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).
On December 20, 2019, the SECURE Act was signed into law by President Donald Trump as part of the Further Consolidated Appropriations Act of 2020. Its various provisions amended the rules governing retirement accounts in a variety of ways, from the age at which Required Minimum Distributions (RMDs) must begin, to the ability to contribute to a Traditional IRA, regardless of age. But individual client situations aside, the SECURE Act change which has received the greatest amount of attention – and for good reason – is its elimination of the ‘stretch’ provision for most non-spouse Designated Beneficiaries of retirement accounts.
Instead of being able to spread distributions out over an IRS-provided life expectancy (which would often span multiple decades), many beneficiaries are now stuck with a new 10-Year Rule. This includes many See-Through Trusts and, in particular, those See-Through trusts drafted as Discretionary Trusts.
In fact, such trusts will nearly always be subject to the 10-Year Rule when named as the beneficiary of a retirement account, unless they fit into a narrowly defined new type of trust – the Applicable Multi-Beneficiary Trust – created by the SECURE Act when a Disabled and/or Chronically Ill person is one of the multiple beneficiaries of a discretionary trust.
Accordingly, as a result of the SECURE Act’s changes, the decision of whether to utilize a trust as the beneficiary of a retirement account in the first place will become more complicated for some retirement account owners. As while discretionary trusts may be appealing for the capabilities of the trust to maintain control of (or protection of) the assets, at the same time, for those who ultimately decide to continue using a discretionary trust as a part of their financial planning, the tax-related costs for doing so will often be substantially higher than was the case prior to the SECURE Act’s enactment.
Trusts As Retirement Account Beneficiaries After The SECURE Act
Trusts are not living persons and have no life expectancy. Therefore, by default, trust beneficiaries of retirement accounts are Non-Designated Beneficiaries, potentially subject to the infamous 5-Year Rule (that the entire account balance must be distributed by the 5th year after death).
However, if a trust meets the requirements outlined under Treasury Regulation 1.401(a)(9)-4, Q&A-5 and qualifies as a See-Through Trust, it is able to be treated as a Designated Beneficiary (by “seeing through” the trust to the underlying beneficiaries and being able to use their life expectancy instead, or the oldest life expectancy in the case of multiple see-through beneficiaries).
The SECURE Act, however, effectively split the ‘old’ group of Designated Beneficiaries into two groups of its own: Designated Beneficiaries who are Eligible Designated Beneficiaries who continue to be able to ‘stretch’ distributions as they were able to do prior to the SECURE Act’s enactment, and Designated Beneficiaries who are not Eligible Designated Beneficiaries (a.k.a. Non-Eligible Designated Beneficiaries) who are now stuck with a newly-created 10-Year Rule, requiring that all funds be distributed from an inherited retirement account by the end of the 10th year after death.
Thus, in the post-SECURE Act world, when a retirement account is left to a See-Through Trust, whether or how much the trust gets to stretch is based on whether those underlying beneficiaries, themselves, will be treated as Eligible Designated Beneficiaries or as Non-Eligible Designated Beneficiaries.
Notably, though, the post-death distribution rules for both types of Designated Beneficiaries (Eligible Designated Beneficiaries and Non-Eligible Designated Beneficiaries) remain more favorable than the post-death treatment which continues to apply to Non-Designated Beneficiaries, like trusts which fail to meet the See-Through Trust rules. Such beneficiaries must distribute all funds from an inherited IRA (401(k), 403(b), or other retirement account) by the end of the 5th year after death if the owner’s death occurs before their Required Beginning Date (RBD), or using the decedent’s remaining Single Life Expectancy if death occurred on or after their RBD.
Discretionary See-Through Trusts After The SECURE Act
Trusts that are named as the beneficiary of a retirement account and qualify as See-Through Trusts actually come in two ‘flavors’: Conduit Trusts and Discretionary Trusts.
Conduit Trusts are See-Through Trusts which require that any distributions received by the trust from an inherited retirement account be passed right out from the trust to the trust beneficiaries (i.e., the trust is merely a ‘conduit’ for distributions from the IRA to the underlying trust beneficiaries). A Discretionary Trust, on the other hand, is any other See-Through Trust (that does not meet the Conduit requirement).
Common examples of Discretionary Trusts include trusts with language that calls for distributions to the trust beneficiaries to be:
- Avoided until the trust beneficiaries reach certain ages;
- Limited to certain purposes, such as for Health, Education, Maintenance, and Support (HEMS); or
- Left solely up to the discretion of the trustee (note that even if the trustee opts to distribute any amounts received by the trust from an inherited retirement account to the trust beneficiaries each year, the trust is still a Discretionary Trust… because the trust had a choice in the matter!).
In other words, discretionary trusts are often trusts that grant the trustee some discretion about when and whether to make distributions (and not necessarily ‘conduit’ them through to the beneficiaries immediately).
One critical aspect of Discretionary Trusts is that, when determining the applicable life (or lives) to use to determine the post-death distribution rules, (i.e., whether the trust will be considered an Eligible Designated Beneficiary and eligible to ‘stretch’, or a Non-Eligible Designated Beneficiary subject to the 10-Year Rule), the lives of all current income beneficiaries and (potential) future beneficiaries must be considered, and then must use the least favorable distribution schedule that would apply to any single beneficiary if they were named directly.
Given this requirement, with only a narrow exception (for Applicable Multi-Beneficiary Trusts, discussed further, below), it would appear that all Discretionary Trusts would be Non-Eligible Designated Beneficiaries, subject to the 10-Year Rule. Because at some point in line of beneficiaries, there’s almost certainly going to at least one of them that’s not an Eligible Designated Beneficiary, right?
Example #1: Veronica is the owner of an IRA and has named a Discretionary Trust as her IRA beneficiary.
Her trust gives her trustee full discretion over when to take distributions, and how much they should be, but requires that any distributions from the trust be used to benefit her husband for as long as he is alive. Upon his passing, the remaining assets shall be held in trust for the benefit of her adult children.
Although Veronica’s husband is an Eligible Designated Beneficiary (meeting the ‘surviving spouse’ criteria), her adult children are Non-Eligible Designated Beneficiaries (as only a ‘decedent’s minor child’ can be considered an eligible designated beneficiary).
And recall that a Discretionary Trust has to look at all current income beneficiaries and potential future beneficiaries to determine the post-death distribution rules that apply, and must then use the least favorable distribution schedule that would apply to any single beneficiary if they were named directly.
As such, Veronica’s trust must be treated as a Non-Eligible Designated Beneficiary (because her adult children are Non-Eligible Designated Beneficiaries), and is therefore subject to the 10-Year Rule.
Applicable Multi-Beneficiary Trusts Are Not Subject To The 10-Year Rule
There is one exception to the general rule that Discretionary Trusts will be ‘stuck’ using the 10-Year Rule, and that’s when the Discretionary Trust is an Applicable Multi-Beneficiary Trust. Such trusts were created by Congress as a way to save the ‘stretch’ provision for disabled and chronically ill individuals left assets via a trust who, given the SECURE Act’s other changes, would have likely lost their ability to benefit from the ‘stretch’ otherwise.
More specifically, disabled and chronically ill persons are frequent recipients of means-tested programs, such as Supplemental Security Income (SSI) and Medicare. These benefits can be lost if an individual’s income and/or assets exceed certain levels. As such, when disabled or chronically ill persons are the intended beneficiaries of an individual’s assets, sound planning generally calls for such assets to be left to a Special Needs Trust (also called Supplemental Needs Trusts) for their benefit.
Leaving assets to a trust benefiting a disabled and/or chronically person (as opposed to leaving them assets outright) can keep the asset from being considered an ‘available’ asset, thereby maintaining the trust beneficiary’s eligibility for means-tested programs. But in order to avoid having distributions from the trust used to benefit the same individual from impacting means-tested benefits, the trust must include certain restrictions around the distributions.
For example, a simple Special Needs Trust might include language that says something to the effect of:
My Trustee shall have complete discretion over the amount and timing of all distributions, provided such distributions are used solely for the benefit of my beneficiary, and solely for goods and services that supplement those provided by SSI, Medicaid, or similar means-tested programs.
At no time shall my Trustee make a distribution from this trust that would jeopardize my beneficiary’s eligibility for any of the aforementioned benefits.
Clearly, this type of language is not the “pay-everything-that-comes-into-this-trust-right-out-to-the-trust-beneficiaries” type of language it takes to create a Conduit Trust. Therefore, the inclusion of such language makes a trust a Discretionary Trust.
So, let’s play this through for a moment. Disabled persons and chronically ill persons generally ‘need’ to have assets left to a trust that includes restrictive language with respect to trust distributions… such language will automatically turn any such See-Through Trust into a Discretionary Trust… and Discretionary Trusts are generally stuck with the 10-Year Rule (as even if the disabled beneficiary themselves is an Eligible Designated Beneficiary, someone or some other entity will typically receive the balance in the trust if not used, and that person is rarely an Eligible Designated Beneficiary as well).
Put all those together and, absent some sort of special carveout, disabled and or chronically ill persons would essentially always be stuck with the 10-Year Rule, even though they are supposed to be Eligible Designated Beneficiaries!
Cue the Applicable Multi-Beneficiary Trust.
Nerd Note: Retirement advisors may recall that in the summer of 2019, the U.S. House of Representatives passed a version of the SECURE Act with overwhelming bipartisan support. In fact, the vote was 417 “yay”, and only 3 “nay!” Nevertheless, despite this strong bipartisan support (and a whole bunch of pressure from lobbyists), the SECURE Act got ‘stuck’ in the U.S. Senate, and was not even able to be brought to the floor for a vote.
That was the case, at least, until the SECURE Act was ‘attached’ to HR 1865, better known as the Further Consolidated Appropriations Act of 2020, an appropriations bill that had to be passed in December of 2019 in order to keep the Federal government funded and to avoid a shutdown. Notably, the House-passed version of the SECURE Act that was passed during the summer of 2019, and the final SECURE Act that was passed as part of the Further Consolidated Appropriations Act of 2019 were nearly identical. Arguably, the biggest difference between the two is that only the final version of the bill (the one that became law) contained the provision which created Applicable Multi-Beneficiary Trusts!
Rules for Applicable Multi-Beneficiary Trusts
Newly created by the SECURE Act, IRC Section 401(a)(9)(H)(v) outlines the requirements for a trust to be considered an Applicable Multi-Beneficiary Trust that is eligible to stretch distributions (at least for its disabled or chronically ill beneficiaries).
Essentially, an Applicable Multi-Beneficiary Trust must meet the following three requirements:
- The trust must have more than one beneficiary, but that’s always going to be the case with a properly drafted Special Needs Trust (which we know must be a Discretionary Trust), because the trust holds property in trust for the disabled beneficiary (which means someone else must get whatever is left thereafter), and all current and potential future beneficiaries are considered beneficiaries of the trust! So… check that box off;
- All the trust beneficiaries must be people. Note that by requiring all the trust beneficiaries to be people, it effectively eliminates the ability for such a trust to make charity a future beneficiary; and
- At least one of the individual beneficiaries be a disabled and/or chronically ill person, as defined by the SECURE Act.
Applicable Multi-Beneficiary Trusts – ‘Master Trust’ With At Least One Beneficiary Disabled/Chronically Ill
It is also worth noting that, per IRC Section 401(a)(9)(H)(iv), Applicable Multi-Beneficiary Trusts effectively come in two ‘flavors’, one where the trust beneficiaries are not necessarily all disabled or chronically ill, and the other where all current income beneficiaries must be disabled or chronically ill.
The first type of Applicable Multi-Beneficiary Trust is a ‘master trust’, which splits out into separate subtrusts for each trust beneficiary immediately upon the retirement account owner’s death, and where at least one subtrust is for the benefit of a disabled or chronically ill trust beneficiary. In such instances, any subtrust for the benefit of a disabled and/or chronically ill person will be able to stretch distributions using the disabled and/or chronically person’s life expectancy (for as long as the disabled and/or chronically ill trust beneficiary lives).
Example #2: Jake is a 45-year-old disabled individual with two healthy adult siblings. Jake’s father has created a (‘master’) trust to be his IRA beneficiary.
Upon his death, the trust immediately splits into three subtrusts, one for each of his children, including Jake.
Here, the two subtrusts created for Jake’s siblings will each be subject to the 10-Year Rule. The subtrust for Jake, however, will be able to stretch distributions over his single life expectancy.
There are a few key points worth highlighting about the “Master Trust” as a kind of Applicable Multi-Beneficiary Trust.
First, the idea that a subtrust of a master trust would be able to use the subtrust beneficiary’s age to stretch distributions is in direct conflict with the IRS’s long-standing position when master trusts split into sub-trusts after death of the retirement account owner. In the past, the IRS has consistently held that when a single trust is named as the beneficiary of a retirement account, there is a single distribution schedule that is applicable to the entire trust, regardless of how the trust itself may subsequently be split. The SECURE Act now codifies a directly contrary position, allowing a sub-trust for the disabled or chronically ill beneficiary to have its own stretch period (but only for this unique case).
Secondly, the precise language of IRC Section 401(a)(9)(H)(iv)(I) says that, to qualify, the master trust “is to be divided immediately upon the death of the employee into separate trusts for each beneficiary.” [Emphasis added]. A plain reading of this statute would mean that if a ‘master’ trust has 10 beneficiaries, and just one of them is disabled and/or chronically ill, the trust must still be split into separate subtrusts for each of the 10 beneficiaries in order for the one disabled and/or chronically ill beneficiary to be able to stretch distributions. Even though the other nine subtrusts will all be subject to the same 10-Year Rule and didn’t necessarily actually need to be (or benefit from being) split!
Applicable Multi-Beneficiary Trusts – All Beneficiaries Disabled/Chronically Ill
The second type of Applicable Multi-Beneficiary Trust is a trust in which all of the current income beneficiaries are disabled and/or chronically ill, and no one other than those disabled and/or chronically ill trust beneficiaries has any right to the trust until all of the disabled and/or chronically ill trust beneficiaries have died. In such instances, the trust would use the age of the oldest disabled and/or chronically ill beneficiary to calculate post-death RMDs.
Example #3: Victor is the owner of a large IRA. He has three adult children, ages 41, 45, and 50, all of whom are disabled with special needs.
Victor can create a trust that allows the trust assets to be used for the benefit of each of his three children, in any amounts and percentages as the trustee sees fit.
If the trust is drafted in a manner that prevents anyone other than Victor’s three children from benefiting from the trust’s assets until all three of his children have died, the trust will be able to stretch distributions using his oldest child’s age.
Challenges Associated With Discretionary Trusts Subject To The SECURE Act’s 10-Year Rule
While the Applicable Multi-Beneficiary Trust provides a window of opportunity for Special Needs Trusts to be able to stretch distributions specifically in the case of disabled or chronically ill beneficiaries, as discussed earlier, the general rule of thumb for Discretionary Trusts is that they are subject to the SECURE Act’s 10-Year Rule.
It’s important to understand, however, that the 10-Year Rule only impacts the time that the trust beneficiary has to empty an inherited retirement account, but not the time that the trust, itself, has to distribute funds out to the trust beneficiaries. That remains dictated by the trust’s terms (and to a lesser extent, states’ laws against perpetuities).
It can be helpful to think of an inherited retirement account left to a Discretionary Trust as having two ‘checkpoints’. The first checkpoint is between the inherited retirement account and the Discretionary Trust. The inherited retirement account funds must pass through this checkpoint at least as rapidly as required by law (e.g., the 10-Year Rule).
The second checkpoint, on the other hand, is between the Discretionary Trust and the trust’s beneficiaries. Funds only pass through this checkpoint as determined by the trust’s language, and potentially, the trustee’s discretion (as allowed by the trust document in the first place!).
Notably, funds passing through the first checkpoint, but not the second (within the same tax year), are subject to trust income tax rates. And while trust income is subject to the same maximum 37% ordinary income tax rate as individuals, they get there a lot faster. Whereas a joint filer does not hit the top 37% Federal income tax bracket until they have more than $622,050 of taxable income, a trust reaches the same 37% bracket at just $12,950 in 2020!
And that’s just at the Federal level! Add in state and local taxes, and a Discretionary Trust which retains income can find itself ‘giving’ close to half of those dollars away in combined income taxes.
This problem, of course, is dramatically compounded by the SECURE Act’s 10-Year Rule. In the past, a modest (at least as far as accounts typically handled by financial planners go) retirement account of $500,000 left to a Discretionary Trust using the ‘stretch’ and accumulating the funds within the trust may have only resulted in only a few thousand dollars of annual distributions being taxed at trust tax rates. Now, the same trust, if subject to the 10-Year Rule, can result in substantial amounts of income taxed at the highest trust tax rate.
Example #4: The Lizzy Simon Trust is a discretionary trust established for the benefit of 26-year-old Lizzy Simon. It was recently funded with a $400,000 inherited IRA.
The trust requires that all distributions be held inside the trust until Lizzy reaches 40, at which time she is entitled the trust’s assets.
Prior to the SECURE Act, the trust would have been able to stretch distributions over Lizzy’s single life expectancy, which would have resulted in first year RMD of roughly $7,100, below the $12,950 threshold for the trust’s top tax rate.
Now, however, the trust must empty the inherited IRA within 10 years. Even if distributions were spread evenly over 10 years, assuming a 7% annual rate of return, that would still result in annual distributions of roughly $56,000, the overwhelming majority of which would be taxable at 37% above the trust’s $12,950 threshold!
More Frequent Use Of Discretionary Trusts May Put Trustees Between A Rock And A Hard Place
Despite the SECURE Act’s 10-Year Rule that accelerates inherited retirement account distributions into potentially tax-inefficient Discretionary Trusts, such trusts are actually likely to see a net increase in use going forward.
Recall that Conduit Trusts require that all distributions received by the trust be dispersed by the trustee to the trust beneficiaries each year. That means that a Conduit Trust subject to the 10-Year Rule (because it is a see-through trust, but the see-through beneficiary is not an Eligible Designated Beneficiary for a life-expectancy-based stretch), which has been named as the beneficiary of an IRA, will be completely useless by the end of the 10th year after death. Because the entire IRA will have been distributed to the trust, and the trustee will have been required under the conduit provisions to distribute those assets out from the trust to the trust beneficiaries!
Accordingly, it’s highly unlikely that most people would want to go through the time, expense, and effort to create a Conduit Trust, when it would only help protect beneficiaries for a maximum of 10 years and potentially accelerate the dollars out at the end of that 10-year window. As such, the only alternative for retirement account owners is to use Discretionary Trusts that will allow for the retention of funds beyond the 10-year horizon.
With respect to distributions from the trust to its beneficiaries, some Discretionary Trusts, like the one in Example #4 above, merely require that the trustee act in accordance with the precise distribution terms outlined in the trust documents (e.g., “pay $X to the beneficiary when they reach age Y”).
Other Discretionary Trusts, however, require more… well… discretion on the part of the trustee. For example, a Discretionary Trust might say something (albeit in more legalese) along the lines of:
I really trust my trustee. That’s why I made them the trustee in the first place!
So, since I’ll no longer be here and won’t really know what’s going on with my beneficiary and the world around them, I’ll just give my trustee the ability to decide what to do with all of the trust funds.
However much – or little – they decide to give to my trust beneficiary is just fine with me, because I’ll be dead. And after all, I trust them to do what’s best anyway.
On the surface, this sounds like a pretty good way to keep money protected when necessary, but also to minimize taxes when possible. For instance, a trustee with sole authority to determine how much of a trust’s assets to pass out to the trust beneficiaries each year might decide to hold money in the trust if the trust beneficiary has a potential creditor issue.
On the other hand, if all is well with the beneficiary both personally and financially, the trustee may decide that it’s better to pass amounts received by the trust out to the trust beneficiary, in order for those amounts to be taxed at the individual trust beneficiary’s personal income tax rate instead of at the more draconian trust tax rates.
Accordingly, this sort of language can put a trustee in a rather difficult and potentially awkward decision. What if, for instance, a Discretionary Trust beneficiary was healthy and had always been fiscally prudent, but recently decided that he wanted to buy a Ferrari to race (legally) as hobby?
If the beneficiary was happy and understood the financial ramifications of the purchase, would the grantor have approved? Or would the grantor have thought it was a fool’s purchase, and that the money should be held in trust so as to protect the trust beneficiary from frivolous expenditures?
Perhaps, all things being equal, the trustee would be compelled to keep the money protected in the trust. But all things aren’t (always) equal. Remember, there may be a significant differential between the tax rate of the trust and the (likely) tax rate of the beneficiary!
Imagine, for instance, that the Discretionary Trust received a $100,000 distribution from an inherited IRA and the trustee was faced with the “to distribute, or not to distribute” question above. Further imagine that the trust beneficiary could pay taxes on the distribution at an effective rate of 18%, whereas if left inside the trust, the distribution would be taxed at a 45% effective rate (between Federal and state taxes).
That might change the calculus of the trustee. Because while the Grantor may not have wanted the trust beneficiary to use distributions to buy a Ferrari, would they have preferred that the distributions stay inside the trust where nearly half would be lost right out of the gate to income taxation? Better the beneficiary use the inheritance to buy a Ferrari than to give half of it to Uncle Sam, no?
That might be a tough choice for any trustee. But imagine if the trustee is the trust beneficiary’s brother or sister. Or worse yet… a stepmother or stepfather? You can see where this sort of thing could lead to some serious family tension.
Planning Strategies To Minimize The Bite Of Income Taxes For Discretionary Trusts Impacted By The SECURE Act
The primary purpose of a Discretionary Trust is to protect the money for the trust beneficiaries, whether from themselves (i.e., irresponsible ‘spendthrift’ beneficiaries) or from third parties (i.e., potential creditors or future ex-spouses). But planning to protect that money should include a candid discussion about taxes as well. Because every dollar of income lost to taxes is a dollar that has, at the end of the day, not been fully protected for the trust beneficiary’s use anyway.
With that in mind, there are a number of strategies that Grantors and trustees may wish to consider when trying to maximize the after-tax value of funds left to a Discretionary Trust.
Consider Roth IRA Conversions During The Retirement Account Owner’s Lifetime
One obvious approach to minimizing the impact of income taxes on distributions made to Discretionary Trusts is to eliminate them altogether by converting pre-tax retirement assets to Roth assets during the retirement account owner’s lifetime, such that when the trust takes its required distributions they’ll be tax-free Roth distributions). This strategy is particularly effective when the retirement account owner is in a low income tax bracket, but it can also be effective in situations where the owner is in higher (but not the highest) tax brackets.
In the end, this strategy is simply about tax rate arbitrage. We know that, at some point, taxes will have to be paid on a pre-tax retirement account. The question then simply becomes, “When will the rate be lowest?” And when you’re comparing it to the 37% rate that applies to the majority of a large retirement account distribution held inside a trust, paying tax at any other rate is better!
Example: Abe is the elderly owner of a $2 million 401(k) that he is leaving to a Discretionary Trust. Abe’s trust beneficiaries will be his three young, healthy grandchildren, all under the age of 4.
As such, Abe’s Discretionary Trust will be subject to the 10-Year Rule (as even though the beneficiaries are minor children, they are not Abe’s minor children).
Further suppose that Abe’s trust calls for the assets of the trust to remain in the trust until his grandchildren go to college. At that point, the trustee can use the money to support their education, and any funds remaining in the trust at the time the last grandchild reaches age 30 will be disbursed evenly.
Accordingly, if Abe were to pass away now, all the distributions from his inherited 401(k) would have to be taxed at trust tax rates, because the trust’s language requires that they be retained inside the trust (until, at the earliest, the grandchildren go to college).
Suppose that Abe is married and has $200,000 of annual income, putting him squarely in the 24% bracket. In this case, it would make sense for Abe to execute annual conversions of around $125,000 (staying under the 24% MFJ tax bracket threshold of $326,600), which would allow him to pay tax at his current 24% bracket, rather than to leave the assets in his 401(k), where nearly all of it (everything over $12,950) would be taxable at the top 37% bracket when distributed (and held) in the Discretionary Trust.
The same logic might even apply if Abe were in the 32% or 35% brackets, as getting funds out of the 401(k) at those rates would still be preferable to having most of the distributions taxable at the 37% bracket!
Life Insurance As A Roth IRA Substitute
Another potential option that can eliminate the issue of trust tax rates on distributions from retirement accounts left to Discretionary Trusts is to take distributions from an IRA during the owner’s lifetime and to use them to fund a life insurance policy. This particular strategy is best reserved for those who are confident they will not need the funds now being directed towards the life insurance policy during their lifetime.
In such cases, life insurance still may not be feasible, depending upon variables such as the retirement account owner’s age, health, and the projected rate of return on such assets if they remain invested in a retirement account. In other situations, however, life insurance may provide a way to avoid the post-death rules associated with retirement accounts, while at the same time providing heirs a potentially guaranteed, tax-free death benefit.
Note, though, that any analysis of the potential benefits of replacing a pre-tax retirement account with life insurance for heirs should include a fair comparison with the potential benefits of a Roth conversion, as $1 of distributions from an IRA is taxed the same whether it goes towards a life insurance policy, or converted into a Roth IRA. And Roth IRAs have a significant built-in tax advantage when compared to life insurance policies. Notably, with a Roth IRA, it’s not just the amount at death that the trust can receive tax-free, but rather, that amount, plus any growth during the following 10 years. By contrast, ‘only’ the death benefit of a life insurance policy is received tax-free to the trust, and subsequent earnings will be taxable to the trust in Day 1.
Trustees of Discretionary Trusts May Be Able To Strategically Time/Stagger Distributions To Maximize Tax Efficiency
Another way to help reduce the bite of income taxes on a Discretionary Trust is to allow the trustee to exercise a reasonable degree of control (or simply be mindful and proactive with the control they already have) over how quickly distributions from the inherited IRA can be made to the Discretionary Trust, and how quickly distributions from the trust can be made to the trust beneficiaries.
In situations where trustees are given this type of latitude, substantial tax optimization may be achievable. A trustee might, for instance, distribute funds from an inherited 401(k) into a Discretionary Trust knowing that they are going to pass those funds right out to responsible trust beneficiaries so that the trust beneficiaries can pay taxes on those funds at their (presumably lower) personal income tax rates.
Alternatively, for a trust with a sizeable IRA where all funds will remain inside the trust – either by virtue of the trust’s own language, or because of decision on the part of the trustee – the trustee might want to hold off on taking distributions from the inherited IRA to maintain tax deferral for the assets for as long as possible.
Another, perhaps even better, possibility may be for the trustee to distribute right up to $12,950 (the trust’s 37% tax bracket threshold amount) from the inherited IRA each year (until the 10th year after death when the full balance would have to be distributed), distributing at least a moderate amount in order to fill up all the trust’s lower (below 37%) bracket space each year. The $12,950 could also be increased by such a trust’s $100 exemption amount, plus any deductible expenses of the trust, such as tax return preparation fees.
Include A ‘Power To Withdraw’ For The Beneficiary To Mitigate High Trust Tax Rates
Another strategy to avoid high trust tax rates is to create a Discretionary Trust that allows a beneficiary to exercise a power of withdrawal over annual distributions made from the IRA to the trust. The goal here is to continue to provide some layer of protection over the inherited assets, while ensuring that they are taxed at the trust beneficiary’s (presumably) more favorable personal tax rates.
More specifically, such trusts seek to take advantage of the rule found in IRC Section 678 that says a person will be deemed the grantor of a trust (meaning the income of the trust will be income taxable to them) if “such person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself.”
But having a power and exercising that power are two very different things. Accordingly, proponents of this strategy would encourage trust beneficiaries who do not need the income to let the right to withdraw lapse, thereby keeping the dollars in the trust.
The result is that the funds retained inside the trust may subsequently continue to have creditor protection (rules vary from state to state, and in many instances, the precise protection afforded to funds when there is a power to withdraw is not entirely clear), but can be taxed at the beneficiary’s individual income tax rate as they move from the IRA into the trust.
While this sounds like a great idea in theory, in practice, there are a variety of potential issues with this approach. Most notably, if you give a trust beneficiary the power to distribute assets from the trust, they might actually use it! If the whole point of a trust is to protect the beneficiary from themselves (i.e., for an irresponsible spendthrift beneficiary, as opposed to ‘just’ protecting the trust assets from third-party creditor risk), then giving the beneficiary an ability to require the trustee to distribute funds to them directly opposes that goal!
Furthermore, as noted above, the creditor protection that such funds would be accorded after the withdrawal power is permitted to lapse is not entirely clear. For instance, if a beneficiary has a right to withdraw assets from a trust and they have an ‘angry creditor’ on the hunt for funds, might the creditor be able to compel the beneficiary to withdraw those funds (so that the creditor can then take them) before the power can be lapsed? Maybe.
And so, while giving the beneficiary of a Discretionary Trust the power to withdraw funds distributed to the trust can provide a significant income tax benefit, it can clearly create other, rather significant planning concerns.
As such, individuals seeking to use Discretionary Trusts to protect assets for beneficiaries – and especially from poor choices made by those very beneficiaries – should think long and hard before choosing to include beneficiary withdrawal powers in their trust document(s). But it can at least help to mitigate the income tax consequences along the way.
Financial Advisor Game Plan For Post-SECURE Act Discretionary Trusts
Like most beneficiaries, Discretionary Trusts are significantly impacted by the changes to the post-death retirement account distribution rules made by the SECURE Act.
Accordingly, financial advisors have an opportunity to add substantial value to clients in situations where a Discretionary Trust has been named as a retirement account beneficiary, or where one is being considered. Here are some of the steps advisors can consider to help their clients do just that.
Know Which Clients Have Named A Discretionary Trust As Part Of Their Planning
It’s very difficult to help a group of people who might have a problem if you don’t know who’s actually in that group! To that end, if an advisor has not already done so, they should make a list of their clients’ retirement account beneficiaries. Such lists should include not only the name of the beneficiary, but also the type of beneficiary.
In most instances, this might be satisfied by simply indicating whether a beneficiary is a Non-Designated Beneficiary, a Non-Eligible Designated Beneficiary, or an Eligible Designated Beneficiary.
However, when a trust is named as a beneficiary, advisors may wish to include more information. For instance, knowing whether the trust is a Conduit Trust or a Discretionary Trust can be helpful, and in the case of the latter, it may also be worth indicating what discretion, if any, the trustee has over accelerating distributions from the trust to trust beneficiaries.
Finally, knowing which trusts, if any, qualify as Applicable Multi-Beneficiary Trusts (i.e., if there are any disabled or chronically ill beneficiaries) would also be important.
Ideally, this information should be stored in the advisor’s Customer Relationship Management (CRM) system to allow for easy reporting and ‘slicing and dicing’ of data. However, while not optimal, organized spreadsheets containing such data that allow for sorting can also be useful.
Ensure That Clients’ Special Needs Trusts Conform To Applicable Multi-Beneficiary Trust Guidelines
The ability for Special Needs Trusts (necessarily drafted as Discretionary Trusts) to stretch distributions is one of the few major benefits created by the SECURE Act when it comes to the post-death distribution rules. In fact, in certain instances, it may allow a disabled and/or special needs individual to stretch distributions via their trust when such treatment would not have been available before the SECURE Act!
Nevertheless, there are specific rules that need to be followed in order for a Special Needs Trust to meet the qualifications of an Applicable Multi-Beneficiary Trust, such as that that a trust with multiple beneficiaries, of which some are not disabled and/or chronically ill, splits into separate subtrusts for each trust beneficiary upon the owner’s death.
Given the significant tax advantages that such treatment (as an Applicable Multi-Beneficiary Trust) provides, advisors should strongly encourage clients with existing Special Needs Trusts to have them reviewed by a qualified attorney to ensure they conform to the Applicable Multi-Beneficiary Trust guidelines.
Explain To Clients How The SECURE Act Amplifies Potential Tax Issues For Discretionary Trusts And Explore Alternatives
Once an advisor is aware of the clients who have named a Discretionary Trust as a beneficiary, they should contact them to discuss how the SECURE Act may impact that trust.
Specifically, advisors should remind clients that any distributions from an inherited retirement account that are not distributed to the trust beneficiaries will generally be taxable at trust tax rates. And that, by virtue of the SECURE Act’s changes, unless the trust is an Applicable Multi-Beneficiary Trust, the trust will have to distribute all the funds from the inherited IRA over no longer than a 10-Year period of time, meaning much more of their pre-tax retirement account may be ‘chewed up’ by taxes than in previous years.
Some clients may be perfectly fine with this dynamic, understanding that the level of control they wish to exercise over their assets from the grave necessitates the tax consequences that result (as while the retirement account must be liquidated to the trust and trigger income tax consequences, the trust can continue to hold those assets from the underlying beneficiaries to maintain control and asset protection). Other clients, however, may have a different outlook. They may feel that they’ve worked too hard for too many years to have that much of their savings lost to income taxation.
In such circumstances, advisors can work with the client to explore countermeasures. In many instances, such options may necessitate the inclusion of other qualified professionals, such as CPAs and estate planning attorneys. Advisors can assist clients by coordinating such meetings, setting the agenda, and working with the other professionals to make sure all potential options are appropriately evaluated.
For example, the advisor may want input from a CPA to determine whether or not systematic partial Roth conversions by the owner would make sense. Alternatively, maybe the answer is amending the trust (or just slightly tweaking the old trust and creating a new one) that changes the trust from one that requires funds be held inside the trust until a certain age, to one that allows for the same treatment, but that also enables the trustee to distribute assets sooner. In doing so, the assets can still be retained if protection is necessary, whereas if tax minimization is more consequential, the trustee can distribute dollars received by the trust from the retirement account directly to the trust beneficiaries to allow those dollars to be taxed at the beneficiaries’ personal rates.
Review Trustee Decisions With The Client
Being the trustee of any trust is a position that carries a great amount of responsibility. This is especially true, however, when that trust is a Discretionary Trust, and where trustees must carefully weigh the balance of control over trust assets versus income tax minimization.
As noted earlier, allowing a beneficiary to use assets from the trust to buy a Ferrari may be preferable to giving those funds to Uncle Sam. On the other hand, giving up 50% of a distribution to income taxes and holding it in trust to protect the trust beneficiary is preferable to allowing the beneficiary to use 100% of it to fuel a drug and/or alcohol addiction.
Ultimately, it is the trustee who will make these decisions.
And while the selection of a trustee is certainly something that should be discussed with legal counsel, advisors can assist clients by helping them to consider various issues which may not otherwise be readily apparent to the client.
Such discussions might include conversations about:
- The age of the trustee and whether, if at the time their services will likely be needed, they can be expected to perform those services;
- The location of the trustee, which may have an impact not only from a logistical perspective but also from a tax perspective, as certain states may deem the trust’s income to be taxable for state income purposes if the trustee resides in that state; and
- The nature of the trustee’s relationship with the trust beneficiary. In short, families often get along great… until they don’t. It isn’t an advisor’s role to tell a client that they shouldn’t allow one sibling to be trustee for another (or other similar intrafamily recommendations), but it is worth explaining to the client how such situations can lead to conflict or family strife.
The SECURE Act’s changes to the post-death distribution rules have a significant impact to many beneficiaries, but Discretionary Trusts are likely to be some of the hardest hit… at least from an income tax perspective. Yet at the same time, these same changes also mean that, for clients who want to utilize trusts to protect assets for their beneficiaries, it’s more likely than ever that those trusts will be Discretionary Trusts (due to the even-less-hospitable treatment the SECURE Act affords to Conduit Trusts with often-Non-Eligible Designated Beneficiaries).
On the bright side, for those IRA owners intending to leave inherited retirement account assets to disabled and/or chronically ill beneficiaries, the SECURE Act provides a window of opportunity to ensure that such individuals can continue to benefit from the stretch via their Special Needs Trust. Financial advisors should act promptly to work with clients naming such trusts as beneficiaries, along with their legal advisors, to ensure that their existing trusts satisfy the requirements of Applicable Multi-Beneficiary Trusts so that the ‘stretch’ can be preserved – an even better outcome than what was feasible prior to the SECURE Act!
Clients who have Discretionary Trusts subject to the 10-Year Rule have more challenging decisions, though. In some situations, they may choose to leave plans as they are. Others may choose to take certain actions, such as changing trust language, or making lifetime Roth conversions, to blunt the impact of the SECURE Act’s changes.
Still, others may decide to abandon a trust altogether given the added complexity and newly increased potential for more of their savings to be lost to income taxes.
In all situations, however, the time for conversations about Discretionary Trusts as beneficiaries is now.