The passage of the SECURE Act in December of 2019 introduced several notable changes to the rules governing retirement accounts. One of the most significant was the elimination of the ‘stretch’ provision applicable to most non-spouse Designated Beneficiaries of inherited retirement accounts. Instead of allowing such beneficiaries to continue ‘stretching’ their distributions over the span of their own lifetimes, the SECURE Act now requires that certain beneficiaries deplete their inherited retirement accounts by the end of the 10th year after the year of the account owner’s death. And while that poses challenges when planning for individuals who are retirement account beneficiaries… the planning challenges increase exponentially for “See-Through” Trusts, which can also be designated retirement account beneficiaries.
See-Through Trusts are treated as a Designated Beneficiary (by “seeing through” to the underlying beneficiaries) of an inherited retirement account and come in two basic forms – a “Conduit Trust” and a “Discretionary Trust”. Whereas conduit trusts require all distributions from an inherited retirement account received by the trust to be passed out (i.e., “conduited”) to the trust beneficiaries each year, discretionary trusts allow for the build-up of distributed dollars within the trust. Under certain circumstances, each type of trust can still take advantage of the stretch provision if the underlying beneficiaries can be considered Eligible Designated Beneficiaries, but See-Through Trusts will generally be subject to the 10-Year Rule if the underlying beneficiaries are Non-Eligible Designated Beneficiaries.
Applicable Multi-Beneficiary Trusts, meanwhile, can be used for trusts that have multiple beneficiaries (all of whom are people), when one or more of the beneficiaries is a disabled or chronically ill person. These trusts were established by the SECURE Act to help beneficiaries maintain their eligibility in certain means-tested programs such as Supplemental Security Income and Medicare. If Non-Eligible Designated Beneficiaries are named as beneficiaries to an Applicable Multi-Beneficiary Trust, the stretch provision can still apply to the disabled/chronically ill beneficiary (and would be based on the oldest beneficiary if all are disabled/chronically ill), provided the trust splits into a separate sub-trust for the disabled/chronically ill person immediately upon the account owner’s death.
The primary challenge that the SECURE Act imposes on discretionary trusts stems from the high trust tax rate – the income threshold for the maximum trust tax rate (37%) is only $12,950, versus the income threshold of $622,050 for the 37% personal income tax bracket for joint filers! And because any funds distributed from a retirement account to the trust will be taxed at the trust’s income tax rate if they are not subsequently distributed to the trust beneficiary in the same tax year, the tax liability that can result from distributions left in the trust can be substantial.
Some strategies that financial advisors can use to help clients maximize the post-tax value of inherited retirement account funds left to a Discretionary Trust include immediate Roth conversions of any distributions from the inherited retirement account, which especially makes sense when the account owner is in a lower tax bracket. If Roth conversions are not possible (e.g., if income is too high to permit them), using distributions to fund a life insurance policy can be a potential alternative strategy, but only if there is relative certainty that the funds won’t be needed during the account owner’s lifetime. Other strategies that permit distributions to be taxed at potentially lower individual income tax rates instead of the higher trust rates include providing the trustee with the freedom to time inherited retirement account distributions and creating a Discretionary Trust that allows a beneficiary to exercise a power of withdrawal over annual distributions made from the IRA to the trust.
Ultimately, the key point is that Discretionary Trusts, like Conduit Trusts, have been significantly impacted under the SECURE Act. Accordingly, it is crucial for advisors to know which clients have named a discretionary trust as part of their planning, and for those clients with special needs trusts, to ensure that they conform to applicable MBT guidelines. The low-income threshold for the highest trust tax rate bracket is a particular challenge for trust distributions and can be avoided by using Roth conversions immediately after distributions are made to the trust; timing distributions between inherited retirement accounts, the trust, and the beneficiaries; and providing the beneficiary with the power of withdrawal over annual distributions (when it makes sense to do so).