SECURE Act: See-Through Trusts Revisited

Take-Away: It has been 18 months since the SECURE Act became law, but we still do not have any Regulations to provide official guidance as to what ithe Act means in many situations. There seems to be no master strategy to overcome the SECURE Act’s elimination of the stretch IRA, or what trust works best for which intended beneficiary.

Background: The SECURE Act eliminated the life expectancy payout for most IRA beneficiaries, replacing it with a 10-year liquidation rule. [IRC 401(a)(9).] This 10-year liquidation rule applies to inherited IRAs and inherited qualified plan accounts unless the beneficiary is an eligible designated beneficiary. The 10-year rule also applies to inherited Roth IRA accounts.

What makes these rules so confusing is that the required minimum distribution rules are tied to either (i) death before the IRA owner’s required beginning date (RBD) which is age 72 years, or (ii) the owner’s death after his/her RBD. In addition, the identity of the beneficiary can also control the distribution requirements e.g., is the beneficiary an eligible designated beneficary? Looming over all these complicated distribution rules is the 50% excise tax that is imposed for the failure to take a required distribution.

Death Before the RBD: If there is no designated beneficiary, e.g. an estate or non-see-through trust, the 5-year liquidation rule applies, which means that the inherited IRA must be distributed by December 31 of the year in which the 5th anniversary of the IRA owner’s death occurs. This rule is unchanged by the SECURE Act. If there is a designated beneficiary, then the 10-year liquidation rule applies, which means that close to 11 years can be used to stretch distributions from the inherited IRA before they must be withdrawn and taxed.

EDB: The only exception to the 10-year liquidation rule is if the beneficiary is an eligible designated beneficiary, spouse, disabled, chronically ill, a minior child of the owner, and a person less than 10 years younger than the decedent, who may continue to use the ‘old’ life expectancy distribution rules, starting with the year after the decedent’s death.

Death After the RBD: If there is no designated beneficiary, the non-designated beneficiary of the inherited IRA must withdraw benefits over what would have been the remaining life expectancy of the deceased IRA owner,  sometimes call the ghost life expectancy. This means, as a generalization, that if the IRA owner dies between ages 73 and 80, a potentially longer period than 10 years can be used to take distributions. Some have argued that if it might make sense to intentionally disqualify the trust as a see-through trust, meaning that there is no designated beneficiary, which would then extend the period of tax deferral before the inherited IRA must be liquidated. If there is a designated beneficiary of the post-age 72 inherited IRA, the 10-year rule applies; a designated beneficiary cannot elect into using a ghost life expectancy to take required minimum distributions (over the slightly longer period than just 10 years.)

See-Through Trusts: As has been previously covered, there are two varieties of a see-through trust which is treated under Treasury Regulations as a designated beneficiary,  like an individual who is named as beneficiary. 

– Conduit Trust: This trust functions the same for the minimum distribution rules. The beneficiary will get the best death benefit  he/she can under the minimum distribution rules as the sole beneficiary of the IRA. The trustee must pass out the benefits to the conduit beneficiary annually, liquidating the balance on the 10th year; once the trustee receives the distribution from the inherited IRA the trustee must pay it out to the trust beneficiary (but the trustee can deduct expenses and pay it for the benefit of the trust beneficiary. These trusts are often used when the trust beneficiary is not financially responsible, but within 10 years the trust will terminate and have to pass to the or for the benefit of the child-beneficiary the balance of the IRA. Thus, the primary advantage of the conduit trust is that the trustee has more control over IRA  investments and distributions and when they occur compared to an outright distribution to the child-trust beneficiary.

– Accumulation Trust: With this trust the trustee can take funds out of the inherited IRA and keep the funds in the trust, in contrast to a conduit trust which must pay out distributions from the inherited IRA to or for the benefit of the trust beneficiary. What makes this trust a see-through trust is that all beneficiaries of the trust must be humans, i.e. no charities as remainder beneficiaries; all of the trust beneficiaries must be individuals. The problem with an accumulation trust is that while the trust can delay taking distributions from the inherited IRA for up to 10 years after the IRA owner’s death, all that income from the IRA is subject to the irrevocable trust’s very compressed income tax brackets, i.e. accumulated income above $13,050 in a year is taxed at the 37% federal income tax bracket.

Trust Accounting Income: Adding to these complicated distribution rules is the fact that trust accounting income is not the same as federal gross taxable income. A trust can have income and can have an income beneficiary, but it gets no income tax deduction for paying income to the beneficiary if it has no trust accounting income. Trust accounting income does not treat a retirement plan distribution as income.

– UPIA: The trust should contain a definition of income for retirement plan benefits that are payable to the trust. For example, the Uniform Principal and Income Act adopted in Michigan (a default set of rules) provides that if the trustee takes distributions from a retirement plan, 10% of the distribution from the inherited IRA is treated as income and the balance is treated as principal. In addition, if the distribution from the inherited IRA is not a required distribution, the distribution is  treated as being all trust principal.

– Example: Husband creates a trust for his surviving wife, the trustee is given discretion to pay to all income to my surviving spouse.  Assume a $1.0 million IRA payable to the trust. If the IRA is cashed out over 10 years it is not a required distribution, i.e. it is an accumulation trust, so there is no required distribution for 10 years until the end of the 10th year, and therefore no income is available to be distributed to the surviving spouse for 10 years.

Planning Considerations: With regard to see-through trusts, considering the following observations:

1. Trust Forms: It is difficult to use a conventional trust form if IRAs are made payable to the trust, for either a conduit or accumulation trust.
2. Who are the Beneficiaries? Consider the class of trust beneficiaries- make sure if it is an accumulation see-through trust that there is no charitable remainder beneficiary because that would make the trust a non-see-through trust, possibly triggering the 5-year liquidation rule.
3. Disabled Beneficiaries:  It may not be possible to convert an accumulation see-through trust to a conduit trust  if a child beneficiary later becomes disabled and thus would qualify as an eligble designated beneficiary. It seems to be that only a ‘snap-shot’ date of the IRA owner’s death will control if the trust beneficairy is disabled or chronically ill.
4. Define Income: The IRS will not accept a flat 10% rule as a definition of income, since it does not provide a fair allocation between trust beneficiaries. The IRS will accept the trustee looking at the internal income of the IRA to be defined as internal income of the IRA as if it were a separate trust, e.g. income and dividends in the IRA. Consider using a unitrust definiton instead of trying to identify interest and dividends if the trustee picks between 3% and 5% of the trust’s value each year and treat that as income.
5. Disabled and Chronically Ill Beneficiaries of Accumulation Trust: Disabled and chronically ill trust beneficaries, i.e. eligible designated beneficaries, are the only class of eligiblebeneficiaries where the settlor can have an accumulation trust that qualifies for the life expectancy payout if the sole beneficiary is the disabled/chronically ill individual. Such a trust can be drafted to coordinate with a special needs trust for that beneficiary. On the disabled or chronically ill beneficiary’s following death, the accumulation trust’s asset must then pass to humans. Prior to the SECURE Act the trustee could have paid unneeded funds in each year to other family members to push the distributable taxable income into lower tax brackets, but that is not longer an option post-SECURE Act.
6. Minor Child as Beneficiary:  While a minor child of the IRA owner is an eligible designated beneficiary, the IRS has yet to define when the minor reaches the age of majority and is no longer an eligible designated beneficiary, which then flips to the 10-year distribution rule. Other confusion arises if the accumulation trust is a ‘pot trust’ for several minor children. Does the eligible designated beneficiary status disappear when the oldest child is emancipated?
7. Surviving Spouse: Consider not creating a conduit trust for the surviving spouse. He/she gets the life expectancy payout just like naming the spouse directly as the beneficiary of the inherited IRA, with the survivor’s life expectancy recalculated annually for purposes of taking required minimum distributions. A rollover of the inherited IRA by a surviving spouse usually provides a better tax result for the survivor.
8. Tax Considerations Should not ‘Wag the Dog:’ The terms of a see-through trust should not be tied too closely to the tax rules, which as we have seen, can change from year to year. The settlor’s goals and the needs of the trust beneficiaries should be paramount in how the see-through trust is drafted, if one is to be used.

Conclusion: The IRS promises us any day now Final Regulations that implement the SECURE Act. Hopefully those Final Regulations will contain plenty of examples to guide trustees in administering see-through trusts. The SECURE Act’s 10-year liquidation rules are complicated enough before you add in the added complication of the Uniform Principal and Income rules that interpret accounting income different from taxable income.