Beware of financial advisors and estate planning attorneys who suggest using a Charitable Remainder Trust (CRT) as the answer to the SECURE Act’s mandatory 10-year distribution rule for Inherited IRA accounts. The solution may not match your goals, since CRTs come with their own set of unique legal and tax issues.
The SECURE Act
You may have heard that the SECURE Act, enacted at the end of 2019, requires most beneficiaries to withdraw the entire balance from an Inherited IRA account within 10 years of the decedent-owner’s death. The prior law allowed for distributions over a beneficiary’s lifetime using a Single Life Table. Under the old law, a 30 year old beneficiary may have 50+ years to withdraw the balance of an Inherited IRA, as opposed to ten years today.
The SECURE Act rules result in beneficiaries losing years of tax deferred growth. They will also be forced to pay higher income taxes since greater amounts must typically be withdrawn to satisfy this ten-year rule.
Is there an answer to the SECURE Act?
Several advisors recommend naming a (CRT) as a beneficiary in order to lengthen the withdrawal period to the beneficiary’s lifetime. In this transaction, the IRA is paid to the CRT upon the account owner’s death. The CRT then pays an income stream to one or more beneficiaries either over the course of their lifetimes or a period of years (described below), before distributing the balance to a qualifying charity.
A CRT itself qualifies as a charity, so upon the IRA account owner’s death, the distribution to the CRT is not a taxable event. In order for the CRT to so qualify, it must pay at least 5% of its value annually to a beneficiary, and the actuarially determined remainder value to the charity must be at least 10%. Because of this 10% requirement, young beneficiaries usually disqualify the CRT, unless the CRT is limited to a period of years (not to exceed 20). So there goes your lifetime payout.
Using today’s interest rates, beneficiaries younger than 40 may disqualify a CRT and ruin the entire plan to begin with. Not only would there not be a lifetime payout, but since the CRT wouldn’t qualify as a charity, the distribution from the IRA to the CRT creates an ordinary income taxable event, resulting in high federal income tax rates upon the death of the account owner.
Types of CRTs
There are different types of CRTs, including Charitable Remainder Annuity Trusts (CRAT), Charitable Remainder Unitrusts (CRUT), Charitable Remainder Net-Income Unitrust (NICRUT), Charitable Remainder Net-Income With Make-up Unitrust (NIMCRUT) and Charitable Remainder Flip Unitrust (FLIPCRUT). Each has their own unique issues, which is beyond the scope of this article.
Assuming the CRT satisfies the 10% remainder rule, what other issues might we run into? First, if the CRUT has a high payout rate, the beneficiary will likely experience decreasing distributions annually. If the Trustee can only earn the Section 7520 interest rate (that rate used by the IRS to make its calculations as to whether the CRT qualifies as a charity), a CRUT that begins with a $100,000 payout may fall to an amount as low as $12,000 before the trust terminates.
Second, if the CRT has hard-to-value assets such as closely held business interests or real estate, an appraisal must be conducted annually to determine the value. If an IRS audit results in an adjustment to the values determined, penalties and interest may apply. Further, partial payouts of these hard to value assets may be necessary depending upon the type of CRT used.
Third, if the CRT has multiple lifetime beneficiaries, and one beneficiary dies resulting in a grandchild beneficiary, generation skipping transfer taxes could become due. A CRT cannot pay estate or generation skipping transfer taxes it triggers. Instead, those must be paid from other assets that might affect different beneficiaries.
Fourth, if S Corporation stock is owned by the CRT, then the S election will likely be defeated, resulting in corporate income taxes owed.
Fifth, CRTs must pay out a percentage, and only a percentage to the beneficiary. If the beneficiary experiences extraordinary medical expenses, for example, the trustee cannot invade the principal of the CRT for those needs.
There are other issues that I could mention, depending upon the client’s goals and the type of CRT employed.
While the CRT strategy may work for some, client and attorney should pay attention to the details of that client’s situation before embarking on this strategy.
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