The Setting Every Community Up for Retirement Enhancement (SECURE Act) was passed into law on December 20, 2019, dramatically changing the post-death distribution rules for most non-spouse Designated Beneficiaries. Whereas in the past, such beneficiaries were generally able to ‘Stretch’ distributions from their inherited retirement accounts over their life expectancy, the SECURE Act generally imposes a new 10-Year Rule on such beneficiaries (Non-Eligible Designated Beneficiaries). And since (as compared to the ‘Stretch,’ the 10-Year Rule generally reduces tax deferral and increases the size of the average distribution (in the years such distributions take place), raising the chances that a beneficiary will be bumped into a higher tax bracket, practitioners have been exploring ways to mitigate this change.
One way that some practitioners have suggested to mitigate the impact of the ‘death’ of the ‘Stretch’ is to name would-be Non-Eligible Designated Beneficiaries as the income beneficiaries of a CRUT, and then naming that CRUT as the beneficiary of the individual’s retirement account (instead of naming the Non-Eligible Designated Beneficiaries directly on the beneficiary form). Notably, CRUTs have the potential to offer certain individuals similar benefits as would have been provided by the ‘Stretch’, such as tax deferral, and the ability to distribute assets annually individual’s (or group of individuals) life expectancy. And similar to the ‘Stretch’, income beneficiaries of a CRUT pay taxes on the distributions they receive (from the trust) on their personal returns.
To establish a valid CRUT, a trust must comply with certain rules and restrictions. CRUTs, for instance, are required to provide no less than 10% of the actuarily projected future value of the trust be left to a qualified charity. Such trusts must also distribute a fixed percentage between 5% and 50% of their assets annually to the CRUT’s income beneficiaries. Distributions retain the tax characteristics of income (e.g., ordinary income, long-term capital gain, etc.) received by the CRUT, and are distributed on a Worst-In, First-Out (least-tax-efficient income first) basis.
But while, on the surface, CRUTs can appear to approximate many of the qualities of the ‘Stretch, they are rarely the optimal choice for those retirement account owners who are primarily interested in transferring as much wealth as possible to heirs. Such trusts are generally not even possible to establish with lifetime distributions for beneficiaries in their early 20s, or younger. Older beneficiaries, meanwhile, often can’t (or don’t) live long enough to diminish the projected ‘loss’ of (at least) 10% of the CRUT assets to charity to a point where it is outweighed by the gain of extended tax deferral (compared to the 10-Year Rule).
While each scenario should be evaluated separately, in general, if a retirement account owner is looking to use a CRUT as a wealth maximization vehicle, the ideal fact pattern would include:
- A young, healthy beneficiary (but not so young that the CRUT can’t actually be established),
- who projects to be in a high tax bracket, and
- expects to have significant long-term returns with at least a reasonable amount of turnover, and/or interest or dividends.
Even where the pieces ‘line up,’ though, it can often take three or more decades for the CRUT beneficiary to reach the breakeven point and ‘catch up’ to a beneficiary who inherited assets via the 10-Year Rule. Thus, there is almost always a substantial mortality risk associated with the use of a CRUT. CRUTs also limit the optionality of a beneficiary, as well as increasing organizational and operational expenses.
But while CRUTs have probably been over-hyped for purely their wealth transfer ability, for retirement account owners looking to satisfy both legacy (to heirs) and charitable goals, they can be a powerful tool. In many situations, the result of such planning will be a modest reduction in the wealth passed to heirs, in exchange for a much larger increase in the amount that goes to charity.
Ultimately, if just the right circumstances present themselves, or if a retirement account owner is sufficiently charitably inclined, naming a CRUT as the beneficiary of a retirement account is a planning strategy worth exploring. But for retirement account owners solely looking to maximize the transfer of wealth to heirs, the bottom line is that a CRUT is generally not a great (or is at least a “risky”) option.