plan before he receives any benefit.

Scenario Two: Second, assume Tom clears up his creditor problems on his own by 2025 and is also wise enough to maximize his deferral, so he instead waits ten years and then withdraws the entire account. Assuming that the rate of investment return inside the inherited IRA is 7% and Tom’s after-tax rate of return is 3.9%, his after-tax net distribution is $1,081,934, which is certainly an improvement compared to scenario one. However Tom still owes a significant amount of income tax in year ten.

Scenario Three: Finally, assume that back in 2020, Vivian establishes and names as the IRA’s beneficiary a testamentary charitable remainder unitrust (TCRUT). The TCRUT pays Tom 5% of the trust’s value each year for life. Assuming that the TCRUT earns an annual return on investment of 7%, Tom’s payments should increase over time and the remainder is designated for Vivian’s church at Tom’s passing

Vivian decides that she wants the trustee to have the “sprinkling” authority to allocate the income between the beneficiaries, so she makes both Tom and her church income beneficiaries. If Tom makes poor life choices, the trustee can decide to allocate income to the church instead of Tom. However, if Tom remains employed and drug free, he can expect to continue to receive the full 5% of the payments each year of his life.

If Tom lives to age 80, the after-tax value of his income payments from the time the TCRUT was funded will be $2,053,424. This result is a significant improvement over scenario one and almost the same after tax result as scenario two. The major advantage of scenario three is the value of the remainder interest for her church at Tom’s demise is $166,345. While Vivian initially did not have any intention of leaving any of her IRA to charity, she is pleased that she will support her church. Vivian will also provide a lifetime “stretch” of payments to Tom and protect the asset from any creditor issues he has.

Conclusion

Those who are willing to “pledge” part of their retirement assets to charity can still provide the “stretch IRA” experience for their adult children and also leave a charitable legacy. For affluent families large enough to owe federal estate tax, a transfer of retirement plan assets into a charitable remainder trust is eligible for an estate tax deduction in addition to the income tax deferral for beneficiaries to “stretch” the payments over their lifetimes.

For those who have designated a trust as the beneficiary of their retirement accounts, they should review the drafting of that trust with an estate planning attorney to understand the implications of the SECURE Act. With careful attention by an estate planning attorney, a trust can be designed to hold an IRA that need not distribute all IRA withdrawals within ten years and may instead accumulate those withdrawals (but at higher trust income tax rates). For those with some charitable intent, they can establish a trust that can pay income for the lifetime of their children, or other loved ones, at their own (likely lower) income tax rates.

If you are interested in offering this solution to your suitable clients, consider the following steps:

1. Discuss with your clients the concept of a TCRT as a way to preserve a lifetime “stretch” for their loved ones.
2. Contact our office for the tools you will need to implement the plan:
   • Checklist with sample documents.
   • Financial illustrations to present the positive economics of preserving the “stretch” using a TCRT.
3. Determine whether your client will leave their retirement account to the TCRT directly through a beneficiary designation or through their dispositive documents. The former is the simplest approach in most circumstances. If the plan will be fulfilled through a beneficiary designation, consider the following steps:
   • Contact the account custodian for a “change-of beneficiary” form.
   • Complete all the blanks on the form that apply to the beneficiary-change request.
     • The designation should leave the account to the trustee for the benefit of a testamentary CRT. (e.g. “University of Florida Foundation As Trustee For the Benefit of “John F. Doe Testamentary Charitable Trust” dated _.”)
     • Sign and date the change-of-beneficiary form and mail it to the retirement plan custodian.
     • Send a signed copy of the trust to the retirement plan custodian.

With these steps in place, your clients can fulfill their philanthropic goals and allow their beneficiaries to inherit more and pay less in taxes.

Appendix A (Tom’s 3 Distribution Options from Vivian’s IRA)