The pending phase-out of the stretch IRA (Individual Retirement Account) has many account owners and advisors reviewing existing plans. The Senate Finance Committee unanimously passed the Retirement Improvements and Savings Enhancements (RISE) Act of 2016 in September 2016, which proposes the end of stretched distributions for most IRA beneficiaries. The stretch IRA offers beneficiaries the option of timing account distributions over their lifetime, a feature that allows long-term tax deferral and growth. Another tool with an eye for long-term growth, and the added benefit of asset protection, is the Standalone Retirement Trust (SRT). The end of the stretch IRA would impact SRTs.
The RISE proposal provides that beneficiaries would need to complete all IRA distributions within 5 years of the account owner’s date of death. With consideration to the current draft of the proposed elimination of the stretch IRA, existing SRTs would still protect IRAs that are paid to the trust for at least 5 years.
Conduit Trusts vs. Accumulation Trusts
Non-spousal beneficiaries who inherit an IRA must start taking required minimum distributions (RMDs) beginning the year following the account holder’s death. The difference between an accumulation trust and a conduit trust is that the accumulation trust can retain (accumulate) the amounts withdrawn and hold them in trust; they need not be paid to the beneficiary. For this reason the accumulation SRT still provides significant value. Even if the stretch goes away and the IRA has to be withdrawn over 5 years, the amounts can be accumulated, retained, and protected in trust.
This option isn’t available with the case with a conduit trust, which requires all distributions received by the trust to be paid to the beneficiary that same year. Thus, with a conduit trust, the entire inherited IRA would have to be paid out to the trust and, ultimately, the beneficiary within 5 years. In contrast, accumulation trusts could continue on and protect the cash/investments once they have been distributed from the IRA to the trust. Having the inherited IRA structured as an accumulation trust with a discretionary distribution power would protect the unwithdrawn, undistributed balance of the retirement account from creditors.
Income Tax and Creditors
If the stretch opportunity is lost, considerations would need to be weighed about certain income tax consequence with confiscatory trust tax rates vs. the potential loss to future creditors. In its current form, the RISE bill provides an exemption from the 5-year distribution rule for the first $450,000 of IRA funds per account owner. If there is a known creditor, paying 40 percent in tax on income paid to and earned by the trust may be a better alternative than losing 100 percent to a creditor.
For most individuals, there are no known creditors, just prudent planning. In those circumstances, paying 40 percent or more in tax may not be ideal. (A trustee can make discretionary distributions to the beneficiary so that the income is taxed at the beneficiary’s tax rate. This is possible if the beneficiary is not under duress.) Distributions from the IRA to the beneficiary’s trust share would result in income at trust tax rates if not distributed from the trust.
Interested in revising retirement trust and planning efforts? Read our post 5 Mistakes With Large Retirement Accounts.