“Save for your retirement!” is the mantra for many of us. So we work and we save, building up the bulk of our wealth in our retirement plans, including IRAs. And for years, estate planners relied on the “stretch provision” for inherited IRA beneficiaries when designing estate plans for clients. This provision allowed beneficiaries who inherited IRAs to stretch distributions over their lifetimes. IRA owners sometimes named trusts as IRA beneficiaries. And, as long as the estate planner was aware of this, the trust could also qualify for stretch treatment, which was the ultimate goal.
When the SECURE Act was passed in December 2019, the landscape of estate planning with IRAs changed. Under the new rules, the owner doesn’t have to take a required minimum distribution (RMD) until she is 72 versus 70 1/2 as before. But at what price? Unless the beneficiary is an Eligible Designated Beneficiary, as defined in the Act, the IRA must be fully paid out by the end of the 10th year following the owner’s death. In other words, the “stretch provision” is no longer available.
This new provision could cause a tax catastrophe (remember: IRA distributions are taxed at ordinary income tax rates) if certain planning techniques under the old laws are still in place.
Consider Onie. He has two children—Ben and Bonnie—and his main asset is an IRA with a current balance of $1 million. Onie worked with his estate planning lawyer and named his trust as the beneficiary of his IRA. The lawyer made sure the trust had certain language so the IRA could be paid out over the life expectancy of the eldest child, or about 40 years.
Additionally, the trust states, “The Trustee shall withdraw from any Inherited Retirement Account only the Required Minimum Distribution for such Retirement Account each year and shall pay all such amounts, net of applicable trust expenses, in equal shares to Ben and Bonnie as soon as administratively practicable.”
In this scenario, there is no required amount until the 10th year. The trustee’s hands are tied so (1) Ben and Bonnie cannot access any of the IRA funds until the 10th year, and (2) Ben and Bonnie must access ALL of the funds within one tax year so that each will increase annual income by $500,000. And in addition to being in the highest income tax bracket, this might also cause disastrous ramifications for Medicare, which is tied to an individual’s annual income.
Options to Mitigate the Tax Catastrophe
Most importantly, if he’s sure that a trust is necessary (e.g., Ben is a spendthrift or Bonnie has asset protection issues), he must amend the trust to give the trustee discretion to withdraw amounts in excess of the RMD amount. If a trust is not necessary, he could name Ben and Bonnie as individual beneficiaries of the IRA.
Onie has other options, too. If he is in a lower tax bracket than Ben and Bonnie, he might consider converting some of his traditional IRA to a Roth IRA. The Roth IRA still has the 10-year distribution rule, but the distributions are not taxed to the beneficiaries. Onie will be responsible for paying taxes on the conversion amount.
If either of Ben or Bonnie is an Eligible Designated Beneficiary, he and/or she can get stretch treatment under the Trust rather than be subject to the 10-year payout rule.
Who Qualifies As an Eligible Designated Beneficiary?
A person must be a/an:
- Surviving spouse;
- Disabled person;
- Chronically ill person;
- Individual within 10 years of the deceased IRA owner’s age; or
- A minor child of the deceased IRA owner.
If Ben or Bonnie is an Eligible Designated Beneficiary due to disability or chronic illness, Onie should discuss this with his estate planning lawyer. There are very specific requirements that must be met in order to get the desired stretch treatment.
Lifetime Stretch Even for Non-Eligible Designated Beneficiary
Maybe the most generally palatable and applicable way to continue stretch treatment for IRA beneficiaries is to use a Charitable Remainder Trust (CRT). There are Charitable Remainder Annuity Trusts (CRATs) and Charitable Remainder Unitrusts (CRUTs). A CRAT pays the same annual amount to the income beneficiaries. A CRUT pays an amount equal to a certain percentage of the annual fair market value to the income beneficiaries.
Onie can name Ben and Bonnie as the CRT’s income beneficiaries and his favorite charity as the CRT’s remainder beneficiary. The CRT pays the income beneficiaries for a term of years or their lifetimes, thus attaining stretch treatment when a 10-year payout may otherwise be required! The benefits of such an arrangement include income tax benefits for Onie or his estate and stretch treatment for Ben and Bonnie.
The downsides include less flexibility should a beneficiary need additional funds. Also, this arrangement does not allow for benefiting multiple generations since the corpus must be paid to the charity at the expiration of the income term. However, a CRT could save beneficiaries thousands of dollars in taxes and satisfy an owner’s philanthropic desires.
While individuals’ mantra has been “Save for retirement!”, estate planners’ mantra has been “Get stretch treatment for inherited IRA beneficiaries!” The SECURE Act made that difficult, if not impossible, for most beneficiaries. But using a CRT may be the backdoor we’ve been searching for. Let us know if we can help you find the best strategies for you.