Using a Charitable Remainder Trust to Leave Your IRA to Your Children…And To Charity
IRA accounts, which for many of us started as annual $2,000 contributions in the early 1980s, have grown to be major factors within the estate planning process. It was recently estimated that more than $19 trillion sits in Traditional IRA accounts as of 2020. At Fidelity Investments alone, there are more than 300,000 IRA accounts with at least $1 million. Naming beneficiaries for IRAs, as well as for 401(k) plans, now requires careful consideration, especially with the changing rules for taking distributions from inherited IRAs, as well as with changing income tax rates.
For many people, naming their spouse as their primary beneficiary is usually the best option, because spousal beneficiaries can simply roll over inherited IRA assets into their own IRA. However, the decision becomes more complicated if the beneficiary is not a spouse. The SECURE Act of 2019 eliminated the “Stretch IRA”, which allowed non-spouse IRA beneficiaries to take distributions from their inherited Traditional IRA over their lifetime. The new rules require that IRAs inherited by non-spouse beneficiaries, with a few exceptions*, must be fully distributed within ten years. Given that many non-spouse IRA beneficiaries, often the IRA owner’s children, are in their prime earnings years when they receive their inherited IRA, this can be costly from a taxation standpoint. For example, an inherited IRA worth $500,000, if taken in equal amounts over the ten-year time period, could add $50,000 per year to the beneficiary’s taxable income and possibly push the beneficiary into a higher tax bracket.
If you have large Traditional IRA or 401(k) balances that you want to leave to your children, and you also would like to leave some money to a charity, you may want to talk to your estate planning attorney about naming a Charitable Remainder Trust (CRT) as the primary beneficiary of your retirement account and naming your children as income beneficiaries of the trust. A CRT is an irrevocable trust that distributes a percentage of assets each year to individual beneficiaries over their lifetime or for a period of up to 20 years. After that, whatever remains in the trust goes to the charity. The trust could pay a regular income stream to your children over their lifetime, with a predetermined charity receiving any assets remaining in the trust after the death of the beneficiaries.
A CRT can be particularly beneficial if the beneficiaries are relatively young, although not so young that the trust does not meet the requirement that at least 10% of the initial value of the assets pass to the charity. It is important to note that the CRT must have no other assets. The payouts can be specified as a percent of the initial value of the trust (Charitable Remainder Unitrust, or CRUT) or can be recalculated each year (Charitable Remainder Annuity Trust, or CRAT) as the value of the trust assets changes, with a minimum payout percentage of 5%. The advantage of a CRAT is that the payouts will reflect inflation and there is no risk of the trust being exhausted.
As the IRA owner, you could select the charity or charities, or you could specify that the beneficiaries make the selection. You also may select the trustees of the trust, which could include a beneficiary of the CRT, who may also have the power to remove and replace any co-trustees. The trust can require that any replacement trustee not be someone related or subordinate to a beneficiary.
One consideration that may be important to some owners of large IRAs is concern over a son or daughter receiving a large amount of money at one time and possibly being ill-equipped to handle it responsibly. Another factor may be the desire to provide protection from the beneficiary’s creditors or from marital property in the event of a divorce. Also, if the IRA owner has a large enough estate that estate taxes will be assessed, the estate receives a tax deduction for the value of the remainder interest that will go to the charity. Note that there is significant uncertainty surrounding the size of the estate tax exemption, which is currently in the $10-11 million range but could possibly fall to $5-6 million or even lower, depending on what Congress does.
Here is how a CRT works. Upon the IRA owner’s death, the trust is funded with 100% of the value of the IRA. There is no immediate income taxation because of the tax-exempt status of the charity. The beneficiary is taxed at ordinary income rates upon receipt of each annual distribution. Once all the pre-tax IRA money is distributed, taxation of payouts is based on the nature of the income within the trust, which could be at ordinary income rates, capital gains rates, or may even be tax-exempt. But the highest tax rate items are deemed to be distributed first.
It is very difficult to compare the ultimate after-tax value of using a CRT versus simply naming the children as beneficiaries, which would require them to distribute all the money within 10 years, because there are so many unknowns. However, it is possible that a CRT may result in higher after-tax results over time for the family as a whole. There are many factors that come into play: how long the beneficiaries live and their marginal income tax rates; the possible tax savings of the charitable contribution if the IRA owner’s estate is large enough to trigger estate taxes; the types of investments the CRT holds and the investment return; the selected payout rate. The after-tax benefit of the CRT could conceivably outweigh the 10-year rule if any of the beneficiaries are grandchildren with longer life expectancies, as long as they are old enough that the CRT is in compliance with the minimum payout rule.
Establishing and administering a CRT does entail some cost and complexity. In addition to the fee charged by the estate planning attorney, a CRT has to file annual income tax returns on Form 5227. Also, the trustees may receive fees for serving as trustees.
*Exceptions are an eligible minor, a person less than ten years younger than the original owner, or the disabled or chronically ill. Once a minor reaches the age of majority, the 10-year rule then applies, although the age of majority can be extended until age 26 if in school.
More information can be found on the westbranchcapital.com Home Page. Simply scroll to the “Do I need a Trust?” button for a helpful guide. Any time you require assistance with Trusts or other matters, give us a call at (833) 888-0534 x2.
About The Author
Anne Christopulos
Anne is a Managing Director and Financial Planner with over twenty years of experience in the financial services industry. After holding corporate management positions in finance and strategic planning in New York City, she moved to Boston to become the Product Manager for the IRA business at Fidelity Investments. Following that, she was Vice President, Retirement Investments, at Fleet Financial Services. A native of Cape Cod, she returned to the Cape in 2001 and made the transition to personal financial planning with Secure Future Financial Services in Dennis and Davis Financial Services in Orleans before joining West Branch Capital. Anne holds a B.A. in music and economics from Wellesley College and an MBA from Harvard Business School.
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