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Meet the worst asset in your client’s estate

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Natalie Choate
Natalie B. Choate

By Natalie B. Choate

What’s the absolute worst asset to deal with in a client’s estate plans? No contest: It’s their IRA (and other retirement plans, like 401(k)s and 403(b)s). When your client leaves their IRA to someone, they are bequeathing that person a giant bag full of taxable income.

Suppose your client leaves their $1 million IRA to their daughter and their $1 million home to their son. Shortly after your client’s demise, their son sells the house and their daughter cashes out the IRA. How much money will each beneficiary then have?

Your client’s son will have the $1 million sales proceeds from the house, minus any brokerage commission or other selling expenses he incurred. But your client’s daughter will have to pay income tax on the full value of the IRA, leaving her with something in the neighborhood of $630,000 after paying federal income tax (less if she is also subject to state income tax).

Back in the "old days" before 2020, your client’s daughter had a way to mitigate those income taxes. She could leave the money inside the IRA she inherited from your client, so it would continue to grow on a tax-deferred basis, and withdraw the money gradually over her life expectancy. Since the life expectancy of a 50-year-old (for example) is 34+ years (according to the IRS’s tables), the "life expectancy payout" option gave most heirs a great way to preserve and build on their inherited retirement benefits by deferring the taxes. Unfortunately, Congress decided that was too good a deal.

In the SECURE Act, which was passed in late 2019, Congress took away the life expectancy payout for most beneficiaries and replaced it with a 10-year payout requirement. This new 10-year rule applies to beneficiaries of IRA owners who die after 2019 (in other words, it’s not retroactive).

If your client was not fortunate enough to die before 2020, it’s still possible that some of their beneficiaries will be able to use the life expectancy payout. Retirement benefits left to their spouse, to a disabled individual, or to any individual who is close to your client in age (or older than your client) will still qualify for the life expectancy payout. Thus, if your client’s estate plan calls for benefiting someone in these groups, they can probably still arrange their IRA to qualify for the life expectancy payout after their death.

If your client’s chosen beneficiaries are not in those categories, however, the stark reality is that their IRA contains a big debt of deferred income taxes. Those taxes must be paid either by your client during their lifetime or by their beneficiary within 10 years after their death. Your client needs to think about who is going to pay those taxes, when, and with what.

Before your client gets too depressed about this, there is a way to avoid that income tax: Leaving the IRA to charity. If your client names a charity as beneficiary of their IRA, the IRS comes to their funeral hoping to start collecting taxes on their IRA and instead sees the entire account go right past them into the tax-exempt charity. Charities are exempt from income tax, so the $1 million IRA that is only worth $600,000 to a human beneficiary is worth a full $1 million to your client’s favorite charity.

Now, saving the best for last: What if your client likes the idea of an income-tax-free treatment of their IRA, and they have a charity in mind for some of their estate, but they also want to provide for a human beneficiary – let’s say their 50-year-old daughter? Consider a charitable remainder trust (CRT): Your client leaves their IRA to the CRT. The CRT receives and cashes out (income-tax-free) the entire IRA. The CRT then pays a life income to your client’s chosen human beneficiary.

The income typically is a fixed percentage of the trust’s value each year, such as 5%, though there are other options. So the first year’s distribution from a $1 million IRA-funded CRT would be about $50,000. Your client’s daughter will receive the 5% payout every year for the rest of her life. Those distributions will be taxable to her, though the trust itself is not subject to tax. Upon her death, the trust terminates and all remaining funds are distributed to the charity your client designated.

For example, if the CRT were funded with a $1 million IRA, had a 5% payout rate, and earned income every year of exactly 5%, your client’s daughter would receive $50,000 a year for life, and on her death, the charity would receive $1 million.

An important drawback of the CRT is that your client’s chosen human beneficiary cannot receive anything more than the designated lifetime payout amount, regardless of what needs he or she may have. So if your client wishes to ensure more discretionary funds are available to their beneficiary, they need to choose a different type of trust instead of or in addition to a CRT. 

Needless to say, CRTs have various technical requirements (one of which makes it suitable only for older beneficiaries – not young grandchildren, for example). But it’s worth investigating this tried-and-true estate planning tool that allows your client’s IRA to bypass the income tax system while providing a life income to their chosen human beneficiary and fulfilling their charitable intent.

Get more practical ideas for real-life situations after the SECURE Act by registering for our May 20 continuing education course featuring Natalie Choate.

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