Inherited IRA to an accumulation trust for benefit of children (now minors) – when does the high trust tax rates kick in?
With a potential $1M balance in retirement accounts, and having minor children currently, I am understanding that accumulation trusts set up as beneficiaries to receive inherited IRAs may be a potential option for passing to minor children in a worst case scenario when both parents pass early. My question is WHEN does the high 37% trust tax rate kick in for calculation purposes, in scenario 1 or scenario 2 below, or some other scenario I am missing?
Scenario 1: Two minor children inherit a $1M balance, per Secure Act 10-year Rule, account needs to be emptied in 10 years (I’m leaning towards yearly withdrawals). For Year 1, 1/10 of IRA is withdrawn at child’s personal tax rate and these after-tax funds are placed into accumulation trust. For Year 2, 1/9 of IRA withdrawn in same manner netting after-tax funds, rinse and repeat every year until emptied at Year 10. All yearly earnings on after-tax funds are taxed at 37% since they are accumulated in the trust.
Scenario 2: Two minor children inherit a $1M balance, per Secure Act 10-year Rule, account needs to be emptied in 10 years (I’m leaning towards yearly withdrawals). For Year 1, 1/10 of IRA is withdrawn at the trust tax rate of 37% and these after-tax funds are placed into accumulation trust. For Year 2, 1/9 of IRA withdrawn in same manner, rinse and repeat every year until emptied at Year 10. All yearly earnings on after-tax funds are taxed at 37% since they are accumulated in the trust.
Permalink Submitted by Norman Cook on Tue, 2022-04-19 00:10
Let me see if I understand the different scenarios. Scenario one the beneficiaries as listed on the beneficiary form are the 2 Children? The children’s Guardian will then deposit the money (tax free) into a standalone trust for the future benefit of the children. Note: the minor children could withdraw the funds over their lifetime or until they reach 18 years of age when the 10 year rule would kick in. In scenario 2 the beneficiary as is listed on the beneficiary form is a IRA trust? The trust then will distribute funds to the children per the terms of the trust. Funds distributed to the children will be a tax deduction to the trust and tax to the children on a K-1. Am I correct? Only income that remains in the trust is tax at the higher rate 37%. Capital gains that remain in the trust are tax at the 20% rate. Any distribution of income or capital gains that are distributed from the trust to the children is a deduction to the trust and are taxed at the children rate when reported on a K-1.
Permalink Submitted by Hiten Patel on Tue, 2022-04-19 04:00
My apologies, my original question was for my children being beneficiaries by naming an IRA trust on the beneficiary form in both Scenario 1 or 2, the only difference being how yearly IRA withdrawals were taxed (as I didn’t know), are they taxed at the Child’s tax rate (Scenario 1) or at the Trust’s tax rate of 37% (Scenario 2). From your explanation for Scenario 2 above, it appears that children named on a beneficiary form in an IRA trust are taxed at the 37% trust tax rate, but if funds are distributed to the children in the same year, then there is a tax deduction and children receive the favorable/lower individual tax rates via a K-1 form. I assume this is only for an accumulation trust that passes through the income directly to the children from the trust in the same year. If however the accumulation trust instead accumulates those assets (without passing income through), then I assume the children will be forced to use the higher trust tax rate of 37%. Thanks for capital gains explanation, I assumed everything was taxed at 37% inside the trust, but it sounds like cap gains get taxed at the lower 20% rate instead. As for your first explanation of Scenario 1, it sounds like that is what would happen if I would instead name the children as outright beneficiaries on the designation form (instead of naming an IRA trust on the form). In your explanation, when the children’s Guardian employes the “standalone trust” is that an accumulation trust that can enjoy a longer duration, or is that a conduit type that has an end date after the 10 year rule ends (age 28 for the child)? I was hoping for a longer duration of asset/creditor/spousal protection. As a result, naming my children as outright beneficiaries wasn’t on my radar.
Permalink Submitted by Norman Cook on Tue, 2022-04-19 14:10
Each year the trust will file an income tax form 1041 that reports all of its income and capital gains. As a part of this 1041 form it reports a deduction for all funds paid to the children on a K-1. Any funds remaining in the trust after the deduction for distributions to the children is tax at the trust rate. Each year the children will file a standard income tax form 1040 and report the income that is reported on the K-1 and pay the taxes at the child’s rate.
Permalink Submitted by William Tuttle on Tue, 2022-04-19 17:54
Any inherited traditional IRA distributions are subject to ordinary income tax rates
Any distributions to dependents < age 19 (< age 24 if a college student) are subject to the Kiddie Tax.
Unearned income > Kiddie Tax limit (2022 = $2300) will be taxed at the parent’s marginal ordinary income tax rate.
If that is > 24%, distributions > the Kiddie Tax limit and < the top of the trust 24% bracket. It would be better for the trust to retain the distributions.
You need a knowledgeable trustee and/or a knowledgeable account to maxmimize tax efficient distributions.