Retirement plan assets are becoming an ever-increasing portion of household wealth—nearly 28% of total US net worth is held in IRAs or other retirement vehicles.* These assets—reaching over $27 trillion at the end of 2018*—are complicating basic estate planning as individuals struggle with how best to structure them to minimize taxes for beneficiaries. At the heart of the discussion is deciding if they should be left in a trust or to individual beneficiaries.
Why a Trust?
A trust has several attractive features: It limits a beneficiary’s access to funds and can help manage spending behavior; it protects assets from future creditors, including ex-spouses; and depending on its structure, a trust can direct control or reduce estate taxes. For example, a qualified terminable interest property trust (QTIP) can be used to limit a surviving spouse’s ability to control the ultimate disposition of assets. In second marriages, a common objective is to provide for a surviving spouse and ensure that after that spouse’s death, the remainder goes to the children from a prior marriage. Alternatively, a credit shelter trust can be used to improve estate tax savings. A trust can also be designed with controls and other provisions when a beneficiary is incapacitated.
Five Years, or Expected Life?
But naming a trust as the beneficiary of an IRA or other retirement account can be complex. The complication centers around whether the retirement assets can be stretched out over the beneficiary’s lifetime or are required to be distributed much sooner. We explain further below.
US Treasury regulations say that only individuals can be designated beneficiaries. So if an estate or a charitable organization is named as a beneficiary, then the retirement account is treated as having no designated beneficiary. As a result, if a participant of the retirement account dies prior to age 70½, which is the age required minimum distributions must start, and there is no designated beneficiary, then the entire retirement account must be distributed within five years of his death. Conversely, if the participant dies on or after age 70½, then the retirement account can be distributed over the deceased’s life expectancy, had he still been living.
Under certain conditions, however, a trust can be considered a beneficiary. For instance, in a see-through trust, the trust’s beneficiaries are considered the designated beneficiaries of inherited retirement assets, and required minimum distributions are based on the oldest beneficiary’s age. A trust qualifies as a see-through trust if it meets four criteria—it is valid under state law, it is irrevocable or will become irrevocable upon death of the grantor, the beneficiaries are identifiable and are considered individual beneficiaries, and upon timely presentation of relevant documentation to the plan administrator. Of these, the third—all the beneficiaries can be identified and are considered individual beneficiaries—is the most difficult criteria for one reason: Determining which beneficiaries should be counted and which beneficiaries are mere successors can be a problem. This is important because mere successor beneficiaries don’t need to be counted when determining if the trust qualifies as a see-through trust.
For purposes of determining mere successor beneficiaries, trusts can be divided into two types: conduit or accumulation. In conduit trusts, the trustee cannot accumulate distributions from retirement accounts. In other words, the trustee is required to issue all distributions from the retirement plan to the trust beneficiary, regardless of the beneficiary’s circumstances. Despite that drawback, conduit trusts are attractive because they ensure a trust qualifies as a see-through trust. In contrast, an accumulation trust has the power to amass retirement plan distributions. But unlike a conduit trust, an accumulation trust is not guaranteed to be a see-through trust because it can be difficult to figure out which beneficiaries are disregarded as mere potential successors, thus triggering the 5-year rule.
Special Spousal Rules
Spouses receive special consideration that may make a trust beneficial. The tax code provides special minimum distribution rules that apply when the sole primary beneficiary is the participant’s spouse. A trust for which the spouse is the sole beneficiary also qualifies. If the spouse alone inherits the benefits, then she is the sole beneficiary. In this case, there are three special rules that allow for favorable treatment of a spouse: the required beginning date for minimum distributions is postponed to the year in which the (deceased) participant would have reached age 70½; the required minimum distributions are based on the spouse’s life expectancy which is recalculated annually, typically resulting in smaller required distributions than the fixed life expectancy method; and the spouse can roll over inherited benefits to her own retirement plan, thus allowing for even smaller required distributions in many cases.
The Goal: Tax Deferral
Whether a see-through trust applies, or special spousal rules can postpone distributions, both are trying to accomplish one thing: to defer the payment of income taxes as long as possible. Leaving retirement accounts in trust is often thought to be less tax efficient then leaving retirement accounts directly to individual beneficiaries. One reason is the uncertainty as to whether an accumulation trust will ultimately qualify as a see-through trust or be forced to distribute all assets from the retirement account within five years of death.
To quantify the potential cost of a trust failing to qualify as a see-through trust, consider the following example:
- Scenario A (Stretch IRA)**: $1 million IRA left to an individual beneficiary age 45; participant died prior to RBD;
- Scenario B (5-Year Rule)**: $1 million IRA left to an accumulation trust that failed to qualify as a see-through trust requiring the entire balance to be distributed within five years
In this example, the 5-year distribution rule appears to be very costly after the fifth year. In fact, at year five, the stretch IRA produces 51% more wealth compared to the 5-year distribution rule, if the trust fails to qualify as a see-through trust (Display).
When the analysis is adjusted for the income taxes embedded in the retirement account’s accumulated value, a much different picture starts to emerge. In this case, the 5-year rule initially eliminates the gap with the stretch IRA. It takes about 15 years for the stretch IRA to produce more after-tax wealth than the 5-year method. Why?
The stretch IRA is essentially deferring taxes on its investment gain. In a balanced portfolio of traditional investments like stocks and bonds, the investment return will consist of capital gains and qualified dividends, which are normally taxed at a maximum rate of 23.8%.*** Thus, the retirement account converts low-tax capital gains and qualified dividends into high-tax ordinary income when distributed. If the investor has a sufficiently long time horizon—over 15 years in this case—the compounding effect of tax deferral will eventually overcome the tax rate differential to provide more after-tax wealth. For example, over 40 years, the stretch IRA creates an additional $800,000 of after-tax wealth (Display).
Trusts Can Make Sense
Leaving retirement assets in trusts may not be as costly as commonly believed and, in fact, may create more wealth. Unfortunately, the devil lies in the details, and ensuring that assets can be distributed over the expected life, and not within five years is the key. With a longer deferral, more after-tax wealth can be created. In that case, leaving retirement assets in a trust, and not to an individual beneficiary makes sense.
But in May, the House of Representatives passed the SECURE Act which among other changes would eliminate the lifetime stretch IRA as an option for many beneficiaries. In Part 2 of our series, we’ll talk about how the proposed changes could impact retirement assets.
*2019 Investment Company Fact Book (59th edition)
**Assume top federal tax rates and an investment allocation of 60% global stocks and 40% fixed income.
*** Consists of a 20% federal capital gain rate and a 3.8% tax on net investment income.
The views expressed herein do not constitute and should not be considered to be legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.