It Ought to be Simpler than This!
I have patience for those tasks that I expect ahead of time will be difficult to complete. I have less patience for those tasks that I expect to be easy, and turn out to be difficult. This is sometimes the case with various estate planning and administration matters. Consider the following common planning scenario that one might expect to be simple to implement, but in actual legal practice is difficult to implement:
A single client wants to designate one or more charities (collectively, “Charity”) as beneficiary of a certain percentage of remaining assets at death (“Charitable Share”). Or, along similar lines, a married couple wishes to designate a Charitable Share at the second death. Among other assets, client or clients own significant assets in a traditional IRA account and/or 401K, 403b, or other tax-deferred account (collectively, “IRA account”).
Not all assets are treated the same for income tax purposes. Children pay income taxes on received IRA account assets; tax-exempt charities do not. The planning strategy, therefore, is to utilize IRA assets to satisfy the Charitable Share. Unfortunately, the logistics of this planning strategy are complicated by two issues:
- First, IRA assets are legally directed at death by beneficiary designation, not directly by a Will or Trust Agreement.
- Second, a labyrinth of tax code provisions apply to the income taxation of IRA accounts payable to a trust. Following the death, if a trust is named as beneficiary, the schedule of the required minimum distributions, “RMDs” depends on whether the trust qualifies as a “see-through” trust. Among other requirements, a trust is a “see-through trust” if no charitable beneficiaries exist as outstanding and unpaid by September 30th of the year following death. So long as the Charitable Share is paid off by this time, the trust receives the same income tax treatment as if the beneficiaries of the trust were named directly as beneficiaries of the IRA on the beneficiary designation form. If not, the IRA Account will be subject to “non-designated beneficiary” rules. In cases when the IRA Account is “non-designated,” the schedule of RMDs depends on the age of the IRA Account owner at death.
- If the IRA account owner died before age 73, the account paid out within 5 years of death.
- If the death occurred after age 73, the account is paid out over the remaining portion of the IRA owner’s remaining life expectancy. 
I present two options to implement a planning strategy to achieve the desired charitable planning objectives.
Two Bucket Approach:
The first option is what I will call a “Two Bucket” Approach. Here, the client creates two distinct Buckets” of assets during lifetime, one for Charity, and one for Family. The “Charitable Bucket” assets comprise of a separate IRA account. The Charitable Bucket IRA Account is legally directed by beneficiary designation to Charity at death. The “Family Bucket” assets are legally segregated from the Charitable Bucket assets. Under a Two Bucket approach, the Charitable Bucket IRA account holds assets that, as a percentage of the owner’s total financial net worth, has the same percentage as the Charitable Share.
For example, a client who desires a 10% Charitable Share should have a separate Charitable IRA Bucket equal to 10% of the client’s total financial net worth. Any other IRA assets are segregated into a separate IRA (a “Family Bucket IRA”) and directed by beneficiary designation to family. The trust agreement would direct all non-IRA assets, such as taxable investment and real estate, to the family as part of the Family Bucket.
The benefits of the Two Bucket approach are as follows:
- The named charitable beneficiaries can be easily revised throughout lifetime by a change in beneficiary form with the IRA administrator; it is not necessary to change the terms of the trust agreement.
- Following death, the charity is responsible for collecting the Charitable IRA Account; neither the trustee nor the family needs to be involved in the collection.
- The Charitable Bucket IRA assets are certain to avoid any income taxes, and the Family Bucket IRA assets are certain to obtain the best possible income tax treatment.
The “One Bucket” Approach
The second option is a “One Bucket” approach. In this approach, IRA assets of a value sufficient to fund the Charitable Share are directed to trust by beneficiary designation at death. Following death of the IRA Account owner, the trustee then calculates a percentage of all assets that must be allocated out of the trust to each of the Charitable Share and Family Shares. The Trustee then uses the IRA Account to satisfy the amount allocated to the Charitable Share.
The benefit of the One Bucket approach is that the calculation of the shares to charity and family is only necessary following death. To successfully implement the One Bucket Approach, three conditions must be met:
- The trust agreement must include specific legal directions to the trustee. Specifically, the trustee must be required to distribute the retirement account itself as a distribution of an asset “in kind” to the charity. The charitable share must be a percentage of the entire estate, not a specific dollar amount.
- The trustee must take action to transfer the specified charitable share to the charity by September 30th of the year following death.
- The IRA administrator must be willing and able to approve the transfer out of the trust ownership and to the charity by September 30th of the year following death.
If any one of these three conditions are not met, the IRA Account is subject to the RMD payout rules summarized above for trusts that do not qualify as “see-through” trusts. If all three of these requirements are met, the charitable objectives would be successfully implemented, and the family would have the same tax treatment as if the family were named directly as beneficiaries on a beneficiary designation form.
The implementation of a charitable plan utilizing retirement account assets is not as simple as clients would expect. However, with the right planning in place, we can achieve the desired planning objectives.
 The four rules for “see through” trust treatment are as follows: (1) the trust must be valid under state law; (2) the trust must be irrevocable upon death; (3) The trust agreement must be given to the plan administrator by 10/31 of the year following death; and (4) The trust must identify the individual persons who are the beneficiaries of the trust.
 Certain individual beneficiaries, such as a surviving spouse, minor children, or children with disabilities, receive a preferred “stretch” payout period, such that the IRA can be withdrawn over the course of the beneficiary’s remaining lifetime, thereby achieving income tax benefits associated with tax deferred. All other individual beneficiaries must withdraw the IRA assets, and pay the associated income taxes, within 10 years of death.
 If the client died at age 73, the payout period would be 14 years; if age 95, then only 4 years. Interestingly, the payout period for clients who die between ages 73 and 80 is longer than the 10 year rule!
 If you prefer not to create a separate IRA, then while we could accomplish the same objectives outlined above through your existing IRAs, we will need to calculate, both now and into the future, the portion of your total net worth is comprised of your IRA, then calculate the charitable percentage of your existing IRAs accordingly.
 For clients interested in the One Bucket Option, it is critical to confirm with the IRA administrator that the IRA administrator is willing and able to conduct this transfer.