Put the Elasticity Back into Your Clients’ IRAs with Testamentary Charitable Remainder Trusts

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Due to the passage of the SECURE Act, “Stretch” IRAs set up for the benefit of your clients’ non-spouse heirs are no longer an available planning option in your toolboxes. Under the new rules, most IRA inheritors are required to take full distribution of the IRA assets within 10 years, which could expose them to much higher tax bills during what might possibly be their highest income-earning decade. A potential work around for your clients with IRAs/401(k)s/retirement plans who want to provide an income stream for their heirs, and who are charitably inclined, is to establish a Testamentary Charitable Remainder Trust (Testamentary CRT) and to name that trust as their IRA beneficiary.  

For starters, a testamentary CRT is an irrevocable trust that becomes active after the death of the IRA holder client. With this approach, income can again be spread over the lifetime of your clients’ beneficiaries, or for a term of years (not to exceed 20 years) before the remainder passes to your clients’ favorite charity(ies). For your clients with philanthropic intent and relatively large IRAs, this option may be a good one. For the rest of your clients with more modest IRAs, the most tax-savvy move may be to simply designate what is left in their IRAs to one or more charities and use other assets to benefit their heirs. That way, the IRA funds will not be subject to income taxes because charities are tax-exempt and your clients’ favorite charities will reap the benefits. So, when does it make sense for your clients with IRAs to consider a testamentary CRT? 

  • First, they must have a strong desire for their IRA gift to convert to a lifetime income stream (or term of years) for their heirs, versus providing them with a lump sum or variable distribution. The trade-off is that with a CRT, while heirs gain a long-term income stream, they lose payout flexibility and access to principal. The CRT payout percentage is fixed and no additional amounts are available to the beneficiaries. With an inherited IRA there are no payout restrictions other than that all funds must be withdrawn within the 10 year window. For example, with an inherited IRA the heirs could decide not to take distributions in a high-income/high-tax-rate year and then decide to take out large distributions in a low-income/low-tax-rate year. Not so with a testamentary CRT. That said, for clients who are worried about beneficiaries squandering a large lump sum or who desire to benefit beneficiaries like children and charities, testamentary CRTs can be ideal. If the trust assets are invested well over the term of the trust, the income beneficiaries can receive a large amount of money, even up to or in excess the dollar amount that was donated to the trust.  
     
  • Second, your clients’ IRAs must be large enough such that it is likely that the mandatory 10-year drawdown period would create a significant tax burden on their heirs that inherit their IRAs. This is particularly an issue if your clients’ beneficiaries are already in a high tax bracket, and that this additional income during their possible peak earning years would push them into an even higher tax bracket. Another important consideration is that assets in the CRT can grow tax-free over the extended period of the beneficiaries’ lifetimes (just like the stretch IRA used to work) rather than only having 10 years of tax-free growth. This can result in much larger amounts of wealth shifting from one generation to another, and to fortunate charities. Further, the administrative burden of setting up and administering a testamentary CRT is not insignificant, so the “juice must be worth the squeeze” to make the effort worthwhile for your clients.
     
  • Third, let’s examine the potential tax benefits of testamentary CRTs. Because these retirement assets often constitute a significant portion of your clients’ net worth, testamentary gifts of these assets into a CRT can make good income and estate tax planning sense. Retirement plan assets are potentially subject to multiple levels of taxation, including income, estate and generation skipping taxes. As a result, leaving retirement plan assets to family can be expensive; in fact, taxes could consume more than half the value of the account especially for those people subject to estate tax. (We note here that because the currently high lifetime estate and gift tax exemptions are set to sunset in 2025, more people may become subject to estate tax in the not too distant future.)

    - State and Federal Income taxes. In general, retirement account balances represent “income in respect of a decedent” (IRD) that must be recognized for tax purposes by the designated beneficiary upon distribution. This means that your clients’ IRA beneficiaries will have to pay income taxes as the assets are distributed from your clients’ IRAs. And, these distributions will be taxable to the beneficiaries at ordinary income rates.

    - Estate taxes. Retirement plan assets are also included in the account owner’s federal gross estate and could be subject to estate tax at death, an expensive problem for your high net worth clients. 

    - Generation skipping taxes. If the named beneficiary is someone much younger than the account owner, for example a grandchild, the assets might be subject to generation-skipping taxes as well. 

Here’s where a testamentary CRT can help. If your clients name a testamentary CRT as the beneficiary of their retirement plan, then most, if not all, of the value of the plan assets can be preserved for the benefit of both family members and charity. Because a CRT is a tax-exempt entity, no income taxes will be due when the trust is funded. CRT beneficiaries will only pay income taxes on the distributions they receive from the CRT. Depending on how the CRT assets are invested, a significant portion of the distributions may be taxable at capital gains tax rates rather than at the higher ordinary income rates. The retirement plan balance will still be included in the donor’s taxable estate, but an estate tax charitable deduction will be available for the value of the remainder gift to charity. So, how might you go about assisting your clients with setting up a testamentary CRT?  

  • As a first step, the terms of the CRT can be included in either the client’s revocable living trust or will, in a revocable trust set up but not funded during the client’s lifetime, or as an attachment to the retirement plan beneficiary designation form. You can guide your clients as to which particular trust type and payout rate to choose for the CRT based on their particular situation and the predicted age of the beneficiaries when the trust is likely to come into play. Note that it is possible for your clients to adjust the trust type or payout rate during their lifetimes by simply amending their trust or by executing a codicil to their will. 
     
  • The second step is for your clients to complete a beneficiary designation form that specifically names the testamentary CRT as the beneficiary of their retirement plan assets. 
     
  • Many large charitable organizations such as University of California, Berkeley Foundation have life income gift programs and thus may be able to serve as Trustee of a testamentary CRT when it is eventually funded. Usually there are minimum funding amounts and other factors that the charity will consider before agreeing to serve as Trustee.