7 Must-Know Facts About Federal Income Tax Treatment of IRAs

For this, my final Morningstar column, I’m tackling a topic not covered in any of the 244 previous columns: fiduciary income taxes. What must financial advisors, estate planners, and trust administrators know about how federal income taxes hit an IRA that is payable to a trust when the owner dies?

A traditional IRA (or other “traditional” retirement plan such as a 401(k) plan or 403(b) account) is a big bag full of income that has not yet been taxed. You know that, when you withdraw from the account, you will have to pay income tax on the distribution you receive—it’s includable in your federal gross income. The same is true for your beneficiaries when they receive distributions from the account after your death. Theoretically, both human beneficiaries and trusts are subject to the same federal income tax rates, with a top rate of 37% in 2023. But there are seven key differences between “fiduciary” (trust) income tax rules and individual taxes that can push the tax bill higher when an IRA is payable to a trust.

Here are the seven “FIT facts” (fiduciary income tax facts) you must know to successfully draft or administer a trust that will be beneficiary of an IRA or other retirement account. This is an abbreviated summary of complex tax rules; see note at the end of this column.

1. Trust tax rates are higher.

How can it be that trust tax rates are “higher” than human rates, since both use the same federal income tax rate schedule, with a top bracket of 37%? The difference is in how fast each type of taxpayer gets to the top level. A single individual pays the top rate only on taxable income over $578,125 (2023 rates). A trust gets into the top bracket at a mere $14,451 of taxable income.

Suppose a trust and a single individual each inherit a $1 million IRA in 2023, to be distributed at the rate of $100,000 a year for 10 years. Suppose that after figuring all their other income and deductions, each beneficiary winds up with exactly $100,000 of taxable income each year, and tax rates and brackets stay the same as in 2023. The individual’s total federal income tax over the 10 years will be $174,000. The trust’s will be $351,445—more than double the human beneficiary’s tax burden.

This difference points out a planning principle: Unless all family members are always in the highest tax bracket, a lower income tax burden will result if IRA distributions can be spread among multiple family members (especially if over a number of taxable years), to take advantage of lower brackets of individuals compared with a trust.

2. Trust gets a “DNI deduction.”

Unlike human taxpayers, a trust gets a deduction for passing its income to someone else. A trust can deduct certain payments of “distributable net income” to the trust’s human beneficiaries, if the distribution is made for the same taxable year the income was received by the trust. The distribution is then taxed to the beneficiary at the beneficiary’s rates. There is no dollar limit on the DNI deduction, but as we shall see, not every distribution qualifies for it.

Unfortunately, some advisors don’t worry about high trust taxes because they assume the trust can “take care of it” simply by passing the distributions out to individual beneficiaries. (One might ask, why have the IRA paid to the trust if the trust is going to just pass the money out to the human beneficiaries? Why not make the IRA payable to the humans to start with? Good question.) But in any case, it is not always legally possible for the trustee to pass the IRA distributions out to humans, for various reasons, for instance:

3. “Trust accounting income” is not the same as “federal gross income.”

Suppose the trust that is beneficiary of the IRA says “pay all income to my spouse for life, and on my spouse’s death, pay the principal to my children.” The trustee receives a required minimum distribution of, say, $250,000 from the IRA. That, of course, is gross income to the trust. Can the trustee get rid of that hot potato by passing it out to the spouse? After all, she is entitled to “all income,” and the $250,000 is “gross income” for federal tax purposes, right?

Answer: Under the terms of this trust, the trustee can pay that $250,000 to the spouse only if it is “trust accounting income.” Trust accounting income means (for example) the interest on a bank account, the rent from a property, or the proceeds of crop sales from the farm. The bank account, the rental property, and the farm are “principal” for trust accounting purposes. In the IRS’ view, an IRA distribution will be considered trust accounting income only if it represents the investment income (interest and dividends) earned inside the IRA or a predetermined percentage (between 3% and 5%) of the IRA’s total value annually. Otherwise, the IRA distribution is part of the “principal” of the trust.

The trustee cannot distribute to the spouse (and get a DNI deduction for) more than the trust allows the trustee to distribute to the spouse. Unless the IRA owner insists that the trust beneficiary must be limited to “income” or some other standard (such as distributions for “health or support”), it can be wise to allow the trustee broad discretion to distribute to the beneficiaries. This will help the trustee avoid getting large IRA distributions trapped in the trust’s high tax rates.

4. Difference between “pecuniary” and “residuary” bequests.

A “pecuniary” bequest is a bequest of a fixed dollar amount. In contrast, a “residuary” bequest is a gift of a percentage or fractional share of what’s left in the trust after paying expenses, taxes, and “pecuniary” bequests.

With some exceptions, a trust does not get a DNI deduction for paying a pecuniary bequest.

Grandpa’s trust says “On my death, pay $10,000 to each of my 10 grandchildren.” The trustee withdraws $100,000 from the IRA, generating $100,000 of gross income at the trust level, and distributes $10,000 to each grandchild. There is no DNI deduction for those “pecuniary” distributions. Unless other deductions or offsets are found, the $100,000 IRA distribution will be taxed at the trust level.

5. Separate shares rule.

Here’s another rule that can block the DNI deduction. Some trusts are set up as separate shares for each beneficiary (as in “The trustee shall hold the trust for the benefit of my children equally. Each child shall receive the income from his or her share plus distributions of principal if needed for health or support. Upon a child’s death, his or her share shall be paid to his or her issue if any, otherwise to the other children.”). Other trusts are “pooled” or “pot” trusts (as in “the trustee shall use income and principal for the benefit of all my issue living from time to time as needed for their health, support, and welfare, based on their individual requirements and resources.”) Both approaches are perfectly legal, fine, and frequently used. But there’s a special rule limiting the trustee’s flexibility to allocate big chunks of income disproportionately in a “separate shares”-type trust.

For example: Walter dies, leaving his IRA and other assets to a trust that is to be paid to his two children, A and B, equally, with each child’s share held in trust for her until she reaches age 40. This is a separate shares trust.

Child A is already age 40 and has large business losses that enable her to absorb a substantial chunk of gross income without tax. Child B is only 35 and has no tax losses.

The trustee cashes out Walter’s $1 million IRA and decides to allocate it to Child A’s share while allocating $1 million of other assets to Child B’s share. Child A won’t pay tax because the income is offset by her loss carry-overs. Great planning idea, right? Nope. Can’t do it, says the Tax Code: The gross income resulting from the IRA distribution is allocated for DNI purposes proportionately to the shares that the trustee could have funded with the distribution.

So the trustee can pay out the $1 million of cash from the IRA to Child A but can only deduct $500,000 as a DNI deduction for that distribution. The other $500,000 of DNI lands in Child B’s share. See number seven for how the trustee may be able to sidestep this rule!

6. No DNI deduction for distributions to charity.

Gretta’s trust contains various charitable gifts but contains no special instructions about how (with what assets) those bequests are to be paid. The trustee cashes out part of the IRA payable to the trust and uses the cash to pay the charities. There is no DNI deduction for these distributions to charity. The DNI deduction applies only to distributions to individual beneficiaries.

There is a charitable deduction for trust distributions to charity, under Code section 642(c). The requirements for a 642(c) deduction are even more stringent than those for a DNI deduction. For example, generally, there is no deduction for a charitable gift unless the trust instrument requires that the gift be paid out of “income.” Unless the trust was drafted with 642(c) in mind, it is common for a trust’s charitable gifts not to qualify for the income tax charitable deduction.

This hurdle is easy to clear at the planning stage: Just specify in the trust instrument that the charitable gifts must be paid out of the decedent’s traditional retirement accounts! Failing that, it may be possible to bypass 642(c) altogether at the administration stage—see number seven.

7. Bypass some requirements by transferring the IRA, intact, to the trust beneficiary.

When an IRA is payable to a trust as beneficiary, the trustee can transfer the IRA out of the trust to the trust’s beneficiaries. Assuming the trust document requires or permits the trustee to transfer assets to a trust beneficiary, the trustee can transfer an inherited IRA to the trust beneficiary(ies) just like the trustee can transfer stocks, real estate, and furniture to the beneficiaries. Sometimes the trustee can use this power to sidestep rules five and six.

For example, if the trustee wants to allocate the IRA to one beneficiary of a “separate shares”-type trust, the trustee can just transfer the IRA itself to that beneficiary. Unlike cashing out the IRA and distributing the proceeds, transferring the IRA to a “residuary beneficiary” does not cause realization of income at the trust level, so the question of proper allocation of DNI does not arise. There is no DNI to allocate when the IRA itself is transferred. Similarly, transferring an IRA to a residual charitable beneficiary bypasses Code section 642(c): Since the transfer doesn’t generate income, there is no need to qualify for a deduction to erase that income.

Transferring the IRA does not solve all problems. It does not work for a “pecuniary” bequest because, according to the IRS, that type of transfer would trigger realization of income at the trust level. Also, of course, the transfers must be permitted under the trust instrument and compatible with the trust’s goals and state law.

***

I hope this column alerts advisors to the income tax pitfalls and opportunities with respect to retirement accounts left to a trust as beneficiary. This concludes my 20th year (plus five months) of writing this monthly column, answering questions for advisors, and covering IRA issues advisors need to know, from RMDs to rollovers to investment pitfalls and how to fix mistakes. It’s time for me to move along and do something else for a change. It’s been a pleasure working for the readers of this column!

Endnote: All tax rates and brackets are for 2023; see IRS Rev. Proc. 2022-38. Needless to say, the actual tax rules and regulations are more complex than this brief summary can convey. For fiduciary tax rules cited in this column, see Internal Revenue Code sections 643–665, Rev. Rul. 2006-26, and any respected treatise on fiduciary income tax. Most comments in this column do not apply to qualified distributions from Roth IRAs or designated Roth accounts (distributions from which are income-tax-free) or to distributions of aftertax money from traditional retirement plans.

Natalie Choate practices law in Boston with Nutter McClennen & Fish LLP specializing in estate planning for retirement benefits. The views expressed in this article may or may not reflect the views of Morningstar. The electronic version of Natalie’s book, Life and Death Planning for Retirement Benefits, is now on a new platform with expanded features. The e-book gives you the entire book in word-searchable format, plus two chapters (on life insurance and annuities in retirement plans). Visit www.retirementbenefitsplanning.net to subscribe or learn more.