Are trust distributions really taxed at 37%?

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Q. A trust is a beneficiary of a deceased IRA owner who died in December 2019. The trust’s beneficiaries are one minor child, one adult and one charity. I was told the IRA funds can’t be passed through to the individuals because the charity was also a beneficiary. I was told all distributions become taxable to the individual and if left in the trust, the taxable percentage will be higher, at 37%. Also, the funds can’t be distributed to the minor beneficiary until age 25. How does this all work?
— It’s complicated

A. There is a ton to unpack here. Trusts can be very complex, and when you throw taxation of trusts into the mix, and a retirement account on top of that, you must navigate a complicated web of rules and laws.

Let’s start at the very beginning.

If an IRA account owner died before Jan. 1, 2020, then a non-spouse individual beneficiary would have had the option to open an inherited IRA account to which the original IRA would be transferred, said Adam L. Sandler, an attorney with Einhorn. Barbarito, Frost & Botwinick in Denville.

He said the beneficiary could stretch out the Required Minimum Distributions over his or her life expectancy, known as the “Stretch IRA.”

However, if the account owner dies on or after Jan. 1, 2020, different results apply.

“The SECURE Act eliminated the Stretch IRA for deaths occurring on or after Jan. 1, 2020, in which case, a non-spouse individual beneficiary would have to withdraw the entire inherited IRA by Dec. 31 after the tenth anniversary of the account owner’s death — known as the `10-year rule,’” Sandler said.

Of course, exceptions do apply for certain individuals.

If a non-individual person such as an estate, trust or charity is named the beneficiary of an IRA, then the IRA must be fully withdrawn by Dec. 31 after the fifth anniversary of the account owner’s death, Sandler said. This is known as the “5-year rule.”

The SECURE Act did not change the 5-year rule, he said.

Certain trusts, however, may escape the 5-Year Rule, he said.

If a trust qualifies as a `see-through trust,’ then the Stretch IRA or 10-year rule could apply, he said.

“The 30,000-foot view is that in order to qualify as a `see-through trust,’ there must be no possibility that the IRA withdrawals can be distributed to a non-individual beneficiary,” Sandler said. “Therefore, if a charity is a current or remainder beneficiary of a trust, then that trust would likely fail the `see-through trust’ requirements and the 5-year rule would apply.”

Sandler said the fact that a charity is a beneficiary of a trust does not on its own prohibit distributions to the individual beneficiaries. It ultimately depends on the terms of the trust.

He offered this example: Assume that Mary has a revocable living trust (the “Mary Trust”) and the terms of the Mary Trust state that upon Mary’s death, the trust is to be divided equally among Alice, Bob and Charity XYZ. Bob’s share is directed to be held in trust until he is 25 (the “Bob Trust”). Mary then designates the Mary Trust as the beneficiary of her IRA. At Mary’s death in 2019, the trustee of the Mary Trust could simply liquidate the IRA and distribute the proceeds in accordance with the terms of the trust.

Sanders also offered this alternative to liquidating the IRA. He said the trustee could establish a single inherited IRA in the name of the Mary Trust, divide it into three separate accounts and distribute one to each of Alice, the Bob Trust and Charity XYZ.

“Unfortunately, the 5-year rule would apply to each separate inherited IRA because Charity XYZ is a current beneficiary of the Mary Trust and receives a share of the original IRA,” he said. “Had Mary designated Alice, the Bob Trust and Charity XYZ as the direct beneficiaries of her IRA rather than Mary Trust, then the Stretch IRA — for a pre-2020 death — would have been an option as long as the original account is divided into separate accounts by Sept. 30 of the year following Mary’s death.”

As you can see, the rules are different if the division is directed to occur at the beneficiary designation level rather than at the trust level.

Now let’s assume the Bob Trust now has its own inherited IRA. While the trust may very well prohibit distributions to Bob if he is under the age of 25, it is certainly not a common approach to drafting trusts. A more “traditional” trust for the benefit of minors and young adults gives the trustee discretion to make distributions to the beneficiary while he or she is under a specified age, which is sometimes limited to distributions for specific reasons like the beneficiary’s health, education, maintenance and/or support, Sandler said.

“Upon turning the specified age, the trust terminates and the remainder of the trust fund is distributed to the beneficiary,” he said. “If that is indeed the case here, the trustee would be able to withdraw from the IRA and make a distribution to Bob while he is under 25.”

Of course, the trust document must be carefully reviewed to determine the trustee’s ability to make such distributions.

Now let’s cover the taxes.

Although certain exceptions do apply, income distributed to a trust beneficiary in the same tax-year that it was earned may carry out “distributable net income” or “DNI,” Sandler said.

“This means that the beneficiary will receive a Schedule K-1 from the trust and would be responsible for reporting such DNI on his or her personal tax return and paying any tax due,” he said. “The trust receives a corresponding DNI deduction so the same income is not taxed twice.”

Generally, Sanders said, the trust must report undistributed income on its own tax return and pay any tax due, but certain exceptions do apply for different types of trusts.

So if income stays in the trust, it is taxed at the trust level, Sandler said, which under current law is the top rate of 37% on income in excess of $12,950.

On the other hand, individuals are taxed at the top rate on income in excess of $518,400, Sandler said.

“Therefore, it may be likely that there would be a lower tax bill if income is distributed to a beneficiary rather than being held and accumulated in the trust,” he said.

Sandler said it’s important to note that the term “income” can actually have different meanings depending on the context in which it is used. Not all income is created equal and certain types do not qualify as DNI, he said. But in the case you presented, the distribution of IRA withdrawals typically qualifies as DNI.

Let’s go back to the Mary Trust example.

Let’s assume the trustee of the Mary Trust liquidates the original IRA and distributes the proceeds in accordance with the terms of the trust, Sandler said.

“The Mary Trust would get a charitable deduction for the one-third share distributed to Charity XYZ. Alice’s one-third share would carry out DNI and be reported on her individual tax return. Bob’s one-third share would also carry out DNI and be reported on the Bob Trust’s tax return,” he said. “To the extent that the Bob Trust makes a distribution to Bob, such distribution would carry out DNI and be reported on his individual tax return with the Bob Trust receiving a corresponding DNI deduction.”

Now let’s assume that the trustee of the Mary Trust was able to establish three separate inherited IRAs for each of Alice, Bob and Charity XYZ. The trustee could distribute the inherited IRAs themselves to the beneficiaries, Sandler said. Then it would be up to Alice and the Bob Trust to withdraw their respective inherited IRA accounts pursuant to the applicable rules. It would make no difference if the trustee liquidated the charity’s share because the Mary Trust would get a charitable deduction for the amount of income distributed to the charity and the charity does not pay income tax, Sandler said.

“There are many open questions here, specifically what the trust actually says and how the trustee acted,” Sandler said. “I would suggest consulting with an attorney who also specializes in trusts and estates and tax law. He or she can review the trust document and the trustee’s actions in order to provide you with more concrete answers applicable to your situation.”

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This story was originally published on Nov. 10, 2020.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.