Beneficiary Income Tax Planning

One of the most overlooked aspect to estate planning is income tax planning for your beneficiaries, whether those include a surviving spouse, children, or grandchildren. Here I’ll review several strategies that may be used to mitigate income taxes for your loved ones.

Sprinkle Trusts

When creating a Family Trust at your death for your spouse and children, give the the trustee has the ability to sprinkle the income amongst the spouse, children, and grandchildren. This enables the trustee to direct the income to the beneficiary(ies) that need it the most. If the spouse is the primary concern, the trust language should direct that the spouse’s needs are first considered. By allowing the income to be distributed to children and grandchildren, the family’s marginal tax rate is likely minimized, assuming those individuals are in lower tax brackets.

Optimal Basis Increase Trusts (OBIT)

Layman refer to the fair market adjustment at death as the “step-up in tax cost basis.” The law instead provides that assets are adjusted to their fair market value, which means that those falling in value will also be adjusted downward, eliminating capital losses. With a testamentary optimal basis increase trust embedded into your plan, capital losses are preserved while unrealized capital gains are eliminated through the basis adjustment upward.

Beneficiary Deemed Owner Trusts (BDOT)

In recent weeks you may have read much about “Intentionally Defective Grantor Trusts” (IDGT) where a transfer to trust occurs resulting in the assets treated as a completed gift, therefore outside of your estate for estate tax purposes, yet for income tax purposes the trust is still yours, meaning that you pay the tax on any income, perhaps receive the benefits (in limited ways) or you can transact sales without recognizing gain. This is a strategy that the Democrats wanted to eliminate, and at the time that I’m writing this column it’s unclear whether the strategy will remain available. The BDOT is like the IDGT except the beneficiary is deemed as the taxpayer for income tax purposes, even if the trust accumulates income, which normally results in the trust paying the taxes. Because the federal income tax rates impose higher marginal rates on irrevocable trusts than they do individuals, this strategy may be used to minimize income taxes for beneficiaries.

Identifiable Beneficiary Trust Shares

Normally non-spouse beneficiaries of IRA and 401(k) accounts become the outright beneficiary of their inherited IRA accounts. Sometimes it’s appropriate to protect the IRA distributions, since they are not creditor exempt, with a qualified retirement account trust. In order for the beneficiary of the account to be considered, for distribution purposes, the direct beneficiary of the inherited IRA account, the trust share beneficiary must meet the “identifiable beneficiary” regulations.

Charitable Remainder Trusts

For those charitably inclined, especially those who have traditional qualified retirement accounts and wish to name a loved one and a charity as the beneficiary after your death, charitable remainder trusts are a viable option. Here, the distribution rules fall outside of the 10 year payout mandated under the 2017 SECURE Act laws. Under a charitable remainder trust your loved one receives an annuity or unitrust payment for their lifetime or a period of years following your death. On the expiration of that term, the balance is distributed to charity.

Charitable Lead Trusts

Again for the charitably inclined, charitable lead trusts work in reverse to charitable remainder trusts. Here the charity(ies) receive the annuity stream for a period of years, then after that term is over the balance is distributed to loved ones. Because of the length of time between your death and distribution to loved ones, this type of trust usually benefits grandchildren or successive generations rather than children. Unlike charitable remainder trusts, charitable lead trusts do not qualify as a “charity” so naming one as a beneficiary to a qualified retirement plan account must be carefully considered.
There are several nuances to each of these strategies, depending upon your situation, and should be carefully considered before implementing.