The Wealth & Wisdom Blog

“Nothing is for Free, Cory,” a physician once explained to me.  “If we take steps to address this particular health problem, it will have adverse consequences on other organs.”  Just as there is often a “cost” for a particular medical treatment option, there are certain tax and control tradeoffs in estate planning decisions.  Tax-deferred retirement accounts can be owned by a trust following death, thereby providing control and protection benefits to the account owner’s family.  However, this usually comes at a “cost” of higher taxes.

Last month, I summarized the current tax rules for post-death IRA assets.  As a follow up to last month’s update, on February 23, 2022, the IRS released 275 pages of “clarifications” to the 2019 SECURE Act.  One noteworthy clarification relates to the required minimum distributions (“RMDs”) required of adult children beneficiaries who do not have a disability or chronic illness (“non-eligible beneficiaries”).  According to the IRS, if the deceased account owner had reached the required beginning date, such non-eligible beneficiaries must continue to take RMDs annually in accordance with the deceased account owner’s RMD schedule.  If the account owner has not yet reached the required beginning date, there are no such annual RMD requirements. However, regardless of when the account owner died, all remaining retirement account assets must be withdrawn by the December 31^st of the calendar year that contains the 10^th anniversary of the account owner’s death.

This month, I share three hypotheticals to illustrate the “trust control” versus “tax efficiency” tradeoff.

1. Accumulation Trust for Adult Child

First, consider the case of providing for an adult child, who could receive the IRA assets either “outright” or in a “testamentary trust.” In cases where the adult child is a “non-eligible beneficiary,” the 10-year rule would apply regardless of whether the child or the child’s testamentary trust is named as the beneficiary. The key benefit of a trust vis-à-vis individual ownership is the retained control over the assets, including the ability to protect the child’s inherited assets in the event of the child’s divorce, personal creditor issues, or death.  In this case, the “tax cost” of using a trust is simply based solely upon the difference in marginal income tax rates between the individual beneficiary and the trust.

For the sake of illustrating this tax cost, if we assume that the adult child is at the 24% federal tax rate, and the trust is at the (top) federal tax rate of 37%, the tax cost of using a trust at different account values are as follows:

The factors to consider in making this decision include the likely size of the account that will be received by the child, taking into consideration the number of other designated beneficiaries, the stewardship capabilities of adult child, and the child’s individual tax rates.

2. Accumulation Trust for Spouse in a Blended Family

Second, consider the case of a married account owner who wishes to provide for her surviving spouse as well as her children from a previous marriage.  The original account owner could decide to create a marital trust for the surviving spouse, thereby allowing the surviving spouse to benefit from assets throughout the surviving spouse’s lifetime, with remaining assets passing to the children following the spouse’s death.  In this case, a conduit trust is not an ideal structure if the account owner wishes to assure that any assets remain for the children.  A conduit trust requires that the RMD amount be distributed directly to the surviving spouse, not retained in the marital trust.  If the spouse enjoys a long life, the RMD requirements would essentially move all assets to the surviving spouse, leaving nothing for the children.  In contrast to a conduit trust, an accumulation trust would retain the IRA assets in the trust, but would require the income tax payment of all remaining retirement accounts paid within the 10-year period.

As an alternative to the accumulation marital trust, the account owner could “spread” the account between her spouse and her children as outright beneficiaries.  In such a scenario, not only would the surviving spouse be able to “stretch” the RMDs across his remaining lifetime as an eligible beneficiary, but he would also likely make use of his lower personal income tax rates.  The children would likewise benefit from a lower tax rate.  To illustrate the difference, consider the difference in the relative tax burden between an accumulation trust (tax rate of 37%) and naming individual beneficiaries.  While every situation will be different, assume for the sake of an illustration that the average personal tax rate is 20%.  In such an event, while significant “control” is lost by naming individual beneficiaries, this approach could yield tremendous income tax benefits.

3. Conduit Trust for Retired Surviving Spouse

Finally, consider the case of providing for a surviving spouse who has more than $3.0 million in assets and who is past her required beginning date (now age 72).  If the surviving spouse is named as the outright primary beneficiary, the surviving spouse can rollover the account into his or her name, and the spouse can take distributions based upon the spouse’s life expectancy.  However, if a conduit trust for the spouse is named as the beneficiary, the life expectancy of the surviving spouse is also used for determining the required minimum distributions for the conduit trust.  As a result, there is no individual tax “cost” to using a conduit trust vis-à-vis individual ownership.

Depending upon the other assets owned by the surviving spouse, the conduit trust may result in substantial estate tax savings to the family.  Of course, if the surviving spouse lives a long life and takes RMDs annually, the RMDs will eventually transfer the account assets, net of income taxes, into the “taxable estate” of the surviving spouse.  For certain of our married Minnesota-resident clients who face a potential Minnesota estate liability, a conduit trust is a good strategy to protect against the possibility that both a husband and wife die with large IRA balances intact.  Here are the estate tax savings to utilizing a conduit trust for Minnesota residents with an eventual Minnesota estate tax liability:

When it comes to estate planning for control issues and tax minimization, nothing is “free,” and most decisions of this type are not easy.  We are honored to be part of these important discussions with you and your clients.