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January 26, 2021

Using Charitable Planning to Get a Stretch Payout After the SECURE Act

The Setting Every Community Up for Retirement Enhancement (SECURE) Act was signed into law on December 20, 2019, and went into effect on January 1, 2020. For all defined contribution plans and IRAs, the SECURE Act eliminates a stretch payout for many non-spouse beneficiaries and requires the balance to be paid out within 10 years.

Prior to the SECURE Act, any individual beneficiary of a qualified retirement account or IRA could, subject to the terms of the plan, receive the balance of the account remaining at the owner’s death over the beneficiary’s remaining life expectancy (referred to as a stretch payout). Now, after the passage of the SECURE Act, only an “eligible designated beneficiary” can use a stretch payout. An eligible designated beneficiary is a spouse or minor child of the account owner, a chronically ill or disabled individual, or an individual who is not more than 10 years younger than the account owner. A minor child, however, can only use a stretch payout until the child reaches the age of majority, and then the remaining balance at that time must be paid out within 10 years of that date. All other individual beneficiaries must now withdraw the entire balance within 10 years of the end of the calendar year in which the account owner died.

The elimination of the stretch payout will affect the designated beneficiaries of many account owners, most notably an account owner’s adult children who are often named the primary or contingent beneficiaries of the account. A stretch payout allows a beneficiary to stretch the payments out over the beneficiary’s remaining lifetime instead of withdrawing the entire balance over only 10 years. The smaller distributions over a longer time period result in a greater deferral of the income tax, which leaves more in the account. The more there is to invest, the more that can be earned on that investment. The smaller distributions also limit the potential that the additional income will push the beneficiary up into a higher tax bracket, thereby increasing the overall income tax that must be paid.

Despite the limitations of the SECURE Act, there remains an option, subject to the terms of the plan, for an account owner with charitable intentions to have the remaining account balance paid to the owner’s adult children over their remaining life expectancies, thereby achieving a form of a stretch payout. The account owner can create a testamentary charitable remainder trust (CRT) for each child under the account owner’s will and then name those CRTs as the beneficiaries of the account in whatever percentages the owner desires. At the owner’s death, the entire remaining account balance can be liquidated and paid in the respective percentages to each CRT, thereby satisfying the requirement that the entire balance be withdrawn within 10 years of the owner’s death, and those amounts will be considered income to the CRT, not the owner’s estate. Since the CRT is tax-exempt, no income tax will be recognized at that time. Instead, each child will only pay tax on the distributions the child receives from that child’s respective CRT at the time of the distribution. By deferring the income tax, the entire remaining account balance can be invested, as opposed to only the net after-tax balance, which results in greater appreciation and earnings for the invested funds. In addition, the account owner’s estate can take an estate tax charitable deduction for the value of the CRT’s remainder interest since that interest passes to a charity.

The term of each CRT can be the life expectancy of the child who will be the income beneficiary of that trust. The distributions to a child may be paid as an annuity, which uses a percentage of the initial value of the trust assets to determine a fixed amount to be paid each year, or as a unitrust amount, which uses a fixed percentage of the value of the trust assets, as revalued each year, to determine the variable amount to be paid each year. In addition to getting a stretch payout over the child’s life, which helps to preserve funds for the child’s own retirement, defers taxes, and potentially results in lower overall taxes by keeping the child out of the higher income tax brackets that a lump sum distribution might put the child into, the use of the CRT also prevents the child from withdrawing the entire balance at once. This can be useful when a child is not financially responsible and the owner has concerns about the child’s ability to manage the funds and make informed tax decisions.

Assuming the income beneficiary survives to or near life expectancy, the portion of the account balance that ultimately passes to charity using a CRT is at least partially offset by the income tax savings and added growth from the deferral of taxes. The account owner also gets to help out one or more charities of the account owner’s choosing.

However, there is a risk that the income beneficiary will die well before that beneficiary’s life expectancy and, as a result, the charity will receive a much bigger amount than expected. As an alternative, the account owner could opt to use a fixed term for the CRT (up to 20 years) instead of the life expectancy of the income beneficiary so that, if the income beneficiary dies before that beneficiary’s life expectancy, the payments will continue for the remainder of the term to the income beneficiary’s estate or heirs. Additionally, if a beneficiary has a life expectancy of less than 20 years, the use of a fixed term may allow for more deferral than would be possible under the prior law.

Further, the CRT is less flexible than leaving the account balance directly to the beneficiary. For example, while use of a CRT can protect against an irresponsible beneficiary withdrawing the entire balance at once, it also prevents a beneficiary from withdrawing additional amounts over the payout from the CRT when a real need arises. As a result, use of a CRT should be carefully considered by the account owner and will not be appropriate in all situations. The account owner should at least have charitable inclinations, and the beneficiary’s specific circumstances will be a significant factor in determining whether to use a CRT to get a stretch payout.

If you have any questions regarding the content of this blog post, please contact Jon McSherry, counsel, at jmcsherry@barclaydamon.com, or another member of the firm’s Trusts & Estates Practice Area.

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