Tuesday January 19, 2021
Article of the Month
SECURE Act Promotes IRAs to Testamentary Unitrust Plans
SECURE Act Encourages Saving for RetirementBy a bipartisan vote of 71 to 23 on December 19, 2019, the Senate passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act. The SECURE Act was part of a larger appropriations bill.
Both House Ways and Means Chairman Richard Neal (D-MA) and Ranking Member Kevin Brady (R-TX) supported the bill. Brady noted, “Our bipartisan legislation makes it easier for main street business to offer retirement plans to their workers by easing administrative burdens, cutting down on unnecessary and often costly paperwork. In this bill, we also offer local businesses the flexibility to tailor retirement plans to best fit the needs of their workers, not to the needs of Washington.”
The bill includes many provisions designed to facilitate and enhance savings for retirement. These changes have bipartisan support and are helpful for workers who desire to save for retirement.
- Traditional IRA Contributions – Individuals over age 70½ with earned income may continue to make contributions each year. Previously, only Roth IRAs could be funded after age 70½. All IRAs may now be funded at any age, provided you have earned income. These traditional IRA contributions may enable seniors to grow retirement accounts during their 70’s and 80’s.
- Required Minimum Distribution (RMD) Age – For individuals who turn 70½ after December 31, 2019, the RMD age of 70½ is increased to age 72. Those who reached age 70½ during 2019 must still start their RMDs under the previous law. The increased age RMD rule will benefit many IRA owners who do not need to withdraw distributions. Because the IRA balances will be larger with one or two years of added growth, RMDs at age 72 and future years will be larger. Many loyal donors may choose to increase their IRA rollover gifts after age 72.
- Part Time Workers – Those individuals who work at least 500 hours per year for three years will be able to participate in qualified retirement plans.
- Retirement Plan Annuities – The rules are generally expanded to permit more qualified retirement plans to offer annuity payout options. Section 204 of the Act generally limits the liability of employers who offer annuity options in their retirement plans. This employer protection is likely to increase the number of annuity options in many larger retirement plans.
- Retirement Benefit Disclosure – Retirement plan administrators are now required to offer an expanded disclosure of future retirement benefits to participants. These disclosures are intended to help employees better understand the benefits of maximizing their contributions to the retirement plans.
- Stretch Distribution Reduced – Inherited IRAs for nonspouse beneficiaries will no longer be distributed over life expectancy, but IRA and other qualified plans of decedents must be paid out over a maximum term of ten years. There are exceptions for recipients with disabilities, minors and individuals who are within ten years of the age of the IRA owner.
- IRA Rollover Limit Potentially Reduced – If an individual makes contributions to a traditional IRA after age 70½, the $100,000 per year qualified charitable distribution (QCD) limit is reduced by the amount of IRA contributions after that age. The IRA contribution amount is cumulative and specific calculations will eventually be published in IRS Regulations. QCD gifts in excess of post age 70½ traditional IRA cumulative contributions will be included in income and deductible if the individual itemizes deductions. It is probable that most donors either will not have earned income after age 70½, will have total income over the IRA phaseout limits (and may not fund an IRA) or may choose to make Roth IRA contributions.
Dramatic Increase in IRA Transfers to Testamentary UnitrustsThe SECURE Act reduces future taxes for IRA owners by increasing the age for required minimum distributions from 70½ to 72. However, to pay for the cost of this tax reduction, the taxes paid by future nonspouse IRA beneficiaries (typically children) will increase.
Married couples usually designate the survivor as the beneficiary of their IRA or other qualified plan. The survivor may roll over the plan into his or her IRA. However, when a single person or surviving spouse passes away, the IRA is transferred to one or more nonspouse designated beneficiaries. If there is a charitable beneficiary, that portion of the IRA is normally distributed in full to the nonprofit. However, distributions to children, nephews, nieces and other family members may be made over a term of years.
For individuals who passed away in 2019, an IRA beneficiary was able to “stretch” the IRA payout over his or her life expectancy. Assume mother Mary owns a traditional IRA and passed away in 2019 at age 90. She designated daughter Susan (age 60) as her IRA beneficiary and Susan could take distributions over her life expectancy. For a child age 60, the potential distribution period was between age 60 and age 87. By “stretching” the traditional IRA payout, Susan reduced her income tax and benefitted from tax-free growth for many years. Yet, even more tax deferral and growth was possible. A grandchild designated beneficiary may have stretched the tax-free growth and IRA payouts over 60 or 70 years.
However, if Mary passed away in 2020, Susan must take all distributions within ten years. She can wait and take the full payout in the tenth year, but that will greatly increase the tax rate paid on the IRA. Most children will choose to take partial payouts each year for the ten years. With a ten-year payout, the income taxes paid by Susan will be substantially higher than the prior “stretch” plan.
What plan could replace the 2019 “stretch” IRA distribution? Could a plan combine the tax-saving benefits of a "stretch" IRA with a term-of-years or life payout to children or other heirs? Could this plan also have the tax-free growth benefit of a stretch IRA?
While it sounds too good to be true, the IRA to testamentary unitrust plan includes all of these benefits. A single person or surviving spouse may create an unfunded lifetime unitrust or testamentary unitrust in a will or living trust. The IRA beneficiary designation is to the trustee of that unitrust. When the IRA owner passes away, the unitrust is funded with the traditional IRA. Because the unitrust is tax-exempt, there is a bypass of the income tax on the traditional IRA and any future growth.
Parents Desire to Protect “Creative Spender” ChildrenSome couples have three, four or more children. If one of the children is a “creative spender,” a parent may set up a trust. Without the protection of a trust, this child may take the full IRA payout, send a huge tax payment to the IRS and quickly exhaust the balance in creative and unexpected ways. To protect these children, many parents have created “conduit” trusts to pay only the RMDs to them.
Unfortunately, the SECURE Act eliminates RMDs for most children (there are exceptions for a disabled or chronically ill child). With some conduit trusts, under the SECURE Act there is no RMD and no payout to the child for ten years. At that time, the full payout is made and the child will face a huge income tax bill.
Jamie Hopkins is a financial expert with Carson Wealth, headquartered in Omaha, Nebraska. He explains the conduit IRA trust problem and notes, “That is a complete disaster from a planning perspective. We just subjected most of that IRA money to the highest tax margin possible and locked up access to it.”
Because many parents have a “creative” child, but desire to treat all children equally, transferring the IRA to a testamentary unitrust is prudent planning. The unitrust for a term of 20 years or the life of the child benefits the recipient through tax-free growth in the trust and larger total payouts over the trust duration. This unitrust has many excellent tax benefits, especially when compared with the SECURE Act mandatory payout over ten years.
While the testamentary unitrust has better tax benefits than the ten-year mandatory payout, the primary reason most parents select a unitrust is to provide children with a steady payout stream for 20 years or life. The protection benefit will be primary, even though there are excellent tax benefits with a testamentary unitrust funded with an IRA or other qualified retirement plan.
IRA to a Unitrust for ChildrenA unitrust pays 5% or more for a life, lives or a term of 20 years. There are two basic options for transferring an IRA to a unitrust for children or other family members. One option is to transfer the IRA to a term of years trust for the children. The second option is to transfer the IRA to a trust that will pay each child for his or her lifetime.
With the increased estate exemptions and the charitable deduction from the unitrust, it is usually possible to create a unitrust in conjunction with a zero estate tax plan. This plan is well suited to both the inheritance and tax reduction goals of most IRA owners.
To use this plan, the IRA owner may create a unitrust during life for one life plus a term of years or a unitrust for his or her life and the lives of the children. The designated beneficiary of the IRA is the trustee of the unitrust. When the owner passes away, the unitrust is then funded.
While the unitrust may be a testamentary trust in either a will or a living trust, it is much easier to create the lifetime trust for one life plus a term of years and then change the IRA beneficiary designation to the trustee of that trust. The living unitrust may be unfunded in some states (California and others) or it may require nominal funding but no administration. Check the applicable state law for funding requirements.
Give It Twice TrustA popular option is a "Give It Twice" trust. This trust is commonly funded with an IRA or other taxable retirement plan and is used with a zero estate tax plan. In this plan, a substantial portion of the estate of the surviving spouse is transferred outright to children. The IRA is the balance of the estate. It is transferred at death of surviving spouse to a term of years unitrust. Since the unitrust is tax exempt, no income tax is paid when the IRA is distributed to the trust. The full IRA value is invested and pays 5% income to children for a term of 20 years.
The 5% income is taxable, but over 20 years approximately equals the initial IRA balance. At the end of the term of years, the trust is distributed to charity. Therefore, this is a "Give It Twice" unitrust. It transfers the value once to family over the selected term of years and then distributes the value a second time to charity.
The "Give It Twice" unitrust not only saves taxes, but also effectively fulfills the family distribution goals. If a family has three or four children, it is very possible that one child is not as financially capable or responsible as the others. Yet, parents desire to transfer assets equally to children in the proper belief that equality is more likely to lead to peace in the family. While the initial distribution of estate principal may indeed result in expenditure by the less responsible children, they have a second opportunity to acquire financial skills by receiving income for a term of years from the trust. Thus, parents are able to treat all children equally and still provide them with additional opportunities to acquire financial management skills.
Anna Perez Funds a Testamentary Term UnitrustSam and Anna Perez raised four children. Sam passed away last year and Anna rolled over Sam's IRA into her own IRA. She now has an estate of $1.6 million. $800,000 is in her IRA and the estate balance is in her home, CDs and mutual funds.
Anna signs a one-life plus term of 20 years unitrust. She and Sam have always supported a local charity, and Anna would like to benefit her four children and the charity. She changes the beneficiary designation of the IRA to the trustee of the unitrust. When Anna passes away, the $800,000 IRA is transferred to the 5% payout unitrust, saving all of the income tax on the IRA. It is invested for a term of 20 years and pays out over $800,000 to the children during that time. After the 20 years, approximately $1 million will be distributed to Anna's favorite charity.
Each of the four children will receive $200,000 from the balance of the estate. Over a period of 20 years, each child will also receive $200,000 of income. Anna especially likes the way the plan is balanced. Each child receives principal when she passes away and then income for a term of years. Anna believes that this is a desirable plan for the children and a $1 million future gift from the trust remainder will help her favorite charity.
Mary Smith Has a Creative ChildMary Smith has three children and an estate of $1.8 million. She has an IRA that has grown to $1 million, and other property valued at $800,000. Mary would like to provide some principal to her children and then income for their lifetimes.
However, one of her three children has a long history of poor money management. Mary wants to treat her three children equally, but believes that this child will benefit from the protection of lifetime income.
Mary creates a four life unfunded 5% unitrust. The trust names her for one life (but there is no funding during her lifetime) and then pays for life to each of her children. The charitable remainder is over 10%, so the trust is a qualified charitable remainder unitrust. She changes the beneficiary of her IRA to: John Jones of Hometown, State, as Trustee of the Mary Smith Unitrust dated July 4, 2020, for the Benefit of Mary Smith and Her Children. When she passes away, the $1 million IRA is distributed to the trustee of the unitrust for the lifetimes of her three children.
The children receive the balance of the estate outright, with each child receiving over $250,000 (after costs). Each of the three children then receives one-third of the unitrust income. Over the lives of the children, the $1 million unitrust will pay out over $2 million of income. Each child will receive total income of about $750,000 during his or her lifetime. After all three children have passed away, approximately $1.6 million will be available for charity.
Document Options to Transfer IRAs to UnitrustsWith the future growth of IRAs and other retirement plans, there will be a dramatic increase in the number of individuals who choose to bequeath IRAs to charity or to testamentary unitrusts. Some of these persons will transfer an IRA to a unitrust for the life of a spouse or to a spouse and then to children. Other parents will transfer an IRA to a unitrust to benefit children for a term of years or for their lifetime.
What are options to create effective documents for a “Give It Twice” unitrust? In order to create a legal transfer of an IRA, 403(b), 401(k) or other retirement plan to a charity or charitable trust, certain legal procedures must be followed.
IRA Beneficiary DesignationIRAs and pension plans are transferred through a beneficiary designation. With the fairly rare exception of an IRA transferred to an estate, the IRA is not governed by the will of the IRA owner. Thus, it is very important that the IRA beneficiary designation be completed correctly.
IRA custodians provide beneficiary designation forms to select a primary and contingent designated beneficiary. In most cases, the IRA owner should enter the selected person as designated beneficiary on the form and should also enter the name of a contingent beneficiary. For many persons with charitable inclinations, it could be desirable to select a charity as the contingent beneficiary. For example, an IRA owner could select a spouse or child as designated beneficiary and a favorite charity as contingent beneficiary. Favorite charity should be designated by legal name, city and state. Depending upon the income and estate tax rules in effect at the time the person passes away, the designated beneficiary may determine that there would be substantial tax savings by "disclaiming" and allowing the distribution to be made to the contingent charitable recipient.
If an IRA owner decides to benefit a spouse, children or other persons through a testamentary unitrust, he or she must decide how to achieve the desired results. It is not acceptable to merely write a request on the beneficiary form, asking your executor to create a unitrust. The Internal Revenue Service has disallowed charitable estate deductions for such requests, since the unitrust must exist as of date of death of the decedent. Therefore, it is necessary to create an actual trust document, and then to designate the trustee of the trust as the beneficiary of the IRA. For example, a person could create a trust for himself and his spouse and then update on the beneficiary designation section with the following sentence, "To ABC Bank as trustee of the charitable remainder trust dated July 4, 2020, for the initial benefit of Mr. and Mrs. IRA owner."
There are three principal ways to draft the unitrust document. The options include a funded charitable remainder unitrust with an addition at the death of the IRA owner, an unfunded unitrust and a revocable trust or will with the required language.
Funded UnitrustOne of the favorable benefits of charitable remainder unitrusts is that an addition can be made during life or at death. In order to do so, there must be a provision in the trust instrument that allows contributions from an estate and requires the contribution to be effective as of the date of death, even though payments may not be made until after full trust funding.
A married couple could create and fund a two life unitrust during life. If one spouse were to pass away first, that spouse's IRA could be added to the unitrust for the benefit of the survivor. The IRA beneficiary form would merely designate the trustee as recipient under provisions of the charitable remainder unitrust. After payment of the unitrust amounts to the surviving spouse, the remainder is distributed to favorite charities.
A parent or couple with children could create a trust for one life plus a term of years or two lives plus a term of years. A one or two life plus term trust is permissible if all recipients are named and living when the trust is created and there is a termination provision that requires the trust to terminate if all named beneficiaries pass away prior to the expiration of the term of years. For example, a unitrust for a married couple with three children is in effect a trust for the lesser of the five lives or the period of two lives plus 20 years. Note that if children are named as beneficiaries, the Sec. 2056(b)(8) marital deduction will not apply. With community property or joint tenancy assets, one-half of the remaining income interest is included in each taxable estate. However, if one spouse contributes separate property to the trust, under the consideration-furnished rules, the income interest will be included in his or her estate.
With a one or two life plus term of years trust, the parent or couple may receive unitrust income distributions during life. For a married couple, the survivor will receive the required IRA distributions from his or her plan, plus the income payouts from the unitrust. After both parents pass away, the IRA designated beneficiary for the surviving spouse is the trustee of the unitrust. This trustee will then receive the IRA distribution, add the IRA proceeds to the unitrust and make payments to children for the term of years.
When the IRA is transferred to the trust, the IRA is terminated and the trust receives the distribution from the IRA. In most cases, a traditional IRA or other qualified retirement plan represents 100% untaxed ordinary income and the entire IRA distribution will be allocated to ordinary income. Thus, unitrust payouts to children will be ordinary income. However, because the unitrust is tax exempt, the trustee may invest full value of the IRA in order to maximize the new income.
With a funded unitrust, an addition may also be made from a profit sharing, retirement or 401(k) account. However, in these cases a spouse must sign a consent form for the beneficiary designation. As a practical matter, since spouses may either live in or move to a community property state, it is good practice for both spouses to sign consents to the plan to create a charitable trust that will later receive IRA or other deferred compensation distributions.
Creating a funded unitrust will require normal trust administration and accounting services. The trustee must invest and manage the trust corpus, track the four-tier trust accounting, make the correct payments to the income recipients and file the annual IRS Form 5227.
Unfunded UnitrustSome individuals desire to create a plan for transfer of an IRA to a charitable remainder trust, but do not want to fund and administer the trust during life. For the individual who does not wish to operate the trust during life but would prefer that the unitrust is available to receive the distribution from an IRA, an unfunded unitrust may be created.
Under the laws of most states, it is permissible to create a trust with nominal or no funding. The IRA owner may sign an unfunded trust and designate the trustee as the IRA beneficiary. In a few states, applicable trust law may require funding of $10 or $20. In those states, the typical practice is to create and sign a trust document and staple a $10 or $20 bill to the trust instrument.
This unfunded trust is valid under state law, but does not require administration under federal statutes until it is funded at the death of the IRA owner. Since no investment or activity is required, Treasury has not objected to this practice.
An unfunded unitrust may be a two life unitrust or could be a one or two life plus term of years trust. The trust should be created prior to signing the beneficiary designation form and filing it with the IRA custodian. For a surviving spouse, the one life plus term of years unfunded unitrust is frequently selected.
Revocable Trust or WillThe final option for documentation is to include a trust document in a revocable trust or a will. The trust will generally be a one life trust for a surviving spouse, a term of years trust for children or a one life trust for a child. It should be clearly identified within the revocable trust or will as a separate charitable remainder unitrust effective only at the death of the testator. It should have a specific number or article designation.
After the living trust or will document has been created by the testator, it is then possible to designate that testamentary trust as the beneficiary of the IRA. The beneficiary designation could be similar to the following: "To ABC Bank as trustee of the charitable remainder unitrust for child A, identified as 'Article H' in the Mary Jones Living Trust dated July 4, 2001." The designation for a will could use comparable language.