If you have read any of Malcom Gladwell’s books, or listen to his podcasts, you are acquainted with various examples of the law of unintended consequences. Gladwell demonstrates how well-intentioned efforts to solve societal problem might actually prove to be an impediment to success. In the 1990’s, Australian lawmakers enacted legislation requiring Australian children to wear bike helmets whenever riding bicycles. As it turned out, the relatively low supply of helmets created such a high cost for helmets that overall bike ridership declined significantly. In that case, the unintended consequence of the legislation was a decrease in the overall health of children.
Along a similar vein, by reason of the recently enacted “SECURE ACT,” an oft-used trust planning structure called a “conduit trust” will have unintended consequences for unsuspecting clients if not properly addressed and corrected. Before the enactment of the SECURE Act, it was possible to name a trust as a beneficiary of a retirement account after the death of the account owner and still obtain the “stretch” typically associated with required minimum distributions (“RMDs”) based upon the life expectancy of the trust beneficiaries. Even though the trust was the legal owner of the inherited IRA, the IRS would “see through” the trust’s ownership and use the life expectancy of the trust beneficiary (or beneficiaries) to determine the RMDs. In this fashion, it was possible to both (1) achieve the sought-after protections of trust ownership, and (2) minimize the income tax implications by “stretching” the withdrawal period over the life expectancy of the trust beneficiary (or beneficiaries). In order to qualify for this preferred “see through trust” tax treatment, however, it was necessary for the trust to be characterized as either a “conduit trust” or as an “accumulation trust.”
Conduit Trust
A conduit trust identifies only one person, as the current trust beneficiary, who will individually receive the RMD amounts as dictated by IRS life expectancy tables. This individual will report, on his or her personal tax return, the entire RMD amount actually distributed to him or her. Under current tax law, by reason of compressed income tax rates on taxable income within trusts, it is almost always the preferred income tax approach to tax income to an individual, rather than to a trust. The conduit trust approach provided for these income tax benefits, while still preserving the trustee’s authority to manage the undistributed remainder of the inherited IRA account.
Accumulation Trust
An accumulation trust allows for the required minimum distribution amount, as dictated by IRS tables, to be withdrawn from the trust-owned inherited IRA account, but not distributed directly to the trust beneficiary (or beneficiaries). Instead, an accumulation trust allows for the withdrawn IRA account assets to be accumulated in the trust, thereby providing the Trustee discretionary authority over trust distributions. If no distribution is made to a beneficiary in a particular year, the trust itself pays the ordinary income tax associated with the withdrawn IRA account assets. While this has generally not been the preferred income tax result, the main benefit of the accumulation trust is that it preserves the trustee’s ongoing authority to manage both the undistributed inherited IRA assets as well as the withdrawn (post-tax) assets.
The Problem with a Conduit Trust For An Adult Child
Many estate planning attorneys, including myself, have preferred the conduit trust approach over the accumulation trust approach because of the potential income tax savings associated with taxing distributions to an individual rather than a trust. Also, from a planning standpoint, a conduit trust is easier to administer and understand, both before and after the death of the account owner. Following the SECURE Act, the use of a Conduit Trust is still the preferred approach for a trust holding retirement account assets for the benefit of a surviving spouse, as the Trustee can use the life expectancy of the surviving spouse to “stretch” IRA distributions across the surviving spouse’s lifetime. In contrast, however, these conduit trust provisions will create an unintended consequence if used within a trust for an adult child. In light of the 10-year time limitation imposed by the SECURE Act, a conduit trust provision for an adult child would require that the entire remaining balance of a trust-owned inherited IRA be distributed directly to the child on the 10th anniversary of the death of the current owner, and not accumulated inside the trust.
Switching from a Conduit Trust to an Accumulation Trust
In order to allow a named trustee to continue to manage the inherited IRA assets, I am recommending to most of our clients who have conduit trusts for adult children that they switch from a conduit trust to an accumulation trust. While the inherited IRA assets will be subject to income taxes at trust tax rates, the Trustee is given the ongoing authority to make discretionary distributions to the beneficiary, thereby transferring the income tax liability from the trust to the individual beneficiary. With this authority, the Trustee could attempt to minimize the overall income tax liability across all ten years following the account owner’s death.
Switching from an “Outright” Distribution to an Accumulation Trust
It is important to remember that, but for a few exceptions, any child or grandchild who receives an inherited IRA account will be required to withdraw all remaining assets within 10 years of death. Historically, many clients would name their young adult children or grandchildren as the “outright” beneficiaries, knowing that the adverse income tax effects of withdrawing inherited IRA assets earlier than necessary would deter such an unwise decision. Now, however, in light of the SECURE Act, I am recommending that many of my clients who hold significant retirement account balances and who previously named their children as “outright” owners now consider designating, as beneficiary, an ongoing accumulation trust instead. Since the income tax effect is the same, why not allow a trustee to manage the inherited IRA assets, both before and after the end of the 10-year time window?