Executive Summary
In December 2019, the Setting Every Community Up For Retirement Enhancement (SECURE) Act was passed into law, bringing with it substantial changes to the laws governing retirement accounts. Of the changes, perhaps the most discussed were the revisions to the post-death distribution rules, which eliminated the ‘stretch’ provision for most non-spouse designated beneficiaries of retirement accounts. As a result, many beneficiaries are now required to distribute inherited account(s) within 10 years after the year of the owner’s. In other words, whereas some beneficiaries may have once been able to distribute their inherited retirement accounts over many decades, such distributions must now often be made in a much shorter amount of time (10 years).
As a response to this 10-Year Rule, many advisors have contemplated an increase in the use of Charitable Remainder Trusts (in particular, the Charitable Reminder UniTrust, or CRUT). A CRUT is a trust that distributes assets annually in a ‘Stretch’-like manner over one or more individual’s life expectancies, then terminates and sends the remainder to a charity. This can allow certain beneficiaries to experience some of the same benefits that they did under the ‘old’ ‘Stretch’ rules, including tax-deferred growth.
But CRUTs must follow a number of rules, which can ultimately limit their effectiveness as a wealth transfer vehicle. For example, at least 10% of the present value of assets contributed to the trust must pass to a qualifying charity when the trust terminates —in other words, upon the heir’s (or heirs’) death(s). At the same time, a CRUT is required to distribute 5–50% of its assets to beneficiaries annually. Together, these requirements make it impossible for a CRUT with lifetime payments to be established for certain young beneficiaries (generally those in their mid-20s or lower.
At the same time, other beneficiaries may be too old to receive the true benefits of CRUT payments if their life expectancy is too short to truly benefit from the tax deferral offered by using a CRUT. No tax deferral is gained when a CRUT is distributed in under a decade, because the 10-Year Rule already offers tax deferral for that time period. In fact, it often takes over three decades of CRUT distributions for its tax deferral to make up for the amount that is ‘lost’ to the charity upon a beneficiary’s death—and that is without considering additional complications, such as organizational and operational expenses and the loss of optionality.
Ultimately, for those who wish to use a CRUT solely to maximize the transfer of wealth to heirs, the bottom line is that a CRUT is generally a ‘risky’ option. With all of that said, for those who want to use CRUTs to both help beneficiaries and satisfy a charitable inclination, a CRUT is an option worth exploring. For some, the ultimate trade-off risk of heirs losing a little, and a charity gaining a lot, is well worth their while!
On December 20, 2019, the Setting Every Community Up for Retirement Enhancement (SECURE Act) was passed into law. While the law made a substantial number of revisions to the rules for retirement accounts, no single change received more attention than the SECURE Act’s rewriting of the post-death distribution rules that apply to most non-spouse beneficiaries of retirement accounts.
More specifically, prior to the SECURE Act, all Designated Beneficiaries (living individuals, along with qualifying See-Through Trusts) were able to use the ‘Stretch’ to spread distributions from their inherited retirement account over their life expectancy. This allowed such individuals to minimize their annual taxable income while maximizing the tax deferral of such accounts.
SECURE Act’s Impact On Post-Death Distributions
The SECURE Act split the ‘old’ group of Designated Beneficiaries into two groups of its own: Eligible Designated Beneficiaries and Non-Eligible Designated Beneficiaries. Eligible Designated Beneficiaries, a limited group of beneficiaries consisting only of a decedent’s surviving spouse, disabled persons, chronically ill persons, individuals not more than 10 years younger than the decedent, and minor children of the decedent (as well as certain trusts established for the benefit of such individuals), continue to be eligible to ‘Stretch’ distributions. By contrast, all other Designated Beneficiaries (the majority of non-spouse beneficiaries) now find themselves in the group of Non-Eligible Designated Beneficiaries and are subject to the SECURE Act’s new 10-Year Rule.
Nerd Note:
Through the end of 2021, beneficiaries who inherit a retirement plan sponsored either by a governmental entity (e.g., the Thrift Savings Plan, a governmental 457(b) plan, a governmental 403(b) plan), or pursuant to a collectively bargained agreement (e.g., a plan maintained by a union) are not impacted by the SECURE Act’s changes to the post-debt distribution rules.
The 10-Year Rule requires that the entire balance of an inherited IRA, 401(k), or other retirement accounts, be distributed by the end of the 10th year following the year of the original owner’s death. From the time of inheritance through the ninth year after death, there are no required minimum distributions (but voluntary distributions of any amount may be taken). In the 10th year, the entire balance of the retirement account is the required minimum distribution, and must be distributed prior to the end of the year in order to avoid the 50% penalty that applies to a shortfall in a required minimum distribution.
Compared to the ‘old’ ‘Stretch’ rules, the 10-Year Rule has the potential to dramatically accelerate distributions from the inherited retirement account to the beneficiary. For instance, under the ‘old’ rules, a 35-year-old healthy child would have been able to stretch distributions over nearly 50 years (the Single Life Expectancy factor for a 35-year-old is 48.5). Today, that same beneficiary would have just 10 years to empty the same account.
Clearly, the loss of tax deferrals for several decades or longer can have a dramatic impact on the net-after-tax value of the inherited account. Accordingly, since the SECURE Act was passed, practitioners have been exploring ways to mitigate the imposition of the 10-Year Rule.
Charitable Remainder Trusts Offer Similar Benefits To The ‘Stretch’
One planning vehicle that has received a substantial amount of attention since the passage of the SECURE Act is the Charitable Remainder Trust (CRUT). More specifically, as a way to mitigate the impact of the ‘death’ of the ‘Stretch’, some practitioners have suggested naming would-be Non-Eligible Designated Beneficiaries as the income beneficiaries of a CRUT, and then naming that CRUT as the beneficiary of the individual’s retirement account (instead of naming the Non-Eligible Designated Beneficiaries directly on the beneficiary form).
At the most basic level, a CRUT is a trust that receives assets, makes ongoing distributions of those assets (and their earnings) for some period of time (as described further below), and then terminates, sending whatever is left in the trust to a qualifying charity.
Notably, CRUTs have the potential to offer certain individuals similar benefits as would have been provided by the ‘Stretch.’ Tax deferral, for instance, is a benefit enjoyed by both an inherited retirement account and a CRUT. As a charitable entity, a CRUT does not pay income tax on any income it receives. In the case of a CRUT named as the beneficiary of an IRA, such income would be distributions from the IRA to the CRUT, as well as any interest, dividends, and capital gains earned within the trust.
Additionally, CRUTs can be established to distribute assets annually in a ‘Stretch’-like manner over an individual’s (or group of individuals) life expectancy (or for a fixed period of up to 20 years). And similar to the ‘Stretch’, income beneficiaries of a CRUT pay taxes on the distributions they receive (from the trust) on their personal returns.
Basic Charitable Remainder Unitrust (CRUT) Rules
Clearly, there are a number of benefits to the use of a CRUT. But using a CRUT to secure those benefits is far from a ‘free lunch.’ Rather, in order to qualify as a CRUT (and take advantage of the corresponding tax benefits), a trust must meet a number of requirements.
IRC Section 664(d)(2)(D), for instance, requires that no less than 10% of the actuarily determined future value of the trust be no less than 10% of the value of the trust at inception. Thus, from the outset, owners of retirement accounts looking to use a CRUT purely as a wealth transfer vehicle (and not because they have charitable intent) must ask themselves the fundamental question, “Are the tax benefits of the CRUT substantial enough for my heirs that they make up for giving away (at least) 10% of my balance?”
Meanwhile, IRC Section 664(d)(2)(A) requires CRUTs to distribute a fixed percentage of at least 5% (but not more than 50%) of their assets annually to the CRUT’s income beneficiaries. Thus, younger beneficiaries will generally receive larger distributions from a CRUT established for their benefit, than they would have under the ‘Stretch.’ For example, as noted above, the Single Life Expectancy factor for a 35-year-old is 48.5. Thus, using the ‘Stretch’ rules, such a beneficiary would only be required to take a distribution of 100 ÷ 48.5 = 2.06% from their inherited retirement account, and wouldn’t be required to take a distribution of 5% or more from their inherited IRA for another 29 years (when their RMD factor would be 48.5 – 29 = 19.5, resulting in a 100 ÷ 19.5 = 5.13% required minimum distribution)!
By contrast, the same 35-year-old beneficiary would be required to receive a distribution of no less than 5% of the assets of a CRUT for which they were named a beneficiary.
Finally, it’s worth noting that whereas all distributions from inherited IRAs are considered ordinary income, a CRUT retains the character of any income it receives or generates, and then distributes that income to trust beneficiaries on a worst-in, first-out basis. In other words, while if a CRUT has capital gain income, it can distribute those amounts to the CRUT beneficiary, but it can only do so after first distributing all ordinary income (because ordinary income is ‘worse’ income because it is taxed at a higher rate!).
Using A CRUT As A Wealth-Transfer Vehicle Is Rarely The ‘Best’ Option
On the surface, the CRUT appears to be a reasonably close approximation to the ‘Stretch’. But unlike the pre-SECURE Act ‘Stretch’ rules, not every person can be the beneficiary of a CRUT. And upon closer inspection, even when the CRUT can be used, for those who are primarily interested in transferring as much wealth as possible to heirs, the CRUT will rarely be the optimal solution.
Some Individuals Are Too Young To Be CRUT Beneficiaries
As noted above, in order to qualify as a CRUT, a trust must both distribute at least 5% of its assets annually and have an actuarial value of the remainder interest of the trust equal to at least 10% of the initial contribution to the trust. That required combination makes it impossible to name “young” individuals as the (or a) beneficiary of a CRUT.
Simply put, young individuals’ long (actuarial) life expectancies make it mathematically impossible to construct a CRUT that satisfies both the payout and remainder (to charity) requirements. If you set the payout rate of the trust at the lowest permissible payout rate of 5% and solve for the actuarial remainder, you get a remainder amount of less than 10%. Similarly, if you set the actuarial remainder amount at the lowest permissible level of 10% and solve for the payout rate, you get a payout rate less than 5%. Regardless of which way you go about it, the result is the same. You can’t make the would-be CRUT work.
Of course, that raises the obvious question… “How young is ‘too young’ to be a CRUT beneficiary?”
The answer, as is often the case, is “It depends.” More specifically, the youngest possible age for a CRUT beneficiary generally hovers somewhere in the mid-20s, but the exact age varies from time to time.
Notably, the actuarial value of the remainder interest of a CRUT is, in part, calculated using what is known as the “Section 7520” rate (due to the section of the Internal Revenue Code under which the rules to calculate it are found). Per IRC section 7520(a)(2), the Section 7520 rate is equal to 120% of the Applicable Federal Midterm rate in effect during the current month. If, however, “an income, estate, or gift tax charitable contribution is allowable for any part of the property transferred” – which is the case when an individual funds a CRUT – “the taxpayer may elect to use such Federal midterm rate for either of the 2 months preceding…” So, for instance, if an individual funds a CRUT in June 2021, they can use the Applicable Federal Midterm rate from April 2021, May 2021, or June 2021 to determine the appropriate Section 7520 rate.
As the Section 7520 rate decreases, the youngest possible age for a CRUT beneficiary increases. For example: using a Section 7520 rate of 1.2% – the highest possible interest rate that can be used for a CRUT funded in June 2021 – it is mathematically impossible to construct a valid CRUT that pays out over the life of a beneficiary who is under the age of 27. By contrast, using a Section 7520 rate of 6.2% (last applicable in August 2007), the youngest possible age for a lifetime-payout CRUT beneficiary drops to 25 years old.
Nerd Note:
A CRUT is a Non-Designated Beneficiary. Accordingly, if a CRUT is named as the beneficiary of a retirement account and the retirement account owner dies prior to their Required Beginning Date, the CRUT would be able to use the 5-Year Rule. As such, the CRUT may be able to hold off receiving distributions from the inherited retirement account long enough (for up to five years) for a young-but-not-too-young beneficiary to reach an age where a valid CRUT with lifetime payout can be used.
Even using an astronomical (at least by today’s standards) Section 7520 rate of 20%, the youngest possible CRUT beneficiary would be 18 years old. Accordingly, it is highly unlikely that a CRUT could be used to re-create the ‘Stretch’ for a minor beneficiary. And because it is impossible to know in advance the Section 7520 rate that will exist at the time of an individual’s death, CRUTs generally should not be considered for use until the intended beneficiary is at least 27 or 28 years old.
Nerd Note:
Term payout-style CRUTs can be established for younger CRUT beneficiaries. However, since the maximum term of such a trust is 20 years, it is virtually impossible for such a trust to enable the owner of a retirement account to pass more wealth to an heir than they could by naming them directly on the beneficiary form.
CRUTs Don’t Make Sense For Beneficiaries With Shorter Life Expectancies
When it comes to using CRUTs as ‘Stretch’ replacement vehicles, “young” individuals are ‘out’ by rule. At the opposite end of the pendulum, older individuals can be named as the beneficiary of a CRUT with a lifetime payout, but doing so does not make financial sense for IRA owners primarily concerned with wealth transfer to heirs.
Notably, the primary tax benefit provided by the use of a CRUT as an IRA beneficiary is that gains are tax-deferred for as long as they remain in the CRUT. The 10-Year Rule, though, essentially the ‘default’ option to which the CRUT is being compared, already provides tax-deferral for a decade. Accordingly, individuals with a life expectancy of less than a decade would not be expected to gain any additional tax deferral through the use of a CRUT than they would through the use of the 10-Year Rule to which they would be entitled simply by being named directly on the beneficiary form.
Additionally, and of even greater importance, it’s important to remember that the tradeoff for a CRUT receiving its tax deferral is that once the income beneficiary of the CRUT dies, whatever is left in the trust (which must be actuarily expected to be at least 10% of the present value of the trust upon contribution) goes to charity. Thus, there is an ever-present risk that the CRUT beneficiary will have a premature death, resulting in a substantial reduction in generational wealth transfer.
For instance, suppose a $1 million IRA was left to a CRUT with a 60-year-old beneficiary. The optimal payout percentage for such a trust, based on the life expectancy of a 60-year-old beneficiary is 14.903% per year (just take my word on this one). What if, however, such a beneficiary unexpectedly died after receiving only one distribution from the CRUT?
In this case, the beneficiary would have received just 14.903% × $1 million = $149,030. The remaining amount in the CRUT (the $1 million IRA less the $149,030 distribution, plus/minus any gains/losses) would go to charity. Thus, while charity would receive a windfall, generational wealth transfer would be largely destroyed by the early death.
Life insurance can be used to mitigate this risk, but at a cost. And the more likely the CRUT beneficiary is to have a limited life expectancy (either due to advanced age or to health issues), the greater the expense of purchasing a life insurance policy… if such a policy will even be issued!
It Can Take A (Really) Long Time To Reach The Break-Even Point With A CRUT
CRUTs don’t eliminate income taxes. They just delay (defer) them. Thus, for IRA owners primarily concerned with transferring wealth to future heirs, the projected additional wealth made possible by the CRUT’s extended tax deferral (compared to the 10-Year Rule) has to outweigh the projected loss of (at least) 10% of the assets left to the trust.
Is that possible? Can extended tax deferral make up for the remainder amount that must be left to charity (thereby enabling an IRA owner to transfer more wealth to future generations using a CRUT than they could have by naming the CRUT beneficiary directly on the IRA beneficiary form?
Indeed, in certain situations, it is possible.
But it generally takes a long time… a really long time.
The breakeven point – the amount of time it would take for wealth created via distributions from a CRUT to catch up to wealth created via leaving the same amount of retirement dollars to a beneficiary directly – varies based on a variety of factors, including the:
- CRUT beneficiary’s ordinary income tax rate
- CRUT beneficiary’s long-term capital gains rate
- Percentage of the growth of the CRUT that is comprised of ordinary income versus capital gain income
- Turnover of CRUT investments
- CRUT payout percentage
While the exact breakeven point varies, it generally takes a CRUT three or more decades for its tax deferral to make up for the amount that is ‘lost’ to charity upon death of the beneficiary.
Example 1: Mary has a $2 million IRA which she plans to leave to her healthy 34-year-old twin sons, Bill and Ted. Mary’s primary goal is to transfer as much wealth to her two boys as possible upon her death.
Bill and Ted are both highly compensated consultants who work for the marketing agency, “Excellent Ad Ventures.” Currently, their income puts them in the 33% ordinary income tax bracket and 15% long-term capital gains bracket.
Since both Bill and Ted are healthy 34-year-old adults, they are Non-Eligible Designated Beneficiaries, subject to the SECURE Act’s 10-Year Rule. Ted is concerned about the limited deferral provided by the 10-Year Rule. Accordingly, he created a lifetime payout CRUT, and asked his mother to leave his share of the IRA to the CRUT instead of him directly. Bill, on the other hand, wants to remain the direct beneficiary of his mother’s retirement account, and plans to spread distributions from the account evenly over the 10 years after he inherits.
Sadly, moments after updating her beneficiary form to list Bill as a direct beneficiary of 50% and Ted’s lifetime payout CRUT as a beneficiary of 50%, the twins’ mother passes away.
If the twins invest their respective accounts identically (based on the assumptions described below), it would take Ted exactly 50 years(!) to accumulate as much wealth using the CRUT as Bill accumulated by being named a beneficiary directly. Notably, by that time, both twins would be 85 years old, which is actually longer than the actuarial life expectancy of the 35-year-old male!
Of course, as an individual’s tax rate increases, so does the value of tax deferral. So, what if Bill and Ted’s business took off, and they found themselves in the highest tax brackets? How would that change things?
Accordingly, increasing Bill and Ted’s tax rates shifts forward the breakeven point… but only by a few years. More specifically, it would take Ted 46 years to catch up to Bill’s wealth using the CRUT.
The value of tax deferral also increases as returns increase (assuming any interest, dividends and/or net positive capital gains). So, what if Bill and Ted were able to squeak out a bit higher tax-preferenced (capital gain) return?
Well, once again, the breakeven point shifts forward. And the combination of the higher tax rate and increased rate of return would result in a much more reasonable breakeven point of 32 years.
Other Downsides Of Using A CRUT As A Retirement Account Beneficiary
As the third scenario above shows, there are certainly some situations where a CRUT could be expected to transfer more wealth to an heir, over time, than leaving them a retirement account outright. That said, even in such situations, there are additional complications of using a CRUT as an IRA beneficiary that should be considered. Such issues include the following:
- The Loss Of Optionality – If an individual is named the income beneficiary of the CRUT, they are entitled to ongoing distributions from the trust, but they generally have no ability to access any additional amounts in the trust. By contrast, if a Non-Eligible Designated Beneficiary inherits a retirement account, they have access to the full inherited amount right away. Taxes, of course, would be owed on any distributions, but that is at least an option for the beneficiary to consider.
- CRUTs Have Organizational And Operational Expenses – A CRUT is a legal document, and as such, it should be drafted by a qualified legal professional (that won’t be free!). In addition to the upfront cost of establishing a CRUT, though, there are generally ongoing expenses. For instance, the CRUT must file a tax return each year, which, given the complexity of such returns, will likely require the assistance of a qualified CPA or other tax professional. Another cost.
It Takes A (Near-) Perfect Storm For A CRUT To Be The Best Wealth-Transfer Vehicle
Ultimately, it’s not a stretch (Ha! Get it?) to say that it takes a near-perfect storm for an individual to find themselves in a situation where naming a CRUT as the beneficiary of their retirement account would be better off for their beneficiaries from a wealth-transfer perspective.
If the intended beneficiaries are too young, it won’t even be possible to use a CRUT. If the beneficiaries are too old (or in poor health), there won’t be enough time to allow the tax deferral of the CRUT to make up for the remainder value that will ultimately be ‘lost’ to charity.
If the CRUT beneficiary is in a more modest tax bracket, the tax deferral that the CRUT offers won’t be worth much. And if expected returns are more modest, the value of the CRUT’s tax deferral is similarly muted.
So, ultimately, for the owner of a retirement account to name a CRUT as their beneficiary in an effort to maximize wealth transfer to an heir, they have to have a Goldilocks beneficiary (not too young, not too old), in a fairly high tax bracket, who expects to have fairly strong portfolio returns over time.
And oh yeah… even if all that ‘adds up,’ the beneficiary will have to actually live long enough to see the net benefit!
Nerd Note:
Another element that can potentially shorten the breakeven point of using a CRUT as an IRA beneficiary (compared to naming a Non-Eligible Designated Beneficiary directly on a beneficiary form) is when the retirement account is left to the CRUT as part of the taxable estate. In such instances, the present value of the expected future amount left to charity can be deducted from the estate’s value, reducing the estate’s Federal estate tax liability.
Charitable Intent Can Make The CRUT Option More Attractive
It’s worth noting that it doesn’t take the near-perfect storm described above to make naming a CRUT as an IRA beneficiary a viable planning strategy. Rather, the near-perfect storm is only required when the CRUT is being used to maximize wealth transfer. But maximizing wealth transfer is not always a retirement account owner’s goal, or at the very least, their only goal.
For instance, sometimes an individual may wish to provide a benefit for heirs, as well as for charity. In such situations, a CRUT could see increased value as a planning tool.
Example 2: Recall Bill and Ted from Example 1. Bill inherited $1 million of IRA money directly, while Ted was named the income beneficiary of a CRUT that was the beneficiary of another $1 million of IRA funds. In the first scenario, it took Ted 50 years to catch up to Bill’s wealth using the CRUT.
Consider, for a moment, though, what would have happened if Bill and Ted each died 40 years after inheriting the IRA. At that time, Ted would have trailed his brother by about $400,000 in net wealth created via the inheritance.
But looking purely at the brothers’ comparative wealth completely discounts amounts left to charity. Notably, in Bill’s case, there is nothing left for charity (of course, Bill could always leave some of his own assets to charity). On the other hand, the CRUT established for Ted still has nearly $1.5 million left that would all go to charity. For some retirement account owners, that trade-off (reducing an heir’s wealth by a little to increase the amount that goes to charity by a lot) might be well worth it.
Since the SECURE Act effectively ‘killed’ the ‘Stretch’ for most non-spouse beneficiaries, retirement account owners and planners have been exploring ways to mitigate the impact of the new 10-Year Rule. One of the more popular concepts being discussed is the potential use of a CRUT as an IRA beneficiary to try to create a pseudo-stretch IRA.
Indeed, a CRUT can allow for many similar benefits to the stretch. Specifically, assets held within the trust remain tax-deferred, as is the case with an inherited retirement account. Similarly, a CRUT can be established to provide an individual with distributions over their life expectancy, similar to the “Stretch.”
But CRUTs are no ‘free ride’. Such trusts require that beneficiaries receive a fixed rate of at least 5% of the trust assets each year (in no more than 50%), and at least 10% of the actuarily determined present value of the trust must go to charity.
The ‘loss’ of 10% of trust assets to charity can be ‘overcome’ by a CRUTs tax deferral, but only in the right circumstances. In general, CRUT returns must be strong, the CRUT beneficiary must be in a reasonably high tax bracket, and the CRUT beneficiary must live three, four, or even five decades or more after the CRUT has been funded.
If just the right circumstances present themselves, or if a retirement account owner is sufficiently charitably inclined, naming a CRUT as the beneficiary of a retirement account is a planning strategy worth exploring. But for retirement account owners looking to maximize the transfer of wealth to heirs, the bottom line is that a CRUT is generally not a great option.
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