Once upon a time, estate planners could offer clients a great gift: The life expectancy payout, or stretch IRA, for the client's retirement plan beneficiaries. What appeared to be an "ugly duckling" tax-challenged asset (the large IRA) could turn into a swan--a beautiful lifelong tax-deferred payout for the client's children or grandchildren.
Then in December 2019, the SECURE Act killed the stretch IRA, replacing it with a strict 10-year maximum payout for most beneficiaries. No more thrilling the client with a chart projecting that 50-year annually increasing payout to his offspring; the estate planner's new job is now damage control. At best we're playing the corners, looking for any little thing that will whittle the taxes on the (once again) ugly duckling tax-heavy IRA.
The search is on for the new Holy Grail, the way to "beat SECURE"--some new or previously overlooked planning device that could at least partly replace the stretch IRA as a tax-favored way to dispose of the IRA at death.
One path that planners are exploring is the charitable remainder trust, or CRT, a tried-and-true, Internal Revenue Code-sanctioned way to benefit a human and a charity.
At first glance, it seems perfect: The CRT named as beneficiary of the IRA cashes out the account income-tax-free, then pays a life income to the client's chosen human beneficiary. The payout lasts for life, not just 10 years. Viewed from a certain angle, the CRT's lifelong payout to the human beneficiary neatly replaces the now-extinct life expectancy payout.
Here's a simple model of a CRT and how it would work for client Clara's $1 million IRA she wants to leave for the benefit of her 50-year-old son, Adam.
The IRA is left to a charitable remainder unitrust, or CRUT, which has no other assets. The CRUT will pay 5% of its value each year to Adam as long as he lives. Since the initial funding is $1 million, the first year's payout would be about $50,000. Future payouts would fluctuate up or down as the trust's investments appreciate or depreciate. Assuming a constant 5% return, Adam will receive about $50,000 a year for life. However, if the trust's investment return is less than 5%, Adam's income will decline. A CRUT does not provide a smooth predictable income stream.
That annual payout to Adam will be taxable income to him; although the CRT itself is tax-exempt, it "remembers" each dollar it receives, whether that dollar is ordinary income, a capital gain, municipal-bond interest, and so on. Then when it passes out money to the life beneficiary, the CRT regurgitates those classes on a "worst first" basis. So, for a CRT exclusively funded with an IRA at the IRA owner's death, 100% of the CRT's initial assets are "ordinary income," and that substantial fund will be the source of Adam's 5% payout every year until the IRA proceeds have been entirely paid out--which may never happen.
On Adam's death, whatever is left in the trust will be distributed to Clara's specified charity. Assuming Clara wants to benefit that charity with a substantial gift at Adam's death, the CRUT provides an attractive way to do that. If prior to SECURE Clara had never considered making a large gift to the charity, it becomes questionable. If the goal is primarily to benefit Adam, is he better off getting 5% of this trust per year for life? Or would he be better off inheriting the $1 million IRA outright, even if he has to pay income tax on it within 10 years?
While you run the numbers for your client, and maybe ask Adam his views on the matter, here are some more pros and cons of the CRT as an IRA beneficiary.
First, the drawbacks:
- The life beneficiary cannot receive anything more than the specified annual payout. If Clara wants a fund that would provide extra funds to Adam in case of emergencies or for any other reason, she would have to leave other assets to a different type of trust to cover that goal.
- The minimum value of the charity's remainder interest, as of Clara's death, must be 10% of the total trust value. The planner can use a software program to calculate the remainder value based on the beneficiary's age to make sure the CRT passes this 10% test. The bottom line is, a life trust for 50-year-old Adam will have no problem with this test, but a life trust for Clara's 14-year-old granddaughter would flunk. For very young beneficiaries, the trust would have to be set up for a term of years (maximum 20) rather than for life in order to pass the 10% test.
- The IRA value can be included in Clara's estate for estate tax purposes and would be only partially offset by a charitable deduction for the value of the charity's remainder interest. With very large estates and very large IRAs, the planner must make sure that payment of the estate tax on the human beneficiaries' interests in the CRT is provided for with other assets.
But there are also some additional advantages:
- Though not covered here for space reasons, there are several variations on the CRT device to choose from, such as annuity payouts versus unitrust (percentage) payouts, and unitrust payouts with a net income limitation (with or without a "makeup" provision). Each variation has its attractions for particular situations.
- If the sole human beneficiary of the CRT is the decedent's surviving spouse, there is no estate tax problem to worry about--the spouse's interest qualifies for the marital deduction and the charity's interest qualifies for the charitable deduction.
- Finally, the CRT is not an untested tax idea. The simple CRT requirements are set out in Section 663 of the Internal Revenue Code, and the IRS has even published sample CRT forms guaranteed to meet those requirements. Thus, this device can be in every estate planner's toolbox without the need to rely on abstruse tax theories.
The CRT named as beneficiary of an IRA is (as it has always been) an attractive way to provide a life income to a human beneficiary and a substantial deferred gift to a charity. It will probably be selected more often now that the stretch IRA has been taken off the menu. Consider it especially for any client with substantial retirement benefits seeking to provide a life income to a middle-aged or older individual and a significant charitable gift. Unfortunately, it will probably not "beat SECURE" for other situations.
Where to read more: Software programs for estate planners perform full calculations and projections for CRT planning. Two of the best known are NumberCruncher and Tiger Tables. For more on IRA planning with charitable remainder trusts, see Chapter 7 of Natalie Choate's book Life and Death Planning for Retirement Benefits (8th ed. 2019; www.ataxplan.com). For a full discussion of tax planning with CRTs, including sophisticated planning at the highest level, look for the writings of Jonathan Blattmachr or Conrad Teitell.
Natalie Choate is an estate planning lawyer in Boston with Nutter McClennen & Fish LLP. Her practice is limited to consulting regarding retirement benefits. The 2019 edition of Choate's best-selling book, Life and Death Planning for Retirement Benefits, is available through her website, www.ataxplan.com, where you can also see her speaking schedule and submit questions for this column. The views expressed in this article may or may not reflect the views of Morningstar.