Dealing with the Inherited IRA 10-Year Termination Rule

By Chris Chapman and Jennifer Rowe

Last year’s new termination rule on Inherited IRAs may have been lost in the turbulence of Covid-19, the severe recession and elections. But it is worth exploring again because so many people have so much of their life savings tied up in tax-deferred accounts.

Recall that a beneficiary of a tax-deferred account must roll over the assets to an Inherited IRA – unless he or she is a surviving spouse (who can treat the IRA as his or her own and avoid the Inherited IRA rules). Until 2020, non-spouse beneficiaries could take distributions from an Inherited IRA based on life expectancy. Doing so allowed them to stretch out those distributions (and the resulting tax) over a period approximating the rest of their lives.

The Problem

Congress’ 2019 SECURE Act made a major change with far-reaching tax consequences. The good news is that the new law exempts most non-spouse beneficiaries from having to take annual distributions. However, it requires that Inherited IRAs created after 2019 terminate entirely after ten years and distribute their contents to the beneficiaries. There are exceptions for spouse beneficiaries, disabled persons, and a few others, but most non-spouse beneficiaries have to anticipate paying income tax on the entire value of the Inherited IRA within ten years.

Non-spouse beneficiaries have some choice in the matter. They can withdraw some amount each year, avoiding a large distribution years later that might push them into a higher tax bracket, or they may defer the tax consequence as long as possible and wait until reaching the termination date. Either way, the tax consequences can be uncomfortably large.

A Solution

For those who want to leave their IRAs in trust for someone as a lifetime benefit, the ten-year termination rule and its tax consequences do not disappear. On the contrary, any undistributed income in an irrevocable trust is subject to compressed tax brackets, resulting in higher tax rates affecting a greater proportion of income.
However, in certain circumstances, an unusual application of a kind of charitable trust can avoid the increased tax burden of a ten-year distribution time period and preserve a distribution stream for the rest of the intended beneficiary’s lifetime. The idea is to name a charitable remainder unitrust as the IRA’s designated beneficiary. Such a trust, known in short by its acronym – a CRUT – is designed to benefit one or more individuals over their lifetimes and then distribute outright to one or more taxexempt charitable organizations.

“But wait,” the owner of a retirement plan account may say, “why would I use a CRUT, knowing that my accumulated wealth will go to charity – and not be available to subsequent generations?” It is true that the assets in a CRUT can benefit only the beneficiaries who are living at the time of Dealing with the Inherited IRA 10-Year Termination Rule Chris Chapman, CTFA &Trust Administrator Jennifer Rowe, Esq., Trust Administrator Last year’s new termination rule on Inherited IRAs may have been lost in the turbulence of Covid-19, the severe recession and elections. But it is worth exploring again because so many people have so much of their life savings tied up in tax-deferred accounts. The Problem the CRUT’s creation. However, the lifetime distribution stream may provide even more benefit than the IRA. Hence, the CRUT is attractive for people who have charitable intent, and it is also a tax-favored method to provide for the actual lifetimes of one or more loved ones, whether the grantor’s spouse or the next generation (or both), before benefiting a charity.

Why It Works

Here’s how a CRUT provides benefit. The IRA owner creates a CRUT, which is a kind of irrevocable trust. It does not have to be funded until the IRA assets are transferred to it (but it can already be in place and funded with other assets). A charitable deduction is available, which is the calculated value of the eventual gift to charity.
The tax on any IRA money that has been left to the CRUT is spread out over the time it takes to distribute an amount equal to the value of the IRA. There are some limitations on the distribution rate to consider, but at a typical 5- or 6-percent distribution rate, it is possible to slow down the IRA distribution – and spread out the tax burden – over a long period of time, creating a stream of cash resembling the old life- expectancy time period that the SECURE Act eliminated.
It is also possible that the beneficiary, if he or she lives long enough, will end up receiving not only the value of the IRA over the course of time but additional cash as well if the portfolio continues to be productive by way of income and appreciation of its investments.

There are limitations, however, which mean that a CRUT will not be appropriate in every case:

• The strategy risks the possibility that the beneficiary will not live long enough to receive distributions equaling or exceeding the value of the IRA.
• The rules for setting up a CRUT require that the value of the calculated charitable remainder be at least 10 percent of the amount contributed to the trust. This imposes limits on the distribution rate and also on the age of the beneficiary. If the distribution rate is too high, or the beneficiary’s life expectancy too long, the amount left over for charity will not be enough to meet the rule. Practically speaking, this means a child of the IRA owner is a good candidate as beneficiary, but not a grandchild.
• The beneficiary will have no access to the trust other than distributions at the predetermined rate, even in an emergency. The CRUT provides less flexibility than a typical lifetime-support trust.
• There is investment risk involved. The investments within the CRUT will need to be productive enough to meet the desired cash distribution stream. However, the risk is mitigated when the portfolio consists of a well-diversified set of highquality investments held for the long term.
  In sum, the new Inherited IRA 10-year termination rule is a serious matter for those with substantial IRA or other tax-deferred retirement plan assets. But charitably inclined IRA owners may find that a CRUT is a useful means to work around it.

Please call us with any questions you may have about these strategies