Thursday April 18, 2024

3.11.4 IRA to Testamentary Unitrust

IRA to Testamentary Unitrust

IRA to Unitrust:  During life, an IRA is an excellent asset.

IRA to Unitrust

During life, an IRA is an excellent asset. It grows tax free, the minimum withdrawals under the regulations are fairly modest and it provides both retirement income and liquidity for the IRA owner. However, for the children or other individual heirs of the IRA owner, the IRA is not nearly as desirable an asset. Many other assets will be distributed to family or other heirs free of income, capital gains or estate tax, but with the IRA frequently comes a very large income tax bill. All distributions from the IRA to the individual heirs are taxable income. Worse yet, the IRA payouts, even if stretched over a long period, are added on to the recipient's taxable income and could increase his or her tax bracket.

There are two attractive planning strategies for IRAs. In some circumstances, the IRA could be transferred to a unitrust for surviving spouse. Another option is a transfer to a trust for a term of years for children.

Example 3.11.4A IRA Unitrust for Children

John and Mary IRA raised a family of four children. Four years ago, John passed away and transferred all of his assets to Mary. She received the house, the CDs, the securities and John's IRA. Mary rolled over John's IRA, added in her IRA and now has $600,000 in the IRA. She also has approximately $600,000 in other assets.

Mary desires to benefit her four children equally, but faces a challenge common to parents. Two of the children are very good money managers, one is somewhat borderline and one is quite creative. If she transfers the assets equally to all four, the creative child will use those assets in new and wonderful ways in perhaps three weeks. She thinks that it would be desirable under the circumstances to "diversify" the inheritance.

A way to provide for zero estate taxes, eliminate the income tax on the IRA and diversify the inheritance is to use the "give it twice" plan. When Mary passes away, her stocks, bonds, home and other "good" assets are transferred outright to children. However the "bad" asset, since it has ordinary income attached to it, is transferred to a testamentary term of fifteen years unitrust. Mary's attorney drafts the unitrust and either funds it nominally or simply creates the unfunded trust, if that is permissible under applicable state law. Her beneficiary designation is then changed to the trustee of the charitable remainder unitrust. Fortunately, under the new Sec. 408 regulations, this does not change her minimum distribution requirement for the IRA.

When Mary passes away, her diversification goal for the inheritance is achieved. The children receive approximately $576,000, after costs of $24,000. The remaining $600,000 IRA asset is transferred to a 7% unitrust for a term of fifteen years. Since the unitrust is exempt, there is no tax paid on the ordinary income. The full $600,000 from the IRA is then invested and earns new income for the children for the term of fifteen years. While this is taxable, over $676,000 is paid to children during that term of years. At the end of the term, the IRA plus growth is distributed to charity.

This plan has the virtue of treating all children equally. There will always be economic differences among children and some children inevitably will be better managers than others. However, diversifying the inheritance allows even the "creative" child the opportunity to learn to manage funds. He or she may not be as successful in the early years, but the fact that there is a fixed number of years for the inheritance payout acts to encourage the individual to learn better managing practices over the selected term.

Example 3.11.4B IRA to Spousal Unitrust

Harold and Mary Wilson have been quite successful in building and selling a business. Their estate is $4,000,000, with approximately $1,000,000 in Harold's IRA. When he was 70½, he rolled over his company pension plan into an IRA and started taking distributions.

Harold and Mary believe that the approximately $3,000,000 in estate assets other than the IRA will be more than adequate for liquidity needs for Mary. They would like to give her flexibility either to accumulate or to take distributions from the IRA. Under the rather unfriendly laws governing IRA distributions, there are mandatory payouts. However, Harold can choose to allow Mary to have an "income control" trust and decide to take distributions or to allow them to accumulate. Since Harold and Mary both have retirement income from pensions, Mary would like the ability to decide whether or not she wishes to take the additional income.

Harold and Mary's attorney creates a two-life charitable remainder trust. Under their state law, an unfunded trust is permissible. Harold then selects this trust as the beneficiary of his IRA and sends the appropriate beneficiary designation form to his IRA custodian. When Harold passes away, the IRA is distributed to the charitable remainder trust. Since the trust is subject to the much more friendly charitable trust rules, it is possible to write a net income plus makeup trust and either invest for growth or for income.

After payment of $80,000 in costs, Mary receives the $2,920,000 balance of the assets and also is the income recipient of the 7% unitrust. If she desires to receive the income, then she will receive approximately $70,000 of income annually from the trust. However, if she chooses not to receive the income, because it would increase her income taxes and she doesn't need the income presently, then it will be possible to invest for growth and simply allow the corpus to grow. One advantage of this strategy is that the trust will build up an accumulated deficit account. If Mary later did need a substantial distribution, the trustee could recognize and distribute gain to Mary all in one year. While this would be taxable gain, the opportunity to have a significant distribution is very attractive to Mary.

After Mary passes away, the unitrust will eventually be distributed to charity. The entire IRA has benefited Mary for her lifetime, with no income tax ever paid on the IRA balance when Harold passes away. While the new income to Mary is taxable, the benefit of having the entire IRA producing earnings is a very substantial economic advantage for this plan.

Case Studies on IRA to Testamentary Unitrust

Changing IRA Beneficiaries Now, Before or After:   Richard Stevenson, 74, is a university professor and ex-Marine. After serving two tours, he returned to the States and began his lifelong dream of becoming a teacher. He received his bachelor's from a local college and his master's and doctorate from a State University. Soon thereafter, he was offered a history teaching position with the University, which he gratefully took. Amazingly, he taught full time at the University for almost 40 years. During that time, he was named Professor of the Year five times! He now works on a part-time basis, staying active with the university and its students. Richard married his high school sweetheart, Sue. Sue and Richard have been married for almost 50 years and have two children, Richard, Jr., and Linda.

Death and Taxes - The Madison Era of Giving, Part 6 of 7:   While George Madison, Jr., repeatedly demonstrated his willingness to give, his younger brother Frank Madison, 75, was another story. In short, Frank was never the "giving" type. He believed only the super-rich, like his brother George, gave to charity, since they were the only ones well off enough to "throw money away." Frank did not consider himself rich because his estate was valued at a mere $3,000,000. Consequently, Frank had never made any kind of charitable gift. Frank's unshakable and outspoken beliefs about giving had not surprisingly earned him the nickname Ebenezer. However, even Ebenezer Scrooge had a change of heart when given the right circumstances.

A Bargain Sale with Insurance:   Chris and Caroline Peters, both age 60, purchased residential rental property ten years ago as an investment for their two children. They would like to one day transfer this home (or like value in cash or other property) to the two children as part of the children's inheritance. The home was purchased for $100,000 and is currently valued at $250,000. The outstanding mortgage on the property is $50,000 and their depreciated cost basis is $65,000.

Private Letter Rulings

PLR 199901023 IRA or Pension Plan to Unitrust, No Sec. 691(c) Income Tax Deduction:   When a qualified retirement plan is transferred at death to a unitrust, there is a charitable estate tax deduction. If the unitrust does not have unrelated business taxable income (UBTI), the transfer is not subject to income tax for the estate or the unitrust. When payments are received, there is Sec. 664 tier one ordinary income to recipients but no Sec. 691(c) income tax deduction for the estate tax attributable to the income interest.

PLR 9244013 QDOT and Unitrust:   Taxpayer desired to create a charitable remainder unitrust (CRUT) for himself and his spouse. However, his spouse was not a U.S. citizen and therefore did not qualify for the Sec. 2056(b)(8) marital deduction. Taxpayer planned to fund the CRUT with separate property and retain a testamentary right of revocation. The CRUT included the required provisions for a qualified domestic trust (QDOT) under Sec. 2056A(a).

Related Topics on IRA to Testamentary Unitrust

3.11.5  Stretch Unitrust with IRA:    Many articles have been written advocating the economic advantages of a Stretch IRA. The Stretch IRA allows the designated beneficiary to receive distributions over his or her lifetime. While there may be substantial estate tax, the tax-free growth inside the IRA will produce an excellent income stream for the beneficiary.

3.2.3  Bequests of IRAs and Other IRD Assets:    Some assets transferred to heirs do not receive a stepped-up basis. This "income in respect of a decedent" (IRD) is defined as gross income "not properly includable in computing [decedent's] taxable income for the taxable year ending with the date of his death." Reg. 1.691(a)-1(b). IRD assets are those in which there is either untaxed ordinary income or a deferral of capital gain. When the beneficiary receives the asset, the beneficiary is subject to taxation on the asset, just as the original owner would have been subject to such taxation if he or she had recognized the income or gain.

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