In 2017, approximately 61% of households held an individual retirement account (IRA) or other tax-deferred retirement plan and more than one-third of American households owned at least one type of IRA, according to the Investment Company Institute (ICI). The ICI estimated that by the end of 2017, Americans held $28.2 trillion in retirement assets, with $9.2 trillion retained in IRAs, making IRAs the largest pool of retirement type assets in the U.S.
Many clients wish to pass on IRA assets to loved ones and to charity after death. One option that may accomplish both of these goals is a testamentary charitable remainder trust. Using a testamentary charitable remainder trust can reduce the federal income tax burden for clients' family members and maximize estate tax savings, while also fulfilling clients' philanthropic goals.
The first article of this two-part series provided the rules applicable to IRA charitable rollovers, addressed some frequently asked questions and illustrated common scenarios in which a qualified charitable distribution (QCD) from an IRA may maximize a donor's benefits. Part I also covered the Legacy IRA Act and its potential to expand the scope of the IRA charitable rollover to include life-income gifts.
Part II of this series discusses the tax implications for the ultimate distribution of an IRA to loved ones. This article explores the use of a testamentary charitable remainder unitrust as a tax-efficient option for distributing IRAs to loved ones. Advisors who have an understanding of testamentary charitable IRA solutions will be better equipped to meet their clients' goals for providing an inheritance and leaving a legacy.
IRA IN AN ESTATE PLAN
IRA required minimum distributions (RMDs) start at approximately 3.8% at age 70½ and increase modestly each year. If an IRA owner withdraws only his or her RMD amount each year, the IRA may continue to grow even during retirement. Assuming a 6% rate of return, the RMDs will not reduce the IRA principal until more than 10 years after the RMDs start. Thus, IRAs may continue to grow and become substantial assets in estates.
Traditional IRAs, 401(k)s, 403(b)s and other qualified retirement plans are categorized as income in respect of a decedent (IRD). IRD includes amounts that are gross income to the decedent but were not taxed prior to the decedent's death. IRD assets represent untaxed ordinary income and are governed by Sec. 691. IRD assets are included in the estate of the decedent and may also be subject to estate tax. Under Sec. 691(c), there is an offsetting income tax deduction for estate tax paid on IRD assets.
IRA distributions from an inherited IRA are subject to tax at the beneficiary's top income tax rate. For example, if a family member inherits a $500,000 traditional IRA, the heir will be subject to income tax at his or her top bracket. If the heir has a top bracket of 35%, the income tax may be $175,000 on the IRA. This may reduce the net value of the IRA from $500,000 to $325,000.
Because IRA owners may have significant balances in their IRAs, thought and care should be put into how the IRA will best complement the estate plan. Generally, a will or trust does not control IRA distributions to heirs. IRAs are distributed according to the beneficiary designation form on file at the time of death. When it comes to the ultimate distribution of IRAs, advisors can provide guidance to clients to help them meet their philanthropic goals and provide tax-advantaged inheritance for loved ones.
Good Asset or Bad Asset?
Generally, IRD assets are known as "bad assets" to pass on to heirs due to the tax consequences. The income held in an IRD asset has not been taxed, thus this asset may come with a large income tax bill. In addition to being included in the decedent's estate, IRD assets are subject to tax at ordinary income rates when distributed to heirs. Most IRD assets have a zero basis or a very low basis. Other appreciated assets, such as stocks and real estate, are considered "good assets." Those so-called "good assets" receive a stepped-up basis upon the original owner's death, allowing the asset to be sold by the beneficiary without significant tax consequences.
One common suggestion from experienced financial planners is to transfer "bad assets" to qualified charities and "good assets" to heirs. This strategy has multiple benefits. The charity is able to sell IRD assets tax free and use the entire proceeds for its charitable purposes. The heirs will avoid the large income tax consequences that result from inheriting an IRD asset and will instead receive a generous inheritance from other assets with a stepped-up basis from the estate. This works particularly well if there are other assets in the estate that equal or exceed the IRA value.
Transfers at death of IRAs to heirs may result in the asset being subject to two tiers of taxation. Generally, IRD assets are included in the decedent's estate for estate tax purposes. The second level of tax is generated when the IRA is distributed to heirs in the form of income tax.
Most estates will not be subject to the estate tax because the lifetime exemption shields estates up to $11.18 million per decedent in 2018. The lifetime exemption is $11.4 million in 2019 and is indexed to increase each year. Because the lifetime exemption is very large, not many estates will be taxable. However, for those clients who are concerned with estate tax consequences, charitable solutions can help reduce estate tax and may alleviate some of the income tax burden on heirs.
Heirs who choose to stretch out the payments may have the IRA distributions end many years prior to their passing because the IRA distributions are based on the heirs' life expectancies, rather than their actual lifetime. Using a testamentary trust gives family members the assurance that payments will continue for the duration of their lives and will also protect loved ones from choosing an accelerated distribution, which can result in a large income tax bill.
Choosing to transfer an IRA to a testamentary trust can alleviate some of the income tax issues and ensure that a professional advisor is actively involved in the process. Advisors can be better equipped to serve their clients by understanding the challenges associated with testamentary transfers of IRAs.
Inherited IRA Options
Spouse as Inheritor
Quite often, IRA owners designate a surviving spouse or children as beneficiary. The tax and inheritance rules are favorable toward a surviving spouse who is the sole inheritor of an IRA. The surviving spouse may roll the inherited IRA into a new or existing IRA and delay RMDs until the surviving spouse reaches the age of 70½. A surviving spouse may choose instead to receive the IRA distributions based on the original IRA owner's RMD schedule, which may result in immediate payments. If the surviving spouse is under 59½ and chooses to receive RMDs based on the original IRA owner's RMD schedule, the surviving spouse would not be subject to an early withdrawal penalty.
Non-Spouse as Inheritor
Children and other loved ones may also be the designated beneficiaries of an IRA. For inherited IRAs, the early withdrawal penalty will not apply to the IRA beneficiary but the distributions will be subject to income tax. If the IRA owner passed away prior to reaching age 70½, the beneficiary may choose to take a lump sum distribution, elect a five-year accelerated distribution or stretch out the distributions over life expectancy. The life expectancy option may end before the beneficiary passes away, because the life expectancy projections may be five, 10 or even 15 years shorter than the beneficiary's actual life.
Angela, age 50, inherited her mother's IRA valued at $400,000. After weighing her options and consulting with her advisor, Angela chose to take the IRA distributions over her life expectancy. By choosing this option, Angela will not be subject the 10% early withdrawal penalty. She will pay income tax on each distribution at her ordinary income tax rate. If instead the charity received the IRA, Angela could inherit other "good assets," like stock or real estate, and sell them tax free. The charity would have been able to receive the IRA tax free. Under the IRA life expectancy tables Angela reached life expectancy at age 84, at which point the IRA payments from the inherited IRA ceased. Angela was an active and healthy woman, she lived to age 98. The IRA distributions ended well before she passed away.
If the original IRA owner reached age 70½ prior to death, the default distribution schedule typically follows the original IRA owner's RMD schedule. The beneficiary does have the option to choose a lump sum distribution or a life expectancy distribution. In many cases, children may elect accelerated distributions instead of the smaller RMD distributions and create large income tax payments.
William inherited an IRA valued at $400,000 from his uncle. His uncle's estate was rather large. William consults with his professional advisor and determines he would like a lump sum distribution. The IRA is subject to estate tax of $160,000 before being distributed to him. William's professional advisor ensures that William has adequate tax withholding on the IRA distribution. William understands that the IRA distribution will increase his tax rate. He will also need to increase his withholding on his wages and other income because his entire income will be taxed at a higher tax rate. He will pay ordinary income tax of $84,000 on the IRA. The original $400,000 IRA will be substantially reduced by estate and income taxes. William is left with $156,000, which is only 39% of the original asset. If his income tax withholding is insufficient, William could also end up with a large income tax bill from the IRS including interest and penalties.
TESTAMENTARY CHARITABLE REMAINDER UNITRUST
Basics of a Charitable Remainder Unitrust
A charitable remainder unitrust (CRUT) is a tax-exempt trust that pays a fixed percentage of its corpus each year. Sec. 664. A CRUT may have a duration for a life, lives, a term of up to 20 years or a combination of a life or lives plus a term of up to 20 years. Reg.1.664-3(a)(5)(i). At the end of the duration of the trust, the trust's remainder passes to the charitable organizations named in the trust document.
If an IRA is going to be used to fund a testamentary CRUT, the IRA beneficiary designation form must direct the funds to the trustee of the CRUT. Generally, the executor or plan administrator will not have the ability to direct the transfer to a charitable trust without the proper authorization on the beneficiary designation form.
Testamentary CRUT Solution
Because CRUTs are tax-exempt trusts, the trustee may sell the funding assets tax free and invest the entire proceeds within the trust. This tax-free treatment includes IRD assets, such as IRAs. IRAs transferred to testamentary CRUTs will avoid an immediate income tax liability. PLR 9634019.
Any income or gains earned inside the trust are not subject to taxation. If an IRA is transferred to a testamentary CRUT, the donor will receive a partial estate tax deduction. Sec. 2055(e)(2)(A). The trust's distributions will be taxable to the income beneficiaries under the four-tier trust accounting rules.
When the IRA is transferred to the trust, the IRA is terminated and the CRUT receives the distribution. Typically, the IRA is untaxed ordinary income and all of the income distributed from the trust will be tier-one ordinary income.
If, instead of leaving the IRA to Angela (see example 1 above), her mother created a testamentary CRUT for the benefit of Angela, the results would better meet her mother's goals. Assume that instead of receiving the IRA through the beneficiary designation form, Angela was the income beneficiary of a testamentary charitable remainder unitrust that was funded with her mother's IRA. When the trust was funded, the IRA was valued at $400,000. Angela received a 5% unitrust payout from the CRUT for her lifetime. Angela lived to age 98 and over the course of her life received over $1.22 million in trust payments. The charity received the remainder value of the trust, which at the time of Angela's passing was valued at almost $645,000. The combined value of the trust payments and remainder value to charity was over $1.86 million. The charity is able to receive the remainder value tax free. Angela's mother left a lasting legacy gift and was able to provide for Angela during her remaining lifetime.
A testamentary CRUT funded with an IRA allows the IRA owner to provide for family in an income tax favored way while also generating a substantial legacy gift for charity. Using a CRUT as the inheritance vehicle for an IRA ensures the proceeds of the IRA are distributed over time and not disbursed in a lump sum. This can aid IRA owners' peace of mind knowing their loved ones will have regular payments measured over their lives or a term of years. This may be a great solution for heirs lacking in money management skills.
The trust payments will be paid out over the beneficiary's life, rather than only his or her life expectancy. A CRUT may be created with the duration of a life plus term of years. Typically, the trust would pay for the life of the surviving spouse and then would pay to children for a term of up to 20 years. A CRUT may also be structured for a term of years up to a maximum of 20 years.
If a spouse is the owner of an IRA and the other spouse is not the beneficiary of the CRUT, it may be a good idea to execute spousal consent forms for the IRA. The donor and his or her spouse may live in or move to a community property state. If this is the case, legal ownership of the IRA may change. As such, the best practice may be to obtain spousal consent prior to designating the IRA to a testamentary CRUT.
Over his lifetime, Edward has accumulated a substantial amount of assets. Edward wants part of his estate to benefit his young children. He wants his favorite charity to benefit from his IRA. His wife will be well cared for through other assets in his estate. Edward's attorney highlights the benefits of using a testamentary term of years CRUT. Edward is very happy that he can benefit his favorite charity and provide his children with some added security.
Edward's attorney drafts the testamentary CRUT. His attorney also creates the required consent form and Edward's wife signs the form. Edward finally updates his IRA beneficiary designation form to reflect the desired outcome. Edward's taxable estate is valued at $14 million and includes his IRA worth $3 million. The IRA plus $7 million other assets will go to the 20-year testamentary trust, creating an estate tax deduction of just over $3.68 million. Edward's estate will save almost $1.13 million in estate taxes with this inheritance plan. Edward's children will receive income for 20 years and the remainder will go to charity. The charity is projected to receive almost $11 million from the trust at the end of the trust term.
The IRA owner should obtain the testamentary CRUT document and the appropriate consent forms from his or her attorney prior to updating the beneficiary designation form to ensure a smooth transfer. The testamentary CRUT must be in existence at the time of the donor's death to qualify for an estate tax deduction. The CRUT can be formed as a funded or unfunded CRUT, but it must be created during the life of the donor to qualify for an estate tax deduction.
A popular structure for donors with children is to create a funded CRUT for one or two lives plus a term of years. The CRUT will pay the parent(s) for life and then pay the children for a term of years. This trust structure will not qualify for a marital deduction under Sec. 2056(b)(8). The trust is usually funded using some other asset at the time of creation because the IRA will not be added into the trust until the IRA owner passes away.
If the CRUT is drafted and funded during the IRA owner's lifetime, the trust must be administered immediately and the trustee must act in his or her fiduciary role. The trustee will be required to administer the trust, conform to four-tier trust accounting and issue payments to the income beneficiary. The trustee will invest and manage the trust and file all appropriate federal and state forms.
A CRUT can receive additional funding during its duration. The IRA owner will need to update the beneficiary designation form to designate the trustee as the recipient of the IRA. Sample beneficiary designation language may be "To the X Family CRUT dated January 5, 2015." When the IRA owner passes away, the IRA will be distributed to the CRUT.
An unfunded CRUT is the preferred solution because the trust is valid under state law, but does not require active administration under federal law. This is a creative solution for donors who wish to transfer an IRA to a CRUT but do not wish to operate the trust. The unfunded CRUT is commonly drawn up as a one or two life plus term of years trust.
The ability to create an unfunded CRUT during life will depend on state law. In states where unfunded trusts are permitted, the IRA owner must execute the trust document to create the trust. Once the trust has been created, the IRA owner must change his or her beneficiary designation form to designate the trustee as the beneficiary of the IRA. For example the beneficiary designation language for the IRA could say: "To XYZ Bank and Trust as trustee of the Smith Family charitable remainder unitrust, dated August 21, 2018."
In some states, the law may require nominal funding of $10 or $20. If that is required, the IRA owner may choose to staple a nominal cash amount to the trust document. The trust may then meet state law requirements.
Revocable Trust or Will
A third option available is to use a testamentary charitable remainder trust with a revocable trust or will. The best practice is to have the trust clearly identified within the revocable trust or will as a separate charitable remainder unitrust effective only at the death of the donor. It should have a specific number or article designation within the estate plan. Using a living trust with an unfunded testamentary trust affords additional privacy regarding the donor's estate plan.
After the living trust or will has been signed, then the beneficiary designation form should be updated to designate the trustee of the testamentary trust as the beneficiary of the IRA. The beneficiary designation could be similar to the following: "To ABC Trust Company as trustee of the charitable remainder unitrust for Child A, identified as 'Article J' in the Grantor's living trust dated November 16, 2018." The designation for a will could use similar identifying language. The trust will not be effective until the death of the IRA owner. In all situations, the trust should be created and signed prior to updating a beneficiary designation form for the IRA.
IRAs are the largest pool of retirement assets in the U.S. and the number of IRAs in existence continues to grow each year. Testamentary transfers of IRAs, 401(k)s, 403(b)s and other qualified retirement plans to testamentary CRUTs may be more attractive to donors than leaving qualified plans outright to family members. If the gift is structured correctly, the IRA will avoid estate tax and immediate income taxation. The trustee of the CRUT can cash in the IRA tax-free and reinvest the proceeds. The income beneficiaries will receive income for the duration of the trust and the remainder will pass to charity.
While many estates may not need the estate tax deduction, heirs will greatly benefit from the ability to receive income over their lifetimes. Donors can ensure the distributions are spread out over their heirs' lifetimes and also leave a substantial legacy gift to charity. By implementing this charitable solution, advisors can provide clients with creative solutions that will meet personal and financial objectives and reduce the income tax burden for heirs.