Under the new Setting Every Community Up for Retirement Enhancement (SECURE) Act that became effective for plan participants (PPs) dying after 2019, individual retirement accounts and other qualified retirement plans left directly to beneficiaries, or to certain see-through trusts for beneficiaries, must be entirely distributed no later than Dec. 31 of the 10th consecutive calendar year that follows the year of the death of the owner (PP) of the IRA/plan.1 This is known as the “10-year rule.” A tax-efficient allocation (TEA) POT trust, and the TEA POT trust system (the System)2 can spray IRA assets subject to ordinary income tax rates to lower bracket beneficiaries, which is accompanied by a separate equalization trust to provide more equal after-tax results for beneficiaries. This may be the best prescription for the new 10-year payout requirements that will apply to most non-spouse beneficiaries.
Eligible Designated Beneficiaries
A 5-year rule applies if the IRA/plan is payable to a trust that doesn’t qualify as a see-through trust. There are exceptions to the 5- and 10-year rules that allow for life expectancy and “age of majority plus 10-year” payouts for IRAs/plans left outright or to see-through trusts for eligible designated beneficiaries (EDBs).
Under Internal Revenue Code Section 401(a)(9)(E), EDBs include:
1. Surviving spouse. A surviving spouse who inherits the IRA/plan may roll it over, in whole or in part, into his own IRA. The surviving spouse will be treated as if he were the original PP of the rolled over IRA, and therefore, required minimum distributions (RMDs) over the surviving spouse’s life expectancy won’t begin until after the spouse has reached age 72. The surviving spouse will then be allowed to select the beneficiaries of the IRA to inherit on his death.
A surviving spouse may alternatively elect to have some or all of the IRA/plan be held as an inherited IRA, so that distributions received before age 59½ wouldn’t be subject to the 10% excise tax, but inherited IRA treatment requires withdrawals to come out beginning the year after the date of the PP’s death using an annually recalculated single life expectancy instead of the much more advantageous “dual life” recalculated life expectancy that can be used for a rollover IRA.
If the original PP doesn’t want to give the surviving spouse the ability to select the beneficiaries who inherit the IRA/plan after the surviving spouse’s death, the IRA/plan can be left to a see-through conduit trust that can qualify for lifetime distributions using the single life non-recalculated method of payment and requires that all distributions from the IRA be paid without delay directly to the surviving spouse, thus exposing the distributions to potential claims from creditors, mismanagement and other threats to wealth.
The conduit trust for a surviving spouse allows for the same life expectancy payout that would be received if the surviving spouse rolled the IRA over into his own IRA, while preserving how the assets remaining in the IRA/plan will pass on the surviving spouse’s death. The downside of this strategy is that it requires that all distributions from the IRA/plan pass to the surviving spouse, who can then do what he likes with such funds.
The TEA POT trust provides much more flexibility than a conduit trust, although the 10-year rule will apply.
2. Disabled or chronically ill individual who meets strict requirements. Such an individual can stretch the IRA over his remaining life. To qualify for the lifetime stretch, the individual must be determined to be disabled on the date of the PP’s death, based on the historical Social Security disability benefit definition under IRC Section 72(m)(7) and Treasury Regulations Section 1.72-17A(f), or chronically ill under IRC 7702B(c)(2). The 10-year rule will begin to apply to require all distributions from the IRA to come out after the 10th anniversary of the end of his disability or chronic illness.
A disabled or chronically ill individual is the only type of EDB who can be the beneficiary of a see-through accumulation trust with a life expectancy payout when the trustee can receive distributions and accumulate them for future use and benefit. Not even a surviving spouse will qualify for this under the new SECURE Act, unless he’s disabled on the date of the PP’s death.
It appears likely that an accumulation trust for a disabled or chronically ill individual will qualify only if it’s directly funded on the death of the PP, as opposed to being funded in the discretion of a trustee of a trust that may be the recipient of an IRA or pension beneficiary designation. Treasury regulations will hopefully be enacted that explicitly allow indirect funding to clarify this.
3. A minor child of the deceased PP. The 10-year rule will apply once the minor reaches the age of majority, and the IRA must be entirely paid out by no later than Dec. 31 of the 10th year after the calendar year in which the minor child reaches the age of majority. Although a minor child reaches the age of majority at age 18 in 47 states and in Washington, D.C.,4 Treas. Regs. Section 1.401(a)(9)-6 indicates that a child may be treated as having not reached the age of majority if he hasn’t completed a “specified course of education” and is under age 26.3 The Internal Revenue Service will need to issue new Treasury regulations to clarify if and how this exception to the usual age of 18 will apply.
Similar to the rules applicable to disabled or chronically ill beneficiaries, a see-through trust for a minor beneficiary can qualify for a life expectancy payout until a child reaches the age of majority and, for the 10-year rule to apply thereafter, must be funded directly on the death of the PP and not through a common trust, as described above. Further, only a conduit trust can be used to qualify for the minor child life expectancy exemption, so that the trustee will be required to pay out the RMDs until the child reaches the age of majority and then pay out the large distribution or distributions that must come out between the date of reaching the age of majority and Dec. 31 of the 10th year following such minor reaching the age of majority. This will cause many 28 and 29 year olds to lose their inheritances to creditors, unwise spending or otherwise.
4. An individual who wasn’t more than 10 years younger than the deceased PP on the date of the PPs’ death. In this case, the IRA can be distributed to the beneficiary over the beneficiary’s lifetime, although some commentators believe that the beneficiary’s life expectancy can’t be used if the plan is payable to a see-through conduit or accumulation trust that would qualify for a 10-year payout. Drafters should be sure to provide trustees or trust protectors with the discretion to disqualify a see-through or conduit trust that may be held for someone no more than 10 years younger than the PP, such as by providing that a charity or another non-individual will be a beneficiary of the trust after Sept. 30 of the year following the year of the PP’s death.
Prior to the SECURE Act, the beneficiary of an IRA/plan could potentially stretch the RMDs over his lifetime without having to fit into one of the special categories mentioned above.
Because an IRA/plan must now be entirely paid out to a non-EDB or a trust for the designated beneficiary under the 10-year rule, and the above exemptions may not be desirable even when an EDB survives the PP, distributions from large pensions and IRAs will now have to come out sooner and, in many cases, will be taxed at higher brackets and cause more Medicare tax to be imposed, because more income will come out each year. Additionally, such beneficiaries will, on average, be younger and in higher tax brackets. As seen in the example below, the result of this is a major tax cost that stems from the inability to have growth in value within the IRA/plan occur without taxation, including the benefit of tax-deferred growth on the portion of the IRA/plan that would otherwise be paid in taxes if it didn’t have to be withdrawn.5
A Better Cup of TEA
Example 1: Pam Participant dies, leaving a trust holding a $1 million IRA that earns a 6% rate of return that would have been paid out over the life expectancy of her 50-year-old child, Archibald Beneficiary, who’s in the 37% income tax bracket. Archibald would then reinvest the net amounts received at a 5% after-tax rate of return. Under the old rules, Archibald would have had $1,676,365 in combined IRA/trust and personal account assets after the 10th year. Now, Archibald will have only $1,184,646 after the 10th year. This is an extremely large difference of $491,719. The difference is $657,158 after 20 years and $802,087 after 30 years.
Further, the implementation of the 10-year rule is also problematic for PPs who have two or more children to whom they want to provide equal benefits.
Example 2: Adam Participant has an estate worth $5 million, $1 million of which is in an IRA. Adam wants to leave his estate to his three children. One child is a neurosurgeon and is in the 40% combined federal and state tax brackets, the second child is a school teacher and is in the 25% combined federal and state tax brackets and the third child stays at home to raise her children and support a disabled spouse, is frugal and is in the 10% combined federal and state tax brackets.
To circumvent having a high tax rate on a significant portion of distributions, Adam could leave the IRA to the frugal child and other assets to the other two, but this arrangement wouldn’t result in each child receiving an equal benefit because the frugal child will have to pay tax on the IRA assets once they’re distributed. Adam could also leave $333,333 of the IRA to each child, but then the neurosurgeon has less after taxes than the other two children.
(Child 1) $333,333 x 60% = $199,999.80
(Child 2) $333,333 x 75% = $249,999.75
(Child 3) $333,333 x 90% = $299,999.70
Another important drawback of using either of the two above options is the fact that the children’s tax-related situations can drastically change over time. While leaving the entire IRA to the frugal child may seem advantageous for tax-savings purposes, there’s no way for Adam to be 100% certain that the status quo will continue after his death or what changes may be made to income tax rates. The frugal child could move to a higher tax bracket by taking a high paying job, or the neurosurgeon could become disabled for a couple of years and have deductible nursing expenses for himself or a disabled family member that would allow for him to receive $100,000 a year from an IRA tax free.
The System
Given the above, PPs with large IRA and pension plan account balances should consider using the System.6
The System consists of two separate trusts and is designed to enable the taxable income from the IRA and pension accounts to be allocated in a manner that minimizes the overall income tax paid from the various trusts and beneficiaries.
The TEA POT trust receives and holds the taxable IRA and pension plan accounts for several beneficiaries. Every year for 10 years, the trustee will decide if and how much of the trust’s income and principal to distribute after considering the following: (1) the tax brackets of the beneficiaries in each generation; (2) whether any beneficiaries have large income tax deductions that can offset the taxable income from plan distributions; and (3) the needs of the beneficiaries.
The second trust, called the “equalization trust,” holds non-taxable assets and is established on the death of the PP. Assets are held in this trust and may be invested and accumulated to allow for growth to occur during the first 10 years from when the TEA POT trust is making distributions. On Year 11, this trust can be used to even up payments to higher bracket taxpayer beneficiaries. The assets held in this trust may then be distributed equally among the beneficiaries or as deemed appropriate by the trustee.
For many, tax savings will be maximized by not having distributions paid out from the equalization trust until the 11th year. Multiple trusts formed by the same grantors for the same beneficiaries will be considered to be one trust for income tax purposes.7 Because it’s unclear whether the IRS will consider the TEA POT trust and the equalization trust as one trust, distributions from only one of these trusts should be made in a single calendar year.
Alternatively, a charitable beneficiary can be included in the equalization trust, so that the two trusts don’t have the same beneficiaries, to prevent them from being treated as one trust for income tax purposes. The IRS may argue that the two trusts should nevertheless be treated as one trust if the charitable beneficiary or beneficiaries don’t receive significant distributions, so it will be advantageous to make substantial distributions for one or more charities, which may include or consist solely of a family foundation that can be controlled by family members who may be reasonably compensated for their efforts.
It’s unknown whether the IRS will take the position that substantially similar trusts that are considered to be one trust under the income tax rules could cause a see-through trust that would otherwise qualify for conduit or accumulation trust status not to qualify. It’s possible that because trusts created by “substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries,”8 which have a principal purpose of “the avoidance of tax,”9 can be considered to be one combined trust under IRC Section 643(f), this might cause disqualification of see-through status. For example, this may be a problem when a separate equalization trust can make distributions to a charity or includes a power of appointment that can be exercised in favor of non-individuals.
Section 643(f) is generally concerned with distributable net income (DNI), and adding a charitable beneficiary will likely prevent the trust from being considered as having substantially the same beneficiaries if the charity receives significant distributions. While it’s unclear how aggressive the IRS will be in application of Section 643(f), the two trusts can be drafted to include a number of other different terms that promote legitimate non-tax purposes.
Using the system, the PP in the above example can place the $1 million IRA into the TEA POT trust and $1 million of assets into the equalization trust. The remaining assets will be placed into a revocable trust and will be distributed equally among the three children shortly after the PP’s death.
The PP can have the TEA POT trust and equalization trust drafted so that the three children are required to get together every year and play a role in determining how distributions from the trusts will be made. The more responsible and financially savvy child can be named as the lead trustee, or all three children can manage the trusts along with a professional or corporate trustee. If the children disagree on how distributions will be made, a lawyer, CPA, financial advisor or close friend can be named to serve as a tie-breaker to make the ultimate decision.
To maximize tax savings and increase the inheritance of the three children, the trustee can retain a competent CPA who’ll look at the tax brackets and possible income tax deductions that the children have every year for the first 11 taxable years, which may take into account the needs of the children, spouses and significant others of the children who may be in lower tax brackets or even have deductions that exceed their otherwise applicable income, based on health or business situations. This could be extremely beneficial, for example, if a beneficiary of the trust is starting a business or profession that will generate taxable losses in the initial year or years. Entrepreneurial and professional endeavors funded by the TEA POT trust may result in significant professional and business achievement that might not have otherwise occurred.
The CPA can then provide advice on whether distributions from the TEA POT trust should be made and to whom. Once the TEA POT trust has been completely distributed, the CPA would then be able to calculate the overall amount that each child and his family have received after taxes and may adjust this amount for the time-value of money when different amounts have been distributed to different beneficiaries in different years. This calculation can determine how the equalization trust may be distributed or held, so that the after-tax distributions from both trusts treat each child in a reasonable and more equitable manner.
While the calculations won’t always be exact or to the liking of all beneficiaries, the tax savings will typically be significant and more than outweigh the efforts and inconvenience of the coordination herein described.
It’s noteworthy that the equalization trust assets won’t need to be distributed directly to any family members at any given time and may instead be used to fund lifetime trusts that have been established separate and apart from the TEA POT trust and the equalization trust to benefit each child’s lifetime health, education and maintenance.
When a PP’s estate is divided between generation-skipping transfer (GST) and non-GST trusts, the TEA POT trust will typically be part of the non-GST allocated assets, because the after-tax value of TEA POT trust distributions typically will be less than the after-tax value of non-income in respect of a decedent assets,10 which denotes that income taxes have to be paid when the asset is withdrawn from its pre-death source, pursuant to IRC Section 691. The equalization trust can be part of the GST allocated assets.
System Advantages
The primary advantages of the System are:11
1. Significant income taxes can be saved by having the income distributed to and for the benefit of beneficiaries who are in lower tax brackets or who have deductions that can result in lower income tax liability.
2. The planning, administration and maintenance of the TEA POT trust can be much more effective and efficient than having each child and his respective trustee work with separate IRA trusts that have smaller balances and will commonly result in the beneficiaries receiving approximately equal benefit from the assets left to them.
3. Having the children work together with the management and distributions of the shared TEA POT and equalization trusts will not only keep the children in contact with each other for approximately 11 years or longer but also help enhance their relationships with each other.
4. The more responsible and financially savvy child would set a good example for the child who typically wouldn’t be interested or proficient in tax planning and administration. This, in turn, would make the less interested child become more inclined to get involved, along with qualified advisors, with the administration of the TEA POT trust and see how his own separate trusts can be administered.
5. The TEA POT trust can provide creditor and asset protection benefits afforded by a spendthrift trust that doesn’t require compulsory distributions to be made.
6. Having the children receive additional distributions approximately 11 years or longer after the PP’s death can help ensure that the trusts for children and subsequent generations aren’t inadvertently exhausted and that those who may have made mistakes or had unfortunate results in the first 10 years after the PP’s death may have learned lessons or have the need for tighter controls on investments and assets, which may be implemented in the discretion of the trustee of the equalization trust.
7. The TEA POT trust and the equalization trust can both be more flexible than traditional accumulation trusts that would be established for each separate child, so that future changes in law and in circumstances can be taken into account.
8. The TEA POT trust and the equalization trust may be drafted to allow the trustee to have a beneficiary who’s in a low tax bracket be considered to be the owner of the trust, or of a separate subtrust, for federal income taxes under IRC Section 678.
9. The drafting of the System is fairly simple and can be customized to a PP’s family situation with very little effort. While the System is being drafted, a PP can also have the provisions and language of any existing trust agreements brought up to speed with federal tax and state law changes that have occurred.
Drafting Requirements
To qualify for the 10-year rule, the TEA POT trust and equalization trust must be specially drafted, and the following requirements must be met to enable the TEA POT trust to qualify under the 10-year rule, instead of the 5-year rule, if the two trusts are considered to be one trust under the multiple trust rules:12
1. The trust must be irrevocable, at least on the day of the PP’s death, and must be valid under applicable state law.
2. None of the assets in either of the trusts can be available or used to pay creditors of the trusts or the estate of the deceased PP after Sept. 30 of the calendar year after the PP’s death.
3. Information regarding the trusts must be provided to the plan administrator by Oct. 31 of the calendar year following the PP’s death.
4. All beneficiaries of the TEA POT trust must be individuals and identifiable by the designation date, which is Sept. 30 of the calendar year following the PP’s death. These trusts can only be for the benefit of individuals and not for the benefit of a charity or company. Before this date, the beneficiaries may choose to donate trust assets to charity. If so, they would then determine how much each of their inheritances will be reduced for the purpose of calculating the even-up distributions from the equalization trust.
One feature of a well-drafted TEA POT trust will be the ability for the trustee to make distributions to charity on or before Sept. 30 of the year following the PP’s death. This will enable charitable beneficiaries to request that distributions be made to satisfy their personal charitable preferences in a tax-advantageous manner.
The TEA POT trust should be drafted to allow for an income tax deduction to be received under IRC Section 642(c) when such charitable distributions are made. The distribution may be made to a family foundation that’s managed and controlled by the beneficiary who’s requested this distribution or to a community foundation or donor-advised fund, if appropriate rules are followed. The equalization trust will have the ability to elect to consider distributions to non-charities made in the first 65 days of the tax year (on or before March 15) as having been paid in the previous year to carry out DNI from the previous year or to take the Section 642(c) charitable deduction in the previous year for charitable distributions made in the subsequent year (on or before Dec. 31 of the subsequent year as opposed to March 15). Therefore, the equalization trust may make even-up distributions in Year 11 that carry out its DNI from Year 10.13
If a PP intends to leave assets from an IRA/plan to a disabled or chronically ill beneficiary, he can establish what we call a “TEA CUP trust.” This trust will be funded separately from the TEA POT trust and should be structured as an accumulation trust to enable the trustees to pay for expenses that Medicaid and other public support systems won’t cover.14 Because a disabled or chronically ill beneficiary is generally in a low tax bracket, the TEA CUP trust likely wouldn’t disqualify the beneficiary from receiving Medicaid because it’s afforded stretch IRA treatment, which would result in lower RMD amounts. It’s important that the terms of the TEA CUP trust allow the trustee to not make distributions to the beneficiary, so that the beneficiary can qualify for government assistance.
Because an accumulation trust established for a minor may need to be funded directly to qualify for the use of the minor’s life expectancy through the age of majority, it doesn’t appear that a TEA POT trust can fund a TEA CUP trust under the new law.15 If a minor is a potential beneficiary of the IRA, then care should be taken to make sure that the IRA proceeds are paid directly to the minor or a see-through conduit trust established for the minor, if it’s desired that the lifetime stretch would apply until the minor reaches the age of majority.
TEA CRUT
The TEA charitable remainder unitrust (TEA CRUT) is a planning tool for families that want to make charitable contributions and stretch their IRAs over a period of time that’s longer than 10 years. It’s an alternative to the TEA POT trust.
A CRUT named as the beneficiary of an IRA/plan can receive the IRA/plan distributions without paying income tax and earn and accumulate income thereon, which also wouldn’t be taxed at the CRUT level. Income tax liability is only incurred if and when the trust makes distributions to non-charitable beneficiaries on a “worst first” basis. This means that items of ordinary income will be paid out to the beneficiary first, followed by capital gains.
Generally, CRUTs will pay out for a fixed term of 20 years or over the life expectancy of one or more distribution beneficiaries. If 20 years is chosen, then the trust will be required to pay out approximately 11% of the value of the trust assets, as determined each year, and the trustee will be able to “spray” the funds or assets distributed among the beneficiaries named in the trust document, so that income tax planning can occur. When the life expectancy of one or more individuals is used, the distributions must be made in equal shares to those individuals, or to the sole individual if there’s only one payment beneficiary, and premature death may cause a windfall to the charitable remainder interest entity or entities.
The following percentages would apply to a CRUT formed in January 2020 for individuals of the following ages:
Term of Years Annual Distribution
Percentage
20-year term of years 10.87%
30-year-old’s life 5.31%
40-year-old’s life 6.92%
50-year-old’s life 9.64%
60-year-old’s life 14.90%
When the fixed period of years for the trust term has been reached, or when the non-charitable beneficiary, or the last of two or more multiple lifetime beneficiaries dies, the remainder of the trust, which must be projected on formation to be at least 10% of the value of the trust, will then go to the charitable beneficiary without incurring income tax liability.
The payments made to the non-charitable beneficiary are based on the life expectancy tables as described under IRC Section 7520, if the term of the CRUT is to be based on an individual’s life. The payout percentage is calculated using the 2000 CM Mortality Tables, which probably underestimate the life expectancy for the non-charitable beneficiary because the life expectancy of affluent individuals will probably be significantly longer than the life expectancy of the general public in 2000.16
Although beneficiaries of the TEA CRUT will generally receive a little bit less than they would have if a TEA POT trust is used, the charitable and stretch features of the TEA CRUT may still make it an attractive option for some, especially those who are at least somewhat charitably inclined.
The TEA flip-net income with makeup charitable remainder unitrust (NIMCRUT) is a variation of the TEA CRUT. The NIMCRUT would only pay income to the beneficiaries when income is received. Any amount that would usually be required to be distributed but for the trust not receiving any income would be made up in future years when the NIMCRUT has income. After the make-up amount is fully distributed, the trust can flip to being treated as a standard CRUT and start making annual payments as described in the TEA CRUT above.
Generally, IRA proceeds are considered to be trust principal, but distributions that a trust receives from a limited liability company (LLC) can be considered to be income. Each state has different rules regarding how much of a distribution from an LLC can be considered income. In Florida, an LLC can distribute up to 10% of its value to the trust and have all of such distribution considered “income.”17 Any amount distributed above 10% of the LLC’s value will be considered to be a distribution of principal.
It appears that some other states aren’t as strict in relation to the amount that can be distributed from the LLC. For example, Delaware law appears to allow all distributions from the LLC as income, regardless of the percent of value that’s distributed from the LLC.18 Because of these variations in state law, it’s important to make sure that the documents are drafted so that the correct law will apply.
The longer the assets are allowed to grow tax free, the more assets there should be available for distributions to the beneficiaries.
This strategy provides a great deal of control because the trust doesn’t have to make any distributions until the beneficiaries are ready to start receiving payments. Once the beneficiaries are ready, the LLC can distribute funds to the TEA NIMCRUT to then be distributed to the beneficiaries.
This strategy may result in the beneficiaries being subject to higher tax brackets because they’ll likely receive a large sum of money in the first year that the distributions are made. After all of the income that was deferred has been distributed, the NIMCRUT can convert to a regular CRUT and start making distributions in the same manner and amount that a standard CRUT would make.
Endnotes
1. The term “individual retirement account/plan” refers to all qualified retirement plans to which the post-death required minimum distribution rules apply, including, without limitation, IRAs, simplified employee pension IRAs, savings incentive match plan for employees’ IRAs, Internal Revenue Code Section 401(k)s, IRC Section 403(b) plans, Roth IRAs and Roth 401(k)s.
2. We refer to this as the “TEA POT trust system” because assets from each trust can be poured out to the beneficiaries in a manner that produces equal after-tax results for all beneficiaries.
3. The age of majority is 21 in Mississippi and 19 in Alabama and Nebraska.
4. See Treasury Regulations Section 1.401(a)(9)-6, Q&A-15.
5. Leimberg Employee Benefits and Retirement Planning Newsletter #715 (Jan. 6, 2020).
6. The TEA POT trust system is a Service Mark created by Gassman, Crotty & Denicolo, P.A., which may be used by any reader of this article by permission of Gassman, Crotty & Denicolo, P.A.
7. See IRC Section 643(f) and Treas. Regs. Section 1.643(f).
8. Section 643(f).
9. Ibid.
10. Income in respect of a decedent denotes that income taxes have to be paid when the asset is withdrawn from its pre-death source, pursuant to IRC Section 691. The equalization trust can be part of the generation-skipping transfer trust.
11. Supra note 6.
12. Supra note 5.
13. Without the risk of having the Year 11 payment be considered as carrying out income from the TEA POT trust that finishes its distributions in Year 10.
14. State laws vary on what provisions can and can’t be in a trust that will enable its primary beneficiary to qualify for Medicaid. The authors have been informed that some states may not allow for Medicaid eligibility if all requirements of a stretch trust for a disabled beneficiary are met.
15. Supra note 5.
16. High Face Amount Mortality Study, Society of Actuaries (April 2012), www.soa.org/globalassets/assets/files/research/exp-study/research-high-face-amount-final-report.pdf.
17. Florida Statute Section 738.401(e).
18. Delaware Statute Section 61-506.