Charitable remainder trusts as IRA beneficiaries.
As a result of this high effective tax rate, individuals receiving IRA distributions who have elected to recalculated life expectancy with their spouses as beneficiaries face a difficult problem if the nonparticipant spouse predeceases the participant. The new IRA recipient, who may be a newly designated beneficiary, will be forced to pay tax on the entire IRA balance within one year of the surviving spouse's death. A similar problem exists for nonspouse IRA beneficiaries when the IRA is not in pay status at death. These beneficiaries are required to liquidate their ERAs within five years of the participant's dead.
The impact of these taxes in situations in which the beneficiary cannot continue to defer income taxes is illustrated in the following example.
Example 1: J, a single individual residing in California, died during December 1995 with a $2,000,000 IRA. The IRA is part of her $5,000,000 taxable estate. J left her entire estate to her only child, B. B is required to withdraw all of the IRA funds immediately. B receives only $295,251 of the $2,000,000 IRA:
IRA balance $2,000,000 Less: Federal and state income taxes (571,677) Estate taxes (at 55% rate) (1,015,578) Excise tax on excess accumulation (153,494) Net to B $ 259,251
One alternative available to individuals who wish to continue the tax deferral is to name a remainder trust (CRT) as the IRA beneficiary. A CRT is a trust that provides income to a beneficiary or beneficiaries for life or a term of years not exceeding 20 years, with the remainder going to a qualified charity. The CRT is exempt from income tax and the donor receives a charitable deduction for the value of the remainder interest. The use of a CRT as an IRA beneficiary can be illustrated in the following example:
Example 2: J, from Example 1, named a charitable remainder unitrust (CRUT) as the beneficiary of her IRA. The CRUT provided that it would pay 9% of its value to B (age 45) for life. On J's death, the CRUT will receive $1,846,506, as follows:
IRA balance $2,000,000 Excise tax* (153,404) $1,846,506 *Note: Use of a CRUT does not eliminate excise tax. Other estate assets will need to make up the $899,569 estate taxes on the IRA. Value of IRA $2,000,000 Deductions: Excise tax (153,454) Charitable deduction (210,966) Taxable value 1,635,580 Estate tax (at 55%) $ 899,569 Assuming B invests the proceeds at 10% and is subject to a 40% income tax rate, compare the two alternatives. No CRUT Proceeds $ 259,251 Additional assets from estate not used to pay estate tax 899,569 Total funds invested 1,158,820 After-tax income 6% (10% X 60%) $ 69,529 CRUT Value $1,846,506 After-tax income 5.4% 90/. X 60%) $ 99,711 If B can wait 20 years (until he is 65) before withdrawing die funds, he can make die CRUT a net income make-up charitable remainder trust (NIMCRUT) and allow the assets to accumulate inside the CRUT. If he does this, the difference is even more dramatic. No CRUT CRUT Value of funds at age 65 $3,716,493 $12,422,369 Annual after-tax income $ 222,989 $670,808
The dramatic difference is the result of the CRUT compounding at 10% versus the after-tax money compounding at 6%. (The details and variations available through the use of NIMCRUTs and recent IRS attacks on these vehicles are beyond the scope of this article.)
Surviving spouses in pay status with beneficiaries who face immediate payout of their IRA balances on the spouse's death should consider the use of a CRUT or NIMCRUT to allow the beneficiary to continue the income tax deferral. Also, individuals with a nonspouse beneficiary may consider the use of a CRUT beneficiary prior to age 70 1/2, particularly if they are in poor health. Prior to receiving payments, they may switch their beneficiary from the CRUT to their nonspouse beneficiary. This strategy will help mitigate the five-year payout requirement to nonspouse beneficiaries.
Individuals contemplating the use of CRUTs must consider the possibility of the beneficiary's early death. Proper planning can help mitigate this problem and allow for a greater transfer of wealth. From Philip J. Baptiste, CPA, MT, Cohen & Company, Avon, Ohio