Thursday, September 23, 2021

Prepare Clients Who Fear Their Heirs are Spendthrifts

The SECURE Act and pending estate-tax changes make it imperative to rethink wills and trusts, says this CFP/CPA.

Some investors don’t want to immediately leave a large inheritance to their children or grandchildren because they fear the money will be spent quickly (and perhaps unwisely). So they’ve often had to decide what to do with their retirement plans, which comprise the largest assets held by many people.

Good estate planning for those in this situation often meant putting their retirement plan in trust rather than giving it outright to their children or grandchildren. The trustee would withdraw the required distribution from the IRA each year, temporarily deposit the funds into the trust account and then pass it on to their beneficiaries. This satisfied the tax rules, while also limiting the amount of money children or grandchildren could get their hands on at one time. The nice thing about this strategy was it could be done annually and stretched over the beneficiaries’ life expectancy.

This was commonly referred to as a “conduit” trust because the trust acted as a conduit to pass through the required distribution from the inherited retirement plan to the child or grandchild.

For all retirement plans, other than Roth IRAs or Roth 401(k)s, income tax would be paid annually by the child (or grandchild) in this situation. What was not distributed annually could be left in the retirement plan to grow tax deferred. This last part, however, bothered many in Congress, which led to tax changes.

Unintended Consequences

On December 20, 2019, Congress passed The SECURE Act, which among other things changed the way certain beneficiaries were required to take distributions from retirement plans they inherited. Annual distributions are no longer required. Instead, for many beneficiaries, the entire account has to be fully withdrawn by the end of the tenth year following the year in which the original retirement plan owner died.

So how has this affected the so-called conduit trust? On one hand, no annual required distributions mean more of the money can stay in the retirement plan and out of the hands of the child or grandchild (or their creditors). Another benefit is investments in retirement plans can continue to grow tax deferred. There is one major downside, however. Due to the way the conduit trust language was drafted, trustees are not permitted to make any annual distributions that were not considered “required distributions” under the tax code.

Since the only required distribution under the new law is in the tenth year following the year of death, trustees would be required to distribute the entire amount to the child or grandchild at that time. This could result in very high income taxes and also put significant assets at one time in the hands of the beneficiary — not exactly what was intended.

Additional Reading: Preparing Non-Moneyed Heirs for a Seven-Figure Windfall

Lower Taxes, Less Protection

One solution to the problem has been to revise the terms of the trust so the trustee has discretion to make distributions from the IRA to the trust. This provides two benefits: It allows the trustee to make distributions throughout the 10 years to minimize taxes in the last year, and it allows the trustee to take a distribution from the IRA – leaving it in the trust rather than passing it on to the beneficiary. This provisions protects the IRA from the child or grandchild.

However, there is a downside to leaving the distribution in the trust: Namely, higher income taxes. Distributions from the IRA to the trust that remain in the trust are taxed at trust tax rates. Trust tax rates are the same as individual tax rates, but trust income is taxed at these higher rates at much lower taxable income levels.

For example, someone filing an individual income tax return in 2021 pays tax at the highest tax rate of 37% only once their taxable income exceeds $523,600. Trusts pay income tax at 37% once the trust taxable income exceeds $12,950. This puts trustees in a bit of a quandary. If the goal is to minimize the amount of money distributed to children or grandchildren then more money may wind up staying in the trust and more taxes incurred. If tax minimization is the goal, then more money will need to be distributed to the children or grandchildren. Although this results in lower taxes, the iherited assets are less protected.

A Client’s Dilemma

We had this potential situation with a client last year. Fortunately, the client is still alive so we had time to evaluate the different strategies. We worked with their estate planning attorney, who was able to draft a plan that under the current law that makes sense.

Our client is widowed, with an estate worth approximately $9 million. Approximately $3 million is in a retirement plan; the balance of the estate consists of real estate and brokerage assets. The current estate plan left the retirement plan to a conduit trust created under the client’s will, so the beneficiary would not inherit the retirement plan outright.

We ran some calculations using life expectancy assumptions for our client, as well as the projected growth in the retirement plan once the child inherited it. Our calculations showed a projected balance of close to $6 million at the end of the tenth year following the year we projected our client were to die. Under the SECURE Act, that amount would have then needed to be fully distributed with significant income tax paid on the distribution.

The estate planning attorney who worked with the client replaced the conduit trust language in the will to allow for discretionary distributions to be made by the trustee each year. This would allow the trustee to determine if it made sense to take distributions before the end of the tenth year and also to determine whether to keep the amount distributed in the trust (and pay income taxes at the trust rates) or pass it out to the child.

Our client wanted to provide for their three grandchildren so three additional discretionary trusts were created in his will, one for each grandchild. This gave the trustee the ability to pass out distributions to four trusts. Since each trust pays its own income taxes, this would allow more of the distribution to be taxed at a lower trust rate.

By the Numbers

Here is how that works: Passing out $48,000 to one trust would result in the amount in excess of $12,950 ($35,050) being taxed at 37%. But passing out $48,000 to four trusts ($12,000 to each) would keep each distribution amount to less than $12,950 and thus less tax would be paid.

The final thing we did was carve out some of the client’s retirement plan and name two charities as beneficiaries of a designated amount. These two charities had been included in the original will to receive direct bequests totaling $200,000. By removing them from the will and instead carving out $200,000 of the retirement plan funds for them, it reduced the amount that would be required to be distributed in 10 years from the retirement plan.

We allowed the $200,000 of direct bequests instead to go to the child and grandchildren. This resulted in a better tax outcome for their child and grandchildren because under current law those direct bequests would receive a stepped up basis eliminating much and maybe all of any taxable gain.

The last part of the new plan was a bit tricky. As you probably can see by now, the use of a discretionary trust makes for more complicated decisions for the trustees. Unlike a conduit trust where the trustee only had to make the required distribution each year, the decisions they need to make with a discretionary trust include whether to make a distribution in a given year and [ITAL: and] whether to distribute any of that amount to the beneficiary, or keep it in trust. The trustee presumably would need to have knowledge of the tax code — or at least have access to someone who does — to help make those decisions. And who would let the trustee know that these decisions even had to be made?

Reach Out to Clients

That was resolved by letting those individuals who were being named as trustees know who they could reach out to if they had any questions about their duties. Fortunately, in this case, we as the advisors and the estate planning attorney knew the trustees well and so such a conversation was arranged.

I fear there are many people in similar circumstances, who under the new law could end up with adverse tax consequences or, even worse, assets going to heirs who may mismanage them. The next few months we are likely going to see other changes to the estate laws that may have additional adverse effects on estates. Now is the time to reach out to your clients and work with them and their estate planning attorneys to evaluate their situation and help them efficiently pass their assets down to family members.

Howard Hook, CFP, CPA, CAP, is a principal and senior wealth advisor with EKS Associates, a fee-only financial planning firm in Princeton, N.J. Hook can be reached at hhook@eksassociates.com.

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