3.11.5 Stretch Unitrust with IRA

For many years, IRA owners relied on the Stretch IRA to pass retirement savings to their families. Until 2020, the Stretch IRA allowed the designated beneficiary of a qualified retirement account to receive distributions over his or her lifetime. While in rare cases there was substantial estate tax on the IRA value, the tax-free growth inside the IRA often produced an excellent income stream for the beneficiary, who was able to extend distributions for 20, 30 or even 40 years.

Under current law, for most nonspouse beneficiaries, IRA distributions must be taken within ten years of the date of the IRA owner's death. There are exceptions for recipients with disabilities, minors and individuals who are within ten years of the age of the IRA owner.

I. Ten Year Stretch IRA

Despite the drastic changes enacted by the SECURE Act, IRA beneficiaries are still able to stretch out the IRA distribution, but only for ten years. The two advantages to all taxable IRAs are the ability to contribute pre-tax dollars and to benefit from tax-free growth. Of these two advantages, the tax-free growth is the greatest economic benefit for the IRA. By stretching out the IRA payments for up to ten years for the child or grandchild, a limited economic advantage of tax-free growth and deferral of tax payments is preserved.

There is another advantage with extending the traditional IRA distribution period as far as allowable. If estate taxes are payable on the traditional IRA, there is a partial income tax deduction for the payment of those estate taxes, termed the Sec. 691(c) deduction. Hopefully, the estate taxes are payable from other assets from the estate and the IRA can be preserved in its entirety for the family. If this is the case, there will be a Sec. 691(c) deduction.

The Sec. 691(c) income tax deduction is dependent upon the amount of estate tax paid. The estate tax attributable to the IRA will typically be used to offset a portion of the income tax on distributions from the IRA. For example, if the IRA is valued at $1 million and there is $400,000 in estate tax paid on the $1 million IRA, then 40% of the first $1 million in distributions would be a Sec. 691(c) income tax itemized deduction.

Before passage of the SECURE Act, Stretch IRA distributions could be made over the life expectancy of the beneficiary. For decedents after 2019, there is no annual distribution requirement on inherited IRAs. The beneficiary may take a distribution of a portion of the IRA each year for the ten-year period if he or she so chooses, but there is no required minimum distribution (RMD). He or she may simply wait and take a lump sum distribution at the end of the ten-year period. The advantage of taking distributions over a longer period of time is that the smaller distributions may reduce the beneficiary's likelihood of being taxed at a higher rate.

If the beneficiary waits until the end of ten years to take the traditional IRA distribution in a lump sum, he or she will maximize the tax-free growth potential inside the IRA. This strategy will, however, cause a much greater increase in the beneficiary's taxable income for the year of the distribution, potentially bumping the beneficiary up to a higher income tax bracket.

While the ten-year option allows tax-free growth and potentially the Sec. 691(c) deduction, there are some major negatives that should be discussed and disclosed to clients.

First, the full value of the IRA is subject to estate tax. There is no discounting, as is possible with family limited partnerships, minority interests in family corporations and other types of transfers. If a traditional IRA is a large portion of the estate, it may also be necessary to pay income taxes by making withdrawals from the IRA and thus accelerating the income tax payable on the IRA.

Second, as noted above, there will be significant income tax on the distributions for the beneficiaries. The value of the traditional IRA is increased by its tax-free growth, but all of the distributions are taxable as ordinary income.

Third, when the traditional IRA is left directly to children, it will often fail to achieve the distribution goals of the parent. An IRA beneficiary may take the entire distribution in the first year after the owner passes away. This would be the least desirable outcome, since the entire amount of the traditional IRA is taxable income to the beneficiary and the beneficiary is giving up ten years of tax-free growth.

One viable alternative to the ten-year IRA distribution is a plan that transfers property to family. Through the use of a combination of the exemptions of both parents, family limited partnerships, charitable lead trusts during life and at death and aggressive gifting, it is possible to move millions of dollars through to family members with no estate tax. The majority of this transfer can enable children to acquire growth stocks or land. If the estate includes an IRA, it may be transferred to a testamentary unitrust and a portion of the inheritance could thus be through an income stream.

The primary benefit of the equities plan is that children and grandchildren pay zero tax on the property transfer, invest in stocks or land and receive income taxed at capital gain rates. By carefully managing the portfolio, turnover costs can be minimized and the growth rate can be very close to the growth rate for the IRA.

There are many benefits of transferring the IRA to family and charity through a charitable remainder unitrust versus an outright beneficiary designation to family. With the demise of the Stretch IRA, those benefits have been amplified.

IV. IRA to Family vs. Stretch Unitrust

There are many benefits of transferring the IRA to family and charity through a charitable remainder unitrust versus an outright beneficiary designation to family. With the demise of the Stretch IRA, those benefits have been amplified.

Many tax advisors would like to see a specific comparison of the benefits of leaving the IRA to family versus the Stretch Unitrust. For parents with sizable estates who are willing to pay the estate tax from the balance of the estate, the question then becomes - which option has the better arrangements or benefits for the children?

The benefits of leaving the IRA directly to family, as listed above, result from the ability to stretch out payments over ten years, the tax-free growth during that period of tax deferral and (in rare cases) from the Sec. 691(c) deduction. However, the benefit of stretching out payments over life expectancy is no longer available.

A Stretch Unitrust can be designed in such a way that it provides lifetime payments, making it comparable in many ways and, in some cases, a superior economic structure to the old Stretch IRA. The Stretch Unitrust is a net plus makeup unitrust with the trustee permitted to allocate long-term capital gain to income. The unitrust corpus is invested in an equities portfolio. Under the Sec. 664 rules, income distributed is first ordinary income, second capital gain, third tax-free or other income and fourth return of principal.

In PLR 199901023, the Service was asked to consider the appropriate rule for charitable unitrusts when an estate tax had been paid due to the value of the income interest. In a decision much criticized by commentators nationwide, the Service determined that the Sec. 691(c) allocation would not flow through with the income distribution, but would, in effect, be trapped in the trust, thus reducing the tier-one ordinary income. Because very few estates are subject to transfer tax, this Sec. 691 issue is generally not applicable.

Given the rules of Sec. 664, all ordinary income must be distributed before making distributions of any capital gain. Thus, when the unitrust is funded by a transfer of a traditional IRA to the unitrust, the unitrust then immediately has tier-one income equal to the initial value of the IRA. However, if the trust earns predominately-capital-gain return, this tier two gain is maintained in the trust until sufficient income has been distributed to equal the initial value of the trust. Thereafter, all ordinary income earned each year is distributed first and the balance of the distributions will be long-term capital gain. A unitrust for the lives of children may eventually pay mostly capital gain amounts each year.

When the IRA is left to family, there is full estate tax on the value of the IRA. There will be a Sec. 691(c) deduction for the initial distributions of income for several years, with fully-taxable ordinary income after that time. In most cases, the inherited IRA must be fully distributed within ten years. However, with the Stretch Unitrust there is a partial estate tax deduction. In most cases, the Applicable Exclusion Amount will be sufficient to zero the estate tax. In addition, the corpus of the Stretch Unitrust is protected and there will be payments for the life of the beneficiary, regardless how long he or she survives.

Finally, the Stretch Unitrust may provide flexible distributions. Under Reg. 1.664-3(a)(1)(i)(b)(3), a charitable remainder trust is precluded from permitting the trustee to have a purely discretionary power to allocate capital gain. The unitrust drafter may allocate all recognized capital gain to income, no recognized capital gain to income or a fixed fractional part of gain to income. An alternative to permit discretionary distribution of capital gain is to place the unitrust assets in a partnership or single-member LLC. When a trust payout is desired, recognized capital gains are distributed from the partnership or LLC to the unitrust, and then to the income recipients.

With a unitrust and partnership plan, a 50-year-old beneficiary may desire to receive smaller distributions for a term of ten or fifteen years. Presumably, he or she is in primary earning years and does not require any additional current income. After reaching retirement age of 65, the beneficiary may desire larger distributions and the trustee can distribute from the partnership to the unitrust and then make larger payouts to the beneficiary.