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George F. Bearup, J.D. Senior Legal Trust Advisor

26-Aug-19

Replacing Stretch IRAs with a Charitable Remainder Unitrust

The House of Representatives passed the SECURE ACT in late May, which would eliminate what is called the stretch IRA. A stretch IRA is a popular planning technique because it allows the beneficiary to take distributions from an inherited IRA or qualified plan account over the beneficiary’s life expectancy. Consequently, the recognition of the taxable income from an inherited IRA or qualified plan account could be stretched over the beneficiary’s life expectancy, in effect deferring income tax while permitting the remaining IRA assets to continue to grow in an income tax deferred environment.

While the Senate has yet to act on the SECURE ACT, it is anticipated that it will be adopted as it has considerable bipartisan support, including that of President Trump. Therefore, the SECURE ACT and its replacement of a stretch distribution with a shorter mandatory ten-year payout out is likely to become law before the end of this calendar year.

Assuming that the SECURE ACT and its elimination of the stretch IRA becomes the law, many individuals who previously adopted see-through trusts that are designed to exploit the stretch distributions from IRAs or qualified plan accounts over the oldest trust beneficiary’s life expectancy should be reviewed.  If the IRA made payable to the see-through trust must be emptied within ten years, it may no longer make sense to name the trust as the IRA beneficiary. On the bright side, this expected tax law change means that advisors and trustees will no longer have to struggle with the byzantine IRS rules that deal with accumulation see-through trusts and the attempt to identify which trust beneficiaries are only mere potential successor beneficiaries to be ignored in identifying the oldest individual trust beneficiary.

However, if income tax deferral with a stretch IRA payable to a see-through trust was not the only motivation to use a see-through trust, a charitable remainder unitrust (CRUT) should be considered as an alternative if the stretch IRA is effectively eliminated. A CRUT is a tax-exempt entity under the Tax Code. [IRC 664(1) (C).] The trust could also be a charitable remainder annuity trust (CRAT) but the fixed annuity paid to the trust beneficiary would not adjust to inflation over the years the trust exists.

  • The CRUT must pay at least 5% of its assets to the designated beneficiary. [IRC 664(d) (2).
  • The duration of a CRUT is for the designated CRUT beneficiary’s lifetime, or 20 years, whichever is longer. [IRC 664(d) (2) (D).]
  • Due to the ordering rules that apply to charitable remainder trusts, the distributions from the CRUT to the CRUT beneficiary would be ordinary income and taxed to the beneficiary as such, which is no different when the distributions were made to the beneficiary from a see-through trust.

Accordingly, if the goal of the see-through trust was to protect a spendthrift beneficiary for his/her lifetime with the trust mechanism, the CRUT would accomplish the same goal, in effect stretching distributions from the CRUT over the beneficiary’s lifetime. The difference between the CRUT and the see-through trust is that the inherited IRA would not have to be maintained as a separate investment of the CRUT trustee. Rather, the IRA would be immediately paid to the trustee of the CRUT on the IRA owner’s death. Since the CRUT is a tax exempt entity, the CRUT would not have to pay immediately an income tax on the inherited IRA’s distribution to the CRUT. Only as distributions were made from the CRUT to its beneficiary would that taxable income then be recognized by the beneficiary as ordinary income.

Often see-through trusts are named as beneficiaries of retirement accounts to shelter the retirement assets from the beneficiary’s creditor claims. If the beneficiary simply inherited the IRA, that inherited IRA was not an exempt asset if that beneficiary later filed for bankruptcy. Clark v. Remaker, 134 S.Ct. 2242 (2014). If the retirement assets were alternatively paid to a see-through trust for the benefit of the beneficiary, then the trust’s spendthrift limitation would protect the retirement assets from the beneficiary’s creditors. The same applies if a CRUT is named as the beneficiary of the inherited IRA or qualified plan account, since the CRUT also uses a spendthrift limitation to protect the retirement assets from the beneficiary’s creditors or in  a subsequent bankruptcy proceeding.

A CRUT can provide for a series of sequential beneficiaries. The only requirement is that the present value of the CRUT remainder interest be at least ten percent of the present value of the trust’s assets when the IRA owner dies. If an IRA is directly inherited, the primary beneficiary is often required, as they age, to receive accelerating income distributions (RMDs) which, in turn, deplete the retirement fund for secondary or contingent beneficiaries. A CRUT does not require such accelerating distributions that can deplete the CRUT’s corpus, thus, preserving the CRUT corpus for success beneficiaries.

For example, a CRUT could be established on the decedent’s death to provide for his/her surviving spouse. Rather than accelerate distributions from the IRA if the survivor is older and required to take his/her own required minimum distributions, if the CRUT is named as the beneficiary of the decedent’s IRA, then the survivor would not have to take possibly as large a taxable distribution when compared to a spousal rollover with its own RMDs. By naming the CRUT as the beneficiary, which provides for the survivor’s lifetime benefit, with children named as contingent CRUT beneficiaries, e.g. a 20-year CRUT, payments of the ordinary income from the CRUT would not be accelerated during the survivor’s lifetime compared to the rollover situation.

Naming a CRUT as the designated beneficiary of an IRA also makes sense if the IRA owner has charitable objectives on his/her death. The CRUT also provides a charitable estate tax deduction equal to at least ten percent (10%) of the present value of the retirement account at the time of the IRA owner’s death. That may not provide much, if any, tax savings benefit with the currently enhanced federal estate tax exemption ($11.4 million per individual exemption). However, if the Bernie Sanders’ tax proposals gain traction in the coming years (he proposes a federal estate tax exemption of only $3.5 million per person) then the ability to obtain a federal estate tax charitable deduction may provide added incentive to name a CRUT as the designated beneficiary of a decedent’s IRA or qualified plan account.

Sometimes a CRUT can exploit the 20-year maximum duration requirement. For example, a CRUT could be established to pay for the decedent’s grandchild’s education. The income distributed for that term of years could coincide to support the grandchild’s college education expenses. This type of CRUT could also be a Net Income Plus Make-up CRUT (or NimCRUT). Under the NimCRUT, the CRUT trustee is required to distribute the fixed percentage amount of the CRUT’s fair market value each year, or the actual income earned by the CRUT, whichever is less. It permits the CRUT trustee to go back later and make up prior deficient payments if in the later years the CRUT earns more than the fixed percentage income payment obligation.

There are admittedly limitations to the use of a CRUT as an alternative to a see-through trust stretch IRA. As noted, in order to qualify as a CRUT, a tax exempt entity must be assured to receive when the lifetime beneficiary dies at least 10% of the present value of the retirement account that is made payable to the CRUT; if the IRA owner is not charitably inclined, then it is not a good option. In addition, the CRUT’s payment schedule is much more inflexible than an accumulation see-through trust; at least 5% of the CRUT’s assets must be distributed from the CRUT each year to the CRUT’s lifetime beneficiary. The rules that govern the CRUT mandate the fixed percentage amount must be paid directly to the CRUT lifetime beneficiary- no ‘hold-backs’ by the CRUT trustee are permitted if the lifetime beneficiary runs into difficulties or creditor problems. Moreover, the distribution from the CRUT trustee must be directly to the CRUT’s lifetime beneficiary; a CRUT does not permit a distribution by the CRUT trustee to or for the benefit of the beneficiary.

To conclude, while the old stretch IRA may soon be going away, it is possible to gain many of the same benefits of a stretch IRA paid to a see-through trust by naming a CRUT as the designated beneficiary of an inherited IRA. Taxable income can be deferred over the beneficiary’s lifetime or 20 years, to minimize the taxation of that income. The reinvested IRA distribution to the CRUT can be used to generate capital gain income that might be taxed at a lower rate, but only after the ordering rules associated with the CRUT tax all of the IRA distribution to the CRUT as ordinary income.