New tax law obliterates IRA trust planning

Register now

The new Secure Act was designed to expand retirement savers’ options. But in the process, it also obliterates IRA trust planning. So it’s on the advisor to contact every client who has named a trust as their IRA beneficiary and make them aware of this monumental tax law change.

Due to the act, the stretch IRA has been eliminated for most IRA beneficiaries. That’s a function of Congress deciding that IRAs and other tax-favored retirement accounts are for retirement and not to pass on to heirs.

Taken together, this means clients’ current trust plans need immediate reviews and probable overhauls. Of course, this involves coordination with the client’s attorney. There are parameters: This change is effective for those who die after Dec. 31, 2019. Those who died in 2019 or earlier are grandfathered under the old rules. Those stretch IRAs will continue, so beneficiaries can have two sets of payout periods, depending on when they inherit.

I can sum up the Secure Act’s effect on IRA trust planning in two words: not good.

I can sum up the Secure Act’s effect on IRA trust planning in two words: not good. To understand the gravity of this change, let’s first review what are now the old rules for inherited IRAs.

The new tax law, passed by Congress wanted, downgrades IRAs as estate planning vehicles.

Under the pre-2020 tax rules for IRA and plan beneficiaries, designated beneficiaries could stretch required minimum distributions from the inherited IRA (or company plan) over their lifetimes — possibly over decades — depending on their age. Certain trusts, known as see-through trusts, also qualified for the stretch IRA, so a person with a large IRA could name a trust for the benefit of a grandchild and RMDs could be spread over 50 years or more, depending on the age of the grandchild.

What is the Secure Act?

Although the act eliminates the stretch IRA option, save for a few exceptions, and replaces it with a 10-year pay down period for designated beneficiaries there are no longer any annual RMDs during this 10-year period. Instead, the entire inherited IRA (or plan) account balance must be emptied by the end of the 10th year after death. All the funds would be taxed by that time (except for tax-free Roth IRA distributions). This is exactly what Congress wanted: to downgrade IRAs as an estate planning vehicle. And that is what the new tax rules do.

The law exempts five types of beneficiaries from these new rules. The law refers to this class of exempt beneficiaries as "eligible designated beneficiaries," or EDBs. These beneficiaries still get the stretch IRA as if they operated under the old rules.

Although these beneficiaries are unaffected by the new rules, once they no longer qualify as EDBs, or die, the 10 years kicks in for them, or for their beneficiaries.
There is another cause for worry for trust-owners and their advisors in the Secure Act era: Most trusts are now subject to the 10-year, post-death payout.

5 Classes of eligible designated beneficiaries for a stretch IRA

Clients with large IRAs often name trusts as their IRA beneficiaries because they want two things from their estate plans. First, they want post-death control — they don’t want beneficiaries squandering this money, or putting it at risk of financial mismanagement, lawsuits, divorce or being vulnerable to financial predators. Second, they want to minimize taxes.

Qualifying see-through trusts under the old rules could often accomplish both objectives, but not anymore. Here’s why: There are two types of IRA trusts — conduit and discretionary (also known as accumulation) trusts.Assuming they each qualified as designated beneficiaries by meeting the conditions of a see-through trust, payouts from the inherited IRA to the trust under the old rules could be stretched over the lifetime of the oldest trust beneficiary.
With a conduit trust, the annual RMDs get paid out from the inherited IRA to the trust and from the trust to the trust beneficiaries. No funds remain in the trust. All funds received by the beneficiaries are taxed at their own personal tax rates.

With a discretionary trust, when more post-death control is desired, the annual RMDs are paid out from the inherited IRA to the trust, but then the trustee has discretion over whether to distribute those funds to the trust beneficiaries or retain them in the trust. This provides the trustee with greater post-death control of what gets paid to the trust beneficiaries, as compared to the conduit trust which pays out all annual RMDs to the trust beneficiaries. Any funds retained in the trust though would be taxed at high trust tax rates.

But a conduit trust will no longer work to accomplish either of the two objectives of post-death control and tax minimization. Since the new law does away with RMDs, there may be no payouts until the end of the 10 years, and then all the funds are released to the trust’s beneficiaries, exactly what the client with a large IRA wanted to protect against.

Since the new law does away with RMDs, there may be no payouts until the end of the 10 years.

Plus, all the taxes will be bunched into the last year unless the trust has language allowing distributions throughout the 10 years to spread out the income. Either way, the entire account will be released to a beneficiary who may squander the funds or lose them, and the inherited IRA funds will all be taxed by the end of the 10 years, making this a lousy estate plan. Trusteed IRAs offered by some financial institutions are conduit trusts and have these same problems under the SECURE Act.

The conduit trust would generally only work now for EDBs who can still stretch payouts over their lifetimes, but even then, once the EDB no longer qualifies as an EDB (for example, when a minor reaches majority), the 10-year payout rule kicks in.

If a trust is still deemed necessary, then a discretionary trust would work somewhat better since inherited IRA funds can still be retained and protected in the trust, even after the 10 years. But all of those funds will still be taxed either at high trust tax rates for funds retained in the trust or at the beneficiaries’ personal tax rates for distributions to the trust beneficiaries. This provides the trust protection clients desire but at a possibly prohibitive tax cost, so this may not work too well either.

The better option then, if a trust is desired, would be to have the client convert to a Roth IRA and leave the Roth IRA funds to a discretionary trust providing the post-death control and eliminating trust or personal taxes.

Under the new law, there are provisions allowing a trust to be set up to inherit retirement funds for the benefit of a disabled or chronically ill individual. The law, however, does not address trusts for the other three EDBs — spouses, minors and those within 10 years of the age of the deceased.

The IRS will have to provide definitive guidance on this but based on existing regulations it appears that trusts can be set up for these groups as well. In that case, the stretch IRA would work as before, but only while the beneficiaries still qualify as EDBs. After that point, the 10-year payout rule would apply.

Other options

Leaving an IRA or plan to a trust will generally not be a favorable estate plan. Here are other options to consider:

Spouse as beneficiary
Since the surviving spouse is an EDB (exempt from the 10-year rule) it may pay to change beneficiaries from children or grandchildren to the spouse. This could extend the time before an inherited IRA will have to be fully taxed and distributed. The law inverts the tax planning here since now a 75-year old spouse can have a longer life expectancy for payouts than a 25-year old grandchild who would have to withdraw within 10 years after death.

Roth conversions
Begin a plan to draw down the taxable IRA funds at today’s low tax rates and convert those funds to Roth IRAs. Roth IRAs will be a better choice if the funds will need to be left to a trust.

Bottom line: The Secure Act has given financial planners plenty of high-value work to do in 2020.

Even if the Roth IRA funds are left directly to a beneficiary, the funds can keep growing for at least 10 years after death. There are no longer any RMDs required until the end of the 10 years when all the funds must be withdrawn. And a Roth IRA account can accumulate tax-free during the 10 years and then be withdrawn tax free at the end of the 10 years. It’s no stretch IRA, but still not a bad deal.

Life Insurance – larger inheritances and less tax
Life insurance will likely be the big winner here, especially for clients who wish to leave their funds in trust to keep them protected for their beneficiaries. Once again, the IRA funds can be withdrawn at low tax rates over several years and the after-tax funds can be put into a permanent, cash value life insurance policy which will satisfy both of the client’s estate planning objectives — post-death control and elimination of taxes.

If a trust is desired for post-death control, the life insurance can be left to a trust. Life insurance is a much more flexible asset to leave to a trust. There are no RMDs or complex tax rules to worry about, and the proceeds are tax free. Life insurance can be retained in the trust for the beneficiary or paid out over time, simulating the best parts of the stretch IRA, but without all the tax and trust complications. Of course, this is something that should only be done with funds clients won’t need during their lifetime and earmarked for their beneficiaries. Even if the funds were needed though, the cash value could be withdrawn tax free during the client’s lifetime.

Qualified charitable distributions, which are available only to IRA owners or beneficiaries who are 70 ½ or older (this age did not change under the act), should be maximized for annual charitable giving. These gifts not only reduce the eventual taxable IRA balance that might be left to beneficiaries, but they also do it tax free since the QCD is excluded from income. Leaving IRAs to charitable trusts can accomplish this as well but only for truly charitably inclined clients. There are drawbacks here too since the funds will eventually go to the charity upon the death of the beneficiary, so this is something to evaluate with your clients.

Bottom line: The Secure Act has given financial planners plenty of high-value work to do in 2020.

For reprint and licensing requests for this article, click here.
Roth IRAs IRAs Retirement planning Tax planning Tax laws IRS Trusts RMDs Estate planning RIAs Practice Management Resource Center Philanthropy Life insurance SECURE Act