The purpose of estate tax planning is to maximize the assets you pass on to future generations by minimizing gift and estate taxes. Estate-tax strategies revolve around the use of irrevocable trusts. This article discusses the most common types of irrevocable trusts that are used to minimize gift and estate […]
Passing an Individual Retirement Account (IRA) on to one’s children or grandchildren can be a great way to build wealth for future generations. The typical, simple gifting of an IRA, however, can carry an immense tax burden — the recipient will be forced to withdraw the money within ten years of the gift, and all of the proceeds will be taxed at ordinary income rates. As a result, IRA gifts can end up being diminished by 60% or more, just on account of these mandatory withdrawal and tax rules.
For this reason, gifting an IRA via a tax-advantaged account — specifically, a Charitable Remainder Trust (also known as a CRT or CRUT) — can be a powerful way to protect assets for one’s family. But how to decide whether, when, and how to make that move? In this post, we’ll explore these important questions, as well as the mechanics behind the strategy.
The first question to ask when evaluating any advanced tax planning strategy is whether it makes sense to pursue at all.
Who is this strategy for? With IRA gifting via a CRUT, the potential returns are incredible — 90% or more additional earnings over the next generation. Because the returns are so large, it will make sense for many, but especially for those with IRA’s over $250k whose inheritors (outside of their spouse) don’t expect to need that money right away.
Given those expected returns, then, why would this ever not be the right strategy? One simple reason: liquidity. Like all Charitable Remainder Trusts, a CRUT holding an IRA will have limited liquidity in the first few years. Compare that reality to the scenario where the IRA holder gifts the account to their kids outright; there, the kids will be able to withdraw the money when they need it. Those withdrawals will be taxed at a punitive rate, though, so there’s a tradeoff here: Outside of a CRUT, the beneficiary will have access to 100% of the assets, but taxed at 50% or more. If the IRA owner passes the assets on via a CRUT, the beneficiary will have access to only around 5% of the assets per year, but taxed at a much lower rate. As with any CRUT, after only a few years of compound growth, those 5% payouts start to accumulate quickly, and you may be able to access as much as 80% of the proceeds, before taxes, in the first 7 years. For this reason, liquidity should be a barrier to using a CRUT for these purposes only if you need a large chunk of the money immediately, and if you are willing to give up significant growth for it.
So you’ve decided this is the right move for you and your family. You don’t need your IRA assets during retirement, and your kids and grandkids don’t expect to need access to the money right away, either. When and how can you get this set up?
As with most tax planning, the answer to “when?” is “now.” The benefits of this strategy come into play as soon as you pass away, but implementing it requires advance planning. To ensure that your IRA is correctly moved into your beneficiaries’ trust, you’ll need to do the work now to establish a “testamentary CRUT.” A testamentary trust is a trust that comes into effect upon an individual’s passing. In this case, you can establish such a trust and designate it as the beneficiary of your IRA. That way, when you pass away, the IRA’s funds will go straight into the trust with no special maneuvering — and, critically, no legal wrangling in probate. Pursuing this approach also has the virtue of being certain; if you wait too long, you might not have the ability to implement the strategy in time for the IRA to move to a CRUT when you pass away.
Aside from whether to pursue the IRA-to-CRUT strategy and when to implement it, there are several key design questions you’ll want to answer as soon as you decide this plan is for you.
How much?
You need not gift your entire IRA — or all of your IRA assets, if you have multiple accounts. CRUTs are flexible, and you are free to assign only some of your retirement account assets to your testamentary trust.
Who will benefit?
Who do you want to receive the income — and, eventually, a relatively large lump sum — from your IRA and trust? That income interest will likely be substantial — 5%+ of the IRA assets every year, an amount that will likely grow over time as the trust’s investments appreciate — so it’s important to think about who will be reaping those rewards and at what stage in their lives.
This is, of course, mostly a personal question, like all estate planning, but there are two technical limitations that you should consider. First, you are allowed to pass an IRA to your surviving spouse free of taxes and mandatory-withdrawal limitations. Accordingly, that should usually be the first move. Then, the surviving spouse will typically be the one to pass the IRA assets to a trust for the younger generation. (To get ahead of the planning, both spouses can establish a testamentary trust that executes only if they are the last to die.)
Otherwise, this part is up to you.
Once you’ve decided to pursue this strategy, there are a few more decisions to be made. Most notably, you’ll have to decide what kind of CRUT you want to leave your beneficiaries, and how long you want it to run for. Although there are numerous permutations, this decision really varies along two axes: (1) Standard CRUT or NIMCRUT; and (2) term trust or a trust that runs for as long as possible.
We’ve written extensively on these decisions in the context of the general analysis of CRUT strategies — we compare Standard CRUTs and NIMCRUTs here, and we look at the different trust lengths here. The calculus isn’t very different in the context of an IRA-to-CRUT transition — the main difference is that you need to be thinking about the needs of the ultimate beneficiary, whoever you choose.
As you think through this choice, the following rules of thumb might be helpful:
A NIMCRUT will likely yield the largest overall returns, because it allows your beneficiaries to choose to further defer the CRUT distributions for many years, to take advantage of additional tax-free compounding. As a beneficiary of an IRA, the returns from a NIMCRUT are even higher because of the high ordinary income tax rates paid on inherited IRAs. A Standard CRUT, by contrast, will have lower returns but will provide more predictable payouts.
The length decision is more complex, but it really comes down to two choices: A term trust (running for 20 years) or a long-term trust. If your chosen beneficiary is younger than 27 1/2, a term trust will be the only option, and that’s totally fine: the returns are still significantly positive even over just a 20-year term. But if your beneficiary is older — and especially if they themselves have children or other younger dependents — the returns can get truly massive. This is because you can elect to set up a trust that runs for your beneficiary’s lifetime plus a term of years after they pass away. Gifting an IRA to a 50-year-old child with children of her own in their 20s, you can choose a maximum-length trust that will be expected (in actuarial terms) to last for as much as 50+ years. Those beneficiaries can draw income distributions from the trust for that entire time, as well as larger lump sums toward the end of the term, and still leave a significant gift for charity at the end.
Fundamentally, as you are deciding whether and how to design your IRA-CRUT strategy, you’ll have to answer three questions: When to do the work to get this in place (as early as possible), when the money should move over (when you pass away, via a testamentary trust), and what you should do in the meantime (let your money grow).
Planning for the end of life is not easy for anyone involved, but you can make that transition smoother by planning ahead for the tax-advantaged transfer of assets via an IRA-to-Charitable Remainder Trust rollover. If you’d like to know more about IRA planning, check out our strategies to pass on your IRA. Use our CRT calculator to evaluate the potential return on investment given your situation. Or if you have any questions, contact us through our chat button below, or schedule a meeting with us.
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