This is, for now, the third and final post related to the changes brought about by the SECURE Act. The first two can be found here and here. As promised, we’ll discuss the impact on QCDs (Qualified Charitable Distributions), issues with naming trusts as beneficiaries of IRAs, and possible strategies for clients with human beneficiaries and charitable interests. The leaf decomposition life cycle piece got shelved for now, apologies to the biologists in the group, who were also deeply uninterested in the topic.
First thing’s first, what about changes to QCDs? Well, despite the SECURE Act changing the date at which clients must take Required Minimum Distributions (RMDs) to age 72, QCDs will continue to be allowed at age 70.5. One important detail, QCDs must be taken after obtaining age 70.5, not just in the year that an account owner turns that age. This will probably provide for some confusion in the future, as those two numbers used to be coupled, which made sense, but that’s our job to track that so you don’t have to. One additional detail that will impact QCDs as a result of SECURE Act changes – since deductible IRA contributions are now allowed post-70.5, there is an anti-abuse provision that prevents clients from simultaneously taking QCDs and deductions for IRA contributions (one doesn’t prevent the other, just changes how they’re accounted for). Rather than confusing everyone with the details, just be aware that if you take a QCD and make a deductible IRA contribution in the same year, you will be impacted – there are planning opportunities to avoid this particular issue.
On to the larger issue, let’s talk about trusts as beneficiaries of IRAs. Before going into greater detail on the topic, we’ll state here that the obvious reason that trusts were used as beneficiaries of IRAs was to provide account owners with some control from the grave – a way to help guide distributions for minor beneficiaries and prevent non-minors from blowing sizeable amounts of money. It was very important, in the past, that those trusts be considered ‘see-through’ trusts to qualify for the stretch provision (distributing over a beneficiary’s life expectancy), but they were great estate planning tools. At the very least, that’s less true now.
There are a couple of reasons why this is the case. First, two major categories of trusts formerly used were conduit and discretionary trusts. The first essentially allowed a trust to only distribute the RMD amount to the designated beneficiary over their lifetime or a predetermined timeframe. The second – discretionary - allowed for the trustee to exercise discretion over when and how much was distributed, annually. The problem with the first is that now, many old trusts have language indicating that only the RMD amount be distributed to the beneficiary annually. Such language would now provide no distributions in the first nine years after an account owner’s death, and distribute the entire account balance to the beneficiary, all in the 10th year. As a large one-time taxable event, it’s not hard to see why that’s a problem. For the discretionary trust, you come up with a similar issue. Even though a trustee would have some discretion to distribute money early, knowing that the entire IRA must be distributed within 10 years would potentially leave large sums in the trust from year to year. Because trust tax rates are so restrictive - $12,950 and above in trust income is taxed at the top 37% federal bracket – leaving money in trusts would provide no tax advantages over distributing large balances.
So, what should a person do if they’re looking to exercise some control over beneficiary distributions? The first thing is something we’ve discussed in one of the previous posts – Roth Conversions. Such conversions eliminate the tax part of the equation (after they’re completed, anyway), even though they still require emptying an account within 10 years. They’re also a better option when used in accordance with a trust because of the different tax status. This, however, requires that the client have a desire to pay taxes during their lifetime that they otherwise would not have paid and also that they’re in a position where it makes sense (doing Roth conversions at the top federal tax rate is not exactly a good strategy in our opinion).
The second option is to use IRA distributions to purchase Life Insurance. Why does this make sense? Multiple reasons – life insurance can be held in a trust, death benefits are tax-free, so there aren’t restrictions as to how the money could be distributed after death, and in general, it would give a person more flexibility. Why would it not make sense? Many people are uninsurable or borderline uninsurable. Even people in good health are extremely expensive to insure at older ages, so you have to weigh the cost of insurance versus the tax trade-off. It might make more sense to do a Roth Conversion or take larger taxable distributions and pass down taxable money to beneficiaries (which gets a step-up in basis after death and doesn’t require distributions, a friendlier set up for a controlled distribution from a trust).
The final option, which we alluded to in the previous posts, was to use a client’s charitable inclination as a tool to control distributions to beneficiaries. It is vitally important and hopefully understood, that for this option to make sense, the client must be charitably inclined. If they’re not, using the charity as a tool to positively impact a beneficiary’s tax situation won’t end up netting them more money overall.
So, assuming the client is charitably inclined, how would this work? We’re going to touch on only one example – other options could work here, as well. A client could select a charity or charities and name them as a beneficiary of a Charitable Remainder Trust (CRT or CRUT). These trusts essentially allow for controlled distributions from the trust during the beneficiary’s lifetime and once the beneficiary passes, the REMAINDER goes to the charity. Obviously, the charitable component allows for some favorable tax treatment and the trust component allows decedents to control distributions to beneficiaries to some extent, but those distributions usually end at the beneficiary’s death, which is an important consideration.
On a different note, IRA owners with both human and charitable beneficiaries should consider the tax implications of their estate plan, as this only reinforces the idea that human beneficiaries make more sense for highly appreciated taxable money, while charities are better options as beneficiaries of IRAs (because they don’t pay tax on distributions) assuming all else is equal. As we know – all else is not always equal, so it’s vitally important, even more so with the new rules in place, that you re-confirm your estate plan and beneficiary designations with your advisor, your attorney, and your accountant. The consequences of failing to do so could be costly. I always tell people, your kids should never complain about one nickel they inherit, but that doesn’t make it any less worth it to pass it on in the most efficient way possible. We’re here to help if you have questions.
This is meant for educational purposes only. It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions. LPL Financial and its representatives do not offer tax or legal advice.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
LPL Financial Representatives offer access to Trust Services through The Private Trust Company N.A., an affiliate of LPL Financial.