One of the most problematic aspects of the Setting Every Community Up for Retirement Enhancement (SECURE) Act applies to an individual retirement account or Internal Revenue Code Section 401(k) plan account (401(k) plan) owner’s children after the account owner’s death. The new mandatory 10-year period for receiving distributions after the IRA or 401(k) plan owner’s death coincides with the likely peak earning years of the children and their spouses, say ages 55-65. Thus, the IRA and/or 401(k) plan distributions will likely be taxed in the highest income tax bracket that they ever could have been taxed. As a direct consequence of today’s higher interest rates, however, and specifically the so-called “Section 7520 rate” (which in April of 2023 was at 5%, compared with 0.4% in November of 2020), it’s now possible for the account owner to partner with charity to offset the harmful post-death aspects of the SECURE Act. What’s more, the new SECURE Act 2.0, passed in late 2022, may actually support this partnering.
Back in the summer and fall of 2020, when the Section 7520 rate was at its lowest point, a SECURE Act strategy of paying the balance of an account owner’s IRA and/or 401(k) plan benefits to a charitable remainder trust (CRT) when the account owner passed resulted in no net benefit to the couple’s children. For example, the account owner could have structured the CRT to pay a 7.1% annuity to the children for 13 years, with the balance of the trust passing to charity at that point, and the trust would have satisfied the requirement that the charity receive at least a 10% of the trust’s initial corpus. However, the children would have received only 92.3% of the trust corpus, on a nominal basis, and most of the income from the IRA and/or 401(k) plan would have been paid to the children during their likely peak earning years.
Effect of Higher Section 7520 Rate
Today, however, with a Section 7520 rate of 5%, at a permissible 7.2% annuity rate, the children would receive 144% of the trust corpus, on a nominal basis, and half of that amount will be received over Years 11 to 20, or in years when the children are more likely to be retired. What’s more, with SECURE Act 2.0’s new rule that, in the future, the children needn’t begin taking their own IRA, etc. distributions until they attain age 75, these second 10 years can turn out to be the lowest tax bracket years of the children’s lifetime.
Assume, for example, that the IRA or 401(k) plan account owner passes when the couple’s youngest child is age 55 and that this child plans to continue working until age 65. Using the April 2023 Section 7520 rate of 5%, the child’s 7.2% maximum annual annuity amount from the CRT would be spread over 20 years. Thus, not only would the annuity payments during the child’s working years be dramatically reduced from what they would have been under the IRA or 401(k) plan had these payments been received directly by the child rather than through the CRT vehicle, but also, the payments that are made during the child’s retirement years (ages 65-75) will likely be taxed at a much lower rate as a result of SECURE Act 2.0’s extending the child’s mandatory beginning date for receiving distributions from their own IRA or 401(k) plan to age 75. The child will likely be retired during this 10-year period but not yet required to take distributions from their own IRA and/or 401(k) plan.
Even though the child will be receiving 144% of the initial value of their IRA and/or 401(k) plan, on a nominal basis, under this 20-year payout plan, the child will only be receiving 90% of the account on a present value basis. Nevertheless, the child will receive less taxable distributions during their peak earning years, that is, ages 55-65, than they would have been forced to receive without the intervention of the CRT vehicle. In their place, the child will now be receiving half of the distributions from the CRT during ages 65-75, when the child is likely to be retired. Further, because of SECURE Act 2.0, the child won’t be required to begin taking withdrawals from their own IRA and/or 401(k) plan until age 75. The child is therefore likely to be in their lowest tax bracket years during this age 65-75 period, and these years therefore become an optimum time for the child to receive the balance, or 50%, of the taxable payments from the CRT.
Further Income Tax Reductions
The charitable arrangement can be refined to further reduce the income tax consequences to the child. With the exception of distributions of employer stock in a 401k plan, when distributions are made directly to the beneficiary from a taxable IRA or 401(k) plan, all distributions are subject to federal income tax without any special qualified dividend, long-term capital gains or tax-exempt treatment. Pursuant to IRC Section 664(b) and Treasury Regulations Section 1.664-1(d)(1), on the other hand, once an amount equal to the initial taxable IRA or 401(k) plan lump sum distribution has been paid out to the beneficiary of a CRT, that is, via the annual annuity payments, the future annuity distributions may become eligible for the same special income tax treatment qualified dividends and long-term capital gains receive for individual investments in taxable accounts." Furthermore, once the annuity distributions have exhausted all forms of federal gross income (including capital gains), it’s even possible for the distributions to be federally tax-exempt, assuming the CRT invests in federally tax-exempt securities. Again, compare this favorable income tax treatment associated with distributions from CRTs to the tax treatment afforded distributions from IRAs and 401(k) plans by the IRC, especially distributions relating to post-death earnings and growth inside the IRA or 401(k) plan versus inside the CRT.
A Better Result
Although the exact application of the “after-tax math” will vary from situation to situation, as a direct consequence of rising interest rates and SECURE Act 2.0’s future extension of the children’s required minimum distribution date to age 75, as well as the manner in which distributions from CRTS are taxed for federal income tax purposes versus the manner in which distributions directly from IRAs and 401(k) plans are taxed, by partnering with charity, the net, after-tax amount that the children will eventually receive from the decedent’s IRAs and/or 401(k) plans can now better approximate, and in some situations even surpass, the after-tax amount the children would have received pre-SECURE Act. The charity obviously also benefits under this scenario, and if the account owner is in a taxable estate situation, the children will also benefit by the available estate tax charitable deduction for the charity’s actuarial interest in the CRT.