10 Dec How does the inheritance tax work when there is a trust?

Q. I’m wondering what happens when the heir of an estate is a trust rather than an individual. Many parents with a disabled descendant would not leave their money to the individual but instead use a special needs trust for that person’s benefit. Is the trust subject to the inheritance tax? Also, the new rules for inherited IRAs require a 10-year payout unless the beneficiary is disabled. How is the trust treated here?
— Wondering

A. We’re going to explain how this works, but because the issues here are complicated, make sure you meet with a financial or legal professional who can help review all the correct planning for someone with a disability.

First, you mentioned the inheritance tax.

The inheritance tax is applied on New Jersey residents and New Jersey property owners, said Andrew Novick, a certified financial planner and estate planning attorney with The Investment Connection and Brookner Law Offices in Bridgewater.

The tax rate depends on the inheritor’s relationship to the deceased, he said.

There are four categories.

Class A includes a spouse, domestic partner, or civil union partner, parent or grandparent, child, stepchild, or grandchild.

Class C is made up of a brother or sister, spouse or civil union partner of the deceased person’s child, surviving spouse or civil union partner of the deceased person’s child

Class D includes everyone else, except for most charities and non-profits, which are considered Class E beneficiaries.

Novick said Classes A and E are exempt from the inheritance tax.

“The first $25,000 of property inherited by a Class C beneficiary is exempt, but additional amounts are taxed at 11 to 16% depending on the transferred amount,” he said. “Class D beneficiaries pay 15 to 16% depending on the transferred amount.”

There is no longer a Class B category.

When assets are transferred into a trust at death — including a special needs trust — the inheritance tax is based on the relationship between the grantor and the trust beneficiaries, Novick said.

This includes the initial trust beneficiary as well as all potential future trust beneficiaries, he said.

“Since it is not known at the time of death how much, if anything, each potential future trust beneficiary may receive, the New Jersey Division of Taxation will take an educated guess, and then will offer to compromise on the inheritance tax,” Novick said.

He said where a Class C or D beneficiary is likely to receive significant assets in the near future, the compromise tax will be high. But where the probability of a Class C or D beneficiary receiving significant assets from the trust is low and/or many years in the future, the compromise tax will be small or even zero, Novick said.

The process is laid out in a detailed, 73-page document here. 

The second part of your question involves the ability to “stretch” inherited IRA accounts after the SECURE Act.

The short answer is that it is possible to take advantage of the “stretch” rules for a special needs trust, Novick said.

He said the act allows Eligible Designated Beneficiaries (EDBs) to calculate required minimum distributions out of an inherited IRA annually based on the beneficiary’s life expectancy, which is the “stretch.”

“EDBs include a spouse, disabled or chronically ill person, a beneficiary not more than 10 years younger than the deceased, and a minor child until the age of majority,” he said. “Most other beneficiaries must distribute the entire inherited IRA over a 10-year period while a few types of beneficiaries have only five years.”

Whether a trust-owned inherited IRA can be stretched generally depends on whether the trust is structured as a “conduit trust” or an “accumulation trust.”

In a conduit trust, all inherited IRA distributions are automatically distributed out of the trust and paid to the beneficiary, Novick said.

“For this kind of trust, inherited IRA distributions can be stretched so long as the beneficiary is an EBD,” he said. “However, the automatic payments can impair a disabled beneficiary’s eligibility for means-tested programs, such as SSI, SSDI, and Medicaid.”

To get around this problem, a special needs trust should be an accumulation trust, which allows the inherited IRA distributions to be accumulated in the trust, i.e. they are not automatically distributed out to the beneficiary – they simply get added to other trust assets and can be distributed to the beneficiary if appropriate pursuant to the trust’s provisions, he said.*

“In most instances, stretch rules cannot be applied to an accumulation trust and inherited IRAs need to be distributed over a 10-year period,” he said. “However, the SECURE Act contains an exception that allows an accumulation trust to qualify for the `stretch’ if it is for the benefit of a disabled beneficiary and certain other criteria are satisfied.

* This story has been corrected to indicate exceptions for accumulation trusts. 

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This story was originally published on Dec. 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.