Another option is to utilize the after-tax withdrawn funds to purchase long-term care insurance (including a hybrid life/long-term care insurance policy), in order to protect the portion of the IRA which has not been withdrawn, and potentially create an income tax deduction for premiums which are paid on a traditional long-term care insurance policy (including a so-called “partnership program” traditional long-term care insurance policy).
Again, if carefully implemented, this type of planning, which combines some elements from alternatives 1 and 2, above, can be beneficial.
4. Pay IRA benefits to income tax-exempt charitable remainder trust. This alternative technique involves designating an income tax-exempt charitable remainder trust as the beneficiary of the IRA proceeds. Assume, for example, a $100 IRA is made payable to a charitable remainder unitrust which pays the owner’s three children (ages 60, 58 and 56), or the survivors or survivor of them, 7.5% of the value of the trust corpus (determined annually) each year, until the last of the three children die. Assume this is 30 years, and that the trust grows at the same 7.5% annual rate throughout the 30 years. Under this plan, the owner’s children will receive a total of $7.5 a year (or $5 after an assumed 33.3% combined federal and state ordinary income tax rate) each year, which when then compounded outside of the trust, at a rate of 6% after 20% capital gains tax rate, will equal almost $400 in 30 years. The charity will receive the $100 principal at the end of the 30 years, and the trust meets the requirements of a qualified charitable remainder unitrust.
This sounds good, but compare this alternative to the alternative of doing no planning under the new tax law. The $100 IRA would grow to $206 10 years after the owner’s death. Assuming a 40% tax rate on this amount compressed during the children’s peak earning years, this would net them $124 10 years after the owner’s death. Next assume this amount grows at a 7.5% rate (or 6% net of an assumed 20% capital gains tax rate) for the next 20 years. Similar to the charitable trust alternative, the children would net almost $400. The difference is that charity does not receive $100 under this no planning scenario. Perhaps more significantly, however, under the no planning alternative the entirety of the IRA funds is available to the children, at all times, whereas under the charitable remainder trust alternative the principal of the trust may not be accessed until paid out to the children according to the designated schedule.
Paying IRA, Etc., Funds To Trusts After The FCAA
Does paying IRA, etc., funds to trusts after the death of the account owner, to protect the funds for the beneficiary, including protection against lawsuits, divorce, and estate taxes, still make sense under the new law? Many will argue it does not, because of the high income tax rates on trusts.
Recall, however, that the high income tax rates on trusts can be addressed through the judicious use of Section 678 of the Internal Revenue Code in the drafting of the trust, which causes the income of the trust to be taxed at the beneficiary’s income tax rates, and not the trust’s rates. Limiting this withdrawal right to 5% of the trust annually will not only eliminate any potential adverse estate or gift tax consequences, but in most states will also eliminate any potential asset protection issues on the annual lapsed withdrawal rights.
The issue, then, is how to address income amounts which may exceed 5% of the value of the trust (including non-IRA assets). Perhaps the best technique will be to allow the trustee to spray these amounts among the designated beneficiary and his or her children, in an effort to lower the overall income taxes on the IRA distributions. If the trustee is also a permissible beneficiary of this spray amount, his or her spray power must be limited by an ascertainable standard when it comes to distributions to himself or herself, in order to avoid potential adverse tax and creditor consequences. An independent trustee can also be given a spray power over income not subject to the Section 678 withdrawal right, without the need for an ascertainable standard.
Note that the above discussion refers to the so-called “accumulation trust” approach to planning for IRA, etc., payments to trusts on a “stretch” basis. It will not work in the case of a so-called “conduit trust,” because conduit trusts mandate that all IRA and plan distributions be paid to the designated beneficiary of the trust, upon receipt. Very few clients are likely to opt for a conduit trust approach when it comes to trusts for grandchildren, however, so paying IRA, etc., benefits to accumulation trusts for grandchildren should normally continue to be the recommended course, going forward.
Note also that existing “accumulation trusts” may need to be modified in light of the new law, in order to ensure the 10-year deferral period for payments to a “designated beneficiary” is achieved over the 50% shorter 5-year default period. The key language for the drafting attorney to focus on is found in Regs. Section 1.401(a)(9)-4, A-1: