Take-Away: Naming a charitable remainder trust (CRT) as the designated beneficiary of a decedent’s IRA or 401(k) account is a great way to avoid the technical complications of either a conduit trust or an accumulation trust, or even a QTIP Trust,  but it should be used only so long as the retirement account owner actually has philanthropic goals.

Background: A charitable remainder trust (CRT) is a Trust that meets the technical requirements of IRC 664. If the Trust meets those requirements the Trust is income tax exempt which provides the benefit. IRC 664(c)(1).

  • Basics: Generally, the CRT must pay out annual income to one or more noncharitable beneficiaries, such as the decedent’s spouse and/or children, either for the longer of (i) their lives or (ii) for a term of not more than 20 years. At the end of the lives or the stated term of the CRT the remaining assets are distributed to a charity selected by the retirement account owner.
  • No Discretionary Invasion Powers: The noncharitable beneficiaries are only entitled to receive a unitrust or annuity (or fixed dollar) amount; thus, there can be no provision that gives the CRT trustee the discretion to invade trust principal to meet the CRT beneficiary’s extraordinary needs.
  • Annuity Or Unitrust Payment: The annual payment to the noncharitable beneficiary must be either a fixed dollar amount, i.e.  a charitable annuity trust (CRAT),  or a fixed percentage of the of the value of the Trust’s assets, a charitable unitrust (CRUT.) If a CRUT is formed it must distribute at least 5% of its assets each year to the noncharitable beneficiary, but the distribution cannot exceed  50% of the CRUT’s assets.
  • Minimum Remainder Value: The value of the charity’s remainder interest in the CRT must be equal to at least 10% of the initial value of the assets that are transferred to the CRT. If the 10% ‘test’ is not met then it is not a qualified charitable remainder trust.
  • CRUTs Are More Flexible: A CRUT is more flexible than a CRAT because the CRUT can pay to the noncharitable beneficiary the unitrust percentage, or the net income of the CRUT if the income is less (called a NiCRUT.) Moreover, the CRUT can provide for makeup distributions to the noncharitable beneficiary in later years if the CRUT’s income exceeds the unitrust percentage amount for that calendar year (called a NimCRUT).  Also, with a CRUT additional assets can be transferred into the CRUT in later years, against which the percentage amount is applied to determine the annual distribution to the noncharitable beneficiary; in contrast, with a CRAT, no additional contributions can be made to the CRAT in later years. Because the CRUT pays a percentage amount to the noncharitable beneficiary each year, it is perceived to be a better hedge against future inflation. In contrast,  a CRAT pays the noncharitable beneficiary the same amount each year, regardless of future inflation and its impact on the purchasing power of the fixed dollar amount.

Benefits From Naming a CRT as Beneficiary of a Retirement Account: Two basic tax benefits can be derived when a CRT is named as the beneficiary of a decedent’s IRA or 401(k) account:

  • Income Taxes: The primary benefit to leaving a retirement account to a CRT on the owner’s death is that the retirement account assets are paid into the CRT with no income tax immediately payable. In contrast,  if an individual is named as the beneficiary of an IRA he/she must begin to take required minimum distributions each year, paying income taxes on those distributions from the inherited IRA. Moreover, the named individual beneficiary is free to take a lump sum distribution from the retirement account, which would expose the retirement plan distribution to marginally higher income tax rates, all that ordinary income being bunched into a single calendar year.
  • Repeal of the Stretch? The incidence of income taxation may become even greater if Congress repeals the stretch required minimum distribution rules and replaces it with a mandatory five year withdrawal period in which the retirement assets must be taken by the individual beneficiary, causing all of that taxable income in the retirement account to be bunched into a short period to time, and thus expose that ordinary income to marginally higher federal income tax rates. Directing the retirement benefits to a CRT is one way to avoid the impact of the possible repeal of the stretch
  • Noncharitable Beneficiary: If all of the assets are distributed from the retirement account to the CRT on the owner’s death, the noncharitable beneficiary can receive life income from the reinvestment of the entire amount of the retirement account- all dollars held in the CRT can be reinvested, since no dollars will be used to immediately pay  income taxes; thus, all the retirement account assets will go to work for the noncharitable beneficiary’s lifetime benefit. In some situations it can be expected that the noncharitable beneficiary of the CRT might receive more income distributions during their lifetime, in contrast to where they are named as the sole beneficiary of the retirement account taking required minimum distributions. But it is also true that an individual named directly as the beneficiary of a retirement plan will receive the entire benefit, not just the income from the benefit which is the result when the CRT is named as the retirement account beneficiary.
  • Estate Taxes: Another tax benefit associated with naming the CRT as beneficiary of a retirement account is that the decedent’s estate will be entitled to a federal estate tax charitable deduction for the value of the charity’s remainder interest in the CRT. This charitable estate tax deduction is calculated following the IRS’ actuarial tables and prevailing interest rates. As noted earlier, the charitable remainder interest of the CRT must be at least equal to 10% of the date-of-death value of the CRT, which is why most Trusts use a ‘word-formula’ to direct the decedent’s estate fiduciary  to fund the CRT at the owner’s death in such a manner so as to make sure that at least 10% of the value of the CRT’s initial assets will ultimately be paid to the charity.
  • Asset Protection: When the U.S. Supreme Court announced its decision in Bowbrow a couple of years ago, there was renewed interest in naming a Trust as the beneficiary of an IRA or retirement account. The Supreme Court held that an inherited IRA was not protected in the bankruptcy of the named beneficiary, in contrast to a traditional IRA funded by that same beneficiary. Thus, in order to protect the inherited retirement assets in the event that the beneficiary might have future creditor problems, the thinking was that directing the retirement account into a Trust for the beneficiary’s lifetime benefit, a trust with a spendthrift clause,  would provide far greater protection to the retirement assets as opposed to using an inherited If creditor protection for the beneficiary is a concern, the CRT functions much the same as a conduit trust or an accumulation trust, but certainly without the complications and technical rules that go along with administering an accumulation trust.

Income Taxation of  A CRT: A CRT generally pays no income tax itself, as the CRT is tax-exempt. But the taxation of distributions from the CRT can become highly complicated because of the multi-tier CRT accounting system imposed by the Tax Code. Then again, the taxation of the CRT’s distributions to the noncharitable beneficiary will function much like a conduit trust.

  • Multi-Tier Accounting: A CRT uses a unique internal accounting system. Every dollar that the CRT receives is allocated to one of several A tier is based on its federal income tax character, e.g. ordinary income, capital gain income, tax-exempt income, or non-taxable principal. IRC 664(b) An IRA or 401(k) is almost always taxed as ordinary income. Even after that amount is paid from the retirement account into the CRT, the retirement assets transferred to the CRT will retain their ordinary income character. Restated, moving the assets from an IRA to the CRT formed on the owner’s death will not change their taxable character as ordinary income.
  • Worst-First Payment Rule: Distributions to the noncharitable beneficiary from the CRT are assigned to tiers on a worst-first Thus, for example, a noncharitable beneficiary of the CRT cannot receive any capital gain income on receipt of CRT distributions (taxed at 15% to 20%) until the CRT has distributed everything it holds in its ordinary income tier (taxed at 10% to 39.6%), which means the entire amount of the retirement plan assets initially paid into the CRT, which are ordinary income. Consequently,  most annual distributions from the CRT to its noncharitable beneficiary will be taxed to that beneficiary as ordinary income, just like a conduit trust which automatically pays to the trust beneficiary the required minimum distributions (RMD) based on the oldest trust beneficiary’s life expectancy.
  • Waste of the IRD Deduction? One drawback to naming the CRT as the beneficiary of the decedent’s IRA is the probable loss of the income in respect of a decedent (IRD) income tax deduction. In brief, the retirement account will be subject to federal estate taxes on the owner’s death. Those same retirement assets are also subject to federal income taxation when they are received after the owner’s death. Thus, in order to avoid double taxation of the retirement plan assets (estate tax followed by income tax) the recipient is given an income tax deduction under the Tax Code to reduce the taxable income from the retirement assets when they are received. IRC 691(c). If the retirement assets are paid to the CRT, the IRC 691(c) deduction reduces the taxable income of the CRT, i.e. the ordinary income assigned to the CRT’s first tier in the year the distribution; thus, the ordinary income amount that is received from the qualified plan or the IRA is a smaller amount. The ordinary income of the CRT that is sheltered by the IRC 691(c) deduction becomes, in effect,  trust principal. But following the worst- first payment rule, that means that it will be a long time before all of the ordinary income from the CRT (the original retirement account assets assigned to the first tier) are depleted in distributions to the noncharitable CRT beneficiary, before principal tier assets will be subject to distribution from the CRT. The bottom line is that the IRC 691(c) deduction is probably wasted, although a few commentators disagree if a CRUT with unitrust distributions to the noncharitable beneficiary is used.

When to Use a CRT as the Beneficiary of a Retirement Account:  A couple of practical examples follow in order to show when a CRT might be considered as the recipient of the decedent’s retirement assets.

  • Take Care of Mom- Side Step RMDs: Suppose I want to use my IRA to provide for my mother should I die before her. My mother turns 97 next month. If I name her as the beneficiary of my IRA, she will be pulling all that ordinary income out over her short life expectancy (only a handful of years), and thus expose that ordinary income arguably to marginally higher income tax brackets. Rather than name my mother as my IRA beneficiary, I name a CRT as the beneficiary of my IRA. My mother is the lifetime beneficiary of the CRT, with my 42 year old son as the contingent beneficiary of the CRT. The result is that I have assured my mother, and my son, a steady stream of income for the rest of their lifetimes.  If I had asked my mother to name my son as the beneficiary of her inherited IRA from me,  he would still have depleted that IRA over his grandmother’s life expectancy after her death. In short, by using the CRT as the designated beneficiary of my IRA I can get around the RMD rules that require the use of my elderly mother’s life expectancy, which causes more retirement assets to be taxed much more quickly than using the CRT.
  • Take Care of Mom and Wife- Wash-Out the RMD Problem: Suppose I want to leave my IRA for the lifetime benefit of my wife, and if she dies, then for the lifetime benefit of my mother if she is still living. There is a 35 year difference in ages between my wife and my mother. If I use separate shares from my IRA, one for each of my mother and my wife, that age differential between them will present no problems; each will take required minimum distributions from their separate shares of my IRA using their own life expectancies. But what if I want to use a single Trust to receive and distribute IRA assets to both my wife and my mother, depending on their respective needs as determined by an impartial trustee; then the trustee must use my mother’s life expectancy to take the required minimum distributions from my IRA- not a good tax result for either my mother or my wife! But if I direct my IRA to be paid to a CRT that directs a unitrust payout to both my mother and my wife each year, I avoid all required minimum distribution problems, because the tax-exempt CRT can cash out the IRA immediately upon my death with no income taxes, and the IRA no longer exists. Thus, a steady stream of distributions can be made from the CRT to both my mother and my wife. Assuming my wife outlives my mother, then all of the annual unitrust distribution will be paid from the CRT to my wife, presumably an informal hedge against inflation for my wife for the balance of her lifetime. The point  is that there is no IRA from which to take RMD’s if the CRT receives the entire IRA balance, and thus no RMD ‘work-around’ will be required; all assets pass from the IRA to the CRT which merely then makes unitrust distributions to its two noncharitable beneficiaries.
  • I Love My Wife, But Suppose She Remarries: Suppose I want to leave all of my IRA assets to a QTIP Trust for my surviving wife’s benefit. The QTIP rules say that in order for that Trust to qualify for the unlimited marital deduction for federal estate tax purposes, that means the QTIP Trust must pay all of the income to my wife for her lifetime; accordingly,  all RMD’s paid into the QTIP Trust will be promptly paid out to my wife. So far, so good. But even if my wife remarries, she must continue to receive all of the QTIP income for her lifetime, meaning all of the RMDs from my IRA pass through the QTIP Trust and out to my remarried wife. There is nothing I can do about that pay all income to the surviving spouse QTIP requirement if I want or feel the need to use the unlimited federal estate tax marital deduction to eliminate federal estate taxes on my death. Suppose, however,  I name a CRUT as the beneficiary of my IRA, with my wife as the lifetime beneficiary of the CRUT. There is no federal estate tax imposed on the transfer of my IRA to the CRUT on my death; the lifetime part of the CRUT is sheltered by the unlimited federal estate tax marital deduction, per IRC 2056(b)(8) and the charity’s remainder interest qualifies for the unlimited federal estate tax charitable deduction. IRC 2055. More to the point,  the CRUT can be drafted in a way that imposes a condition on my wife, which causes her to forfeit her unitrust interest in the CRUT if she marries, or perhaps the CRUT imposes a condition that cuts the unitrust amount back to a smaller unitrust amount if my wife remarries. This ability to impose a condition on the surviving spouse’s right to receive distributions from a marital deduction trust only applies to a CRT and not to a conventional QTIP Trust.

When to Not Use a CRT as the Beneficiary of a Retirement Account:

  • Overfunded CRT for Non-spouse Beneficiary: Recall that the IRA will be taxed in the IRA owner’s estate. While the remainder interest in the CRT will be eligible for the federal estate tax charitable deduction, if the noncharitable beneficiary of the CRT is not the owner’s surviving spouse, then there will be some federal estate tax imposed on the noncharitable beneficiary’s share of the CRT. Other assets owned by the decedent will have to be dedicated to pay the federal estate tax on this non-deductible portion of the IRA that is made payable to the CRT. If that noncharitable beneficiary is young, i.e. he/she holds a long life expectancy, the lion’s share of the IRA distribution to the CRT will result in substantial federal estate taxes that will have to be paid, which then begs the question as to the source of funds required to pay that federal estate tax liability on the CRT’s assets. Too much of a retirement account passing to the CRT coupled with a noncharitable non-spouse beneficiary with a long life expectancy exacerbates this tax problem, both as to the amount of the federal estate tax to be paid,  and as to the source of funds to used to pay the CRT’s estate tax liability.
  • Noncharitable Beneficiaries Are Too Young: Recall that at least 10% of the total value of the CRT must be allocated to the charitable remainder interest in order for the CRT to meet the IRS’s qualifications as a tax-exempt Trust. If the CRT’s beneficiaries are ‘too young’ their life interest could reduce the charity’s remainder interest below the 10% threshold level, in effect disqualifying the CRT from the get-go. A term of up to 20 years might work for younger noncharitable beneficiaries, but not if the CRT is to provide for their lifetime benefit.

Charitable Gift Annuity: A charitable gift annuity is a sum left to a charity, and the charity agrees to pay a fixed income to a noncharitable beneficiary. Usually an older noncharitable beneficiary is identified for the charitable gift annuity. An IRA can be made payable to the charity subject to the restriction to provide an annuity for the lifetime of the noncharitable beneficiary. The payment of the retirement account to the charity is income tax free,  but for the present value of the annuity that is to be paid by the charity to the noncharitable beneficiary for his or her lifetime. The amount of the annuity that is to be paid to the noncharitable beneficiary is reflective of current interest rates and the age of the beneficiary. As a rough generalization, more assets would be paid to the beneficiary using a CRT than a charitable gift annuity, but there is no Trust instrument required with the charitable gift annuity. Many sophisticated charities will issue one-page charitable annuity gift agreement, which older beneficiaries tend to like because they are easy to understand, and there is no complex tax reporting required with the gift annuity in contrast to the CRT.

Charitable Lead Annuity Trust:  One last word of clarification. Unlike a CRT, a charitable lead annuity trust (CLAT) or charitable lead unitrust (CLUT) is not treated as a tax exempt entity. As such, a CLAT or CLUT is normally not a good candidate to be named as the beneficiary of a retirement account.

Conclusion:  For those clients who are charitably inclined and who possess sizeable retirement accounts, some mention should be made as to the possible use of a CRT as the beneficiary for some, or perhaps all, of the client’s retirement benefits. Let me know if you have questions.