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For any of you who have traveled to Europe, or like me, watch the National Geographic Channel, you know that the Strait of Messina lies between Sicily and Calabria. In Greek Mythology, Homer wrote about Odysseus's dilemma as he tried to cross the strait.
You see, two mystical sea monsters, Scylla and Charybdis, were on opposite sides of the strait. Scylla was described as a six-headed sea monster on the Calabrian side who ate six sailors of any ship that came close.
Off the coast of Sicily, Charybdis was cursed by Zeus and transformed into a hideous monster with an uncontrollable thirst for the sea, causing whirlpools as she drank the water.
They posed an insurmountable threat to passing ships because avoiding Charybdis meant passing too close to Scylla and having six sailors eaten. Avoiding Scylla meant getting too close to the whirlpool and losing your entire boat.
Homer tells us that Odysseus chose to face Scylla.
Is Giving Your IRA to Charity the Only Choice? Caught Between Scylla and Charybdis
For investors with large IRAs, the SECURE Act, which went into effect in January of 2020, has resulted in an Odysseusian sized problem.
At one end of the strait is Scylla, the monster that forces your non-spousal heirs to pay income tax on your IRA no later than the end of the 10th year after you pass away. For a designated beneficiary, married and filing jointly, if the IRA results in a total of $628,300 or more of combined taxable income, they will be at a maximum 37% tax bracket.
That is a 37-headed monster with each head taking 1% of your IRA. If you live in a state with an income tax, it gets worse. For example, California has a 13.3% state income tax. That is a 50-headed monster picking off 1% of your IRA each. This 50% of your IRA eaten by Scylla can severely reduce your IRA assets and the resulting income left to the people you love.
You may steer clear of Scylla by using a charitable trust for your IRA beneficiaries. While it eliminates the tax and provides more income to your beneficiaries during their lifetime, you will confront Charybdis on the other side. The whirlpool will take your entire IRA as it goes to a charity after the beneficiary passes away, leaving nothing for grandchildren or others you would have liked to share the unused portion with.
There is a solution, and its key lies in the DTC IRA Replacement Trust® from Dunham Trust Company (DTC).
A Solution for the SECURE ACT Tax Robbing Some or All of Your IRA from Your Grandchildren
The DTC IRA Replacement Trust® intends to replace some or all of the assets lost to taxes. If a charitable trust is used, it replaces some or all of the assets given to charity when your IRA's beneficiary passes away.
The DTC IRA Replacement Trust® accomplishes this by utilizing an Irrevocable Life Insurance Trust (ILIT). When we use this type of trust, an insurance policy is purchased on the person we want to be insured, and the ILIT is both the owner and the beneficiary of the life insurance policy.
The benefit of properly structuring life insurance in this manner is that you create one of the most tax-efficient assets for your beneficiary, free of estate, income, and capital gains tax.
Let us explore this through two case studies.
Case Study 1: Pay the Tax
In this case study, we have an IRA owner who wants to leave her IRA to her child and maximize income. When her child passes away, she wants the unused portion of her IRA to go to her grandchild. She does not want any of her assets to go to a charity.
Step 1: Name the child the beneficiary of Mom's IRA.
Step 2: Work with a financial advisor to purchase life insurance on Mom's life.
Step 3: Mom's financial advisor works with DTC to establish the Irrevocable Life Insurance Trust through the DTC IRA Replacement Trust®.
Step 4: After consulting with her tax advisor, for large IRAs, Mom should consider the option of paying for the premiums using assets in her IRA. She examines this choice because the IRA assets may create unneeded income taxation through Required Minimum Distributions. These are the assets taxed at the high ordinary income tax for mom's beneficiary. In essence, she may be trading tax-toxic IRA assets for the assets that will reside in the replacement trust, which will be highly tax-efficient, free of estate, income, and capital gains tax.
Step 5: When Mom passes away, her daughter receives the IRA and pays the high-income tax for large IRAs. However, the DTC IRA Replacement Trust® will replace some or all of the assets lost to taxation, resulting in more assets and more income for the daughter.
Step 6: When the daughter passes away, the assets remaining from the IRA and the DTC IRA Replacement Trust® can be arranged to be distributed to the grandchild.
In this scenario, mom and her financial advisor chose to follow Odysseus's path and steer her ship close to Scylla. The multi-headed monster took a large chunk of mom's IRA, but these sailors were partially or fully replaced through the DTC IRA Replacement Trust®. Mom avoided the whirlpool of Charybdis that would have devoured her IRA when her daughter passed away, allowing her to leave assets for the next generation.
Case Study 2: Eliminate the Tax Through a DTC IRA Charitable Trust®
In this case study, we have an IRA owner who wants to leave his IRA to his child and wants to maximize his child's lifetime income by the elimination of the SECURE Act tax that the child will be required to pay at the end of the 10th year of Dad's death.
Using a charitable trust would maximize his child's income because if we eliminate the tax, we have more assets. With more assets, we can create more lifetime income. The IRA owner is charitably inclined and likes that the balance of the trust assets will pass as a gift to his Alma Mater after his child passes away. However, he is upset that his grandchildren do not receive any assets.
Step 1: Working with his financial advisor and DTC, Dad establishes a DTC IRA Charitable Trust®.
Step 2: Dad names the child as the income beneficiary of the charitable trust and his Alma Mater as the remainder beneficiary.
Step 3: Dad then names the charitable trust as the beneficiary of his IRA.
Step 4: Working with his financial advisor and DTC, Dad establishes a DTC IRA Replacement Trust®, placing the life insurance on the life of his son, and the grandchildren are named the beneficiaries of the replacement trust.
Step 5: When Dad passes away, the IRA's assets pass to the DTC IRA Charitable Trust®, eliminating the SECURE Act tax, providing more lifetime income to his son, and even giving Dad's estate a tax deduction.
Step 6: When the son passes away, the charitable trust's remaining assets are gifted to Dad's Alma Mater.
Step 7: At the same time, when the son passes away, the life insurance placed on the son's life is paid to the replacement trust, and the properly structured trust passes those assets to the grandchildren free of estate, income, or capital gains tax.
In this scenario, Dad and his financial advisor chose to steer his ship away from Scylla so the multi-headed monster could not take any of Dad's IRA. By navigating to the other end of the strait, the IRA was engulfed by Charybdis at his son's passing away. However, the assets that went to charity were partially or fully replaced through the DTC IRA Replacement Trust®, allowing Dad to leave assets for the next generation.
Planning for Multiple Generations
Your IRA is far too important an asset to have casual planning. A knowledgeable financial advisor can work with you on these types of issues and other planning items, like not disinheriting your child after a second marriage or placing guardrails for a child who will inherit a large IRA but is irresponsible with money or is affected by substance abuse challenges.
Your financial advisor, along with Dunham Trust Company, can help you navigate these treacherous straits.
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Disclosures:
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
Risk Associated with all three trusts in the DTC IRA Trust Trilogy®:
Current tax environments are subject to change at any time and no one can predict with certainty what Congress or the IRS may do.
Dunham Trust Company does not guarantee the investments in the DTC IRA Trust Trilogy® as investments are subject to risk and market fluctuation, including possible loss of principal. Dunham Trust Company does not guarantee that your investment objectives will be achieved.
Fees Associated with all three trusts in the DTC IRA Trust Trilogy®:
To maintain a DTC IRA Trust Trilogy® you may incur fees and expenses. Generally, there are no administrative fees associated with the DTC IRA Special Situations Trust® and DTC IRA Charitable Trust® until the IRA owner passes, at which point the trust administration fee schedule published at the time will apply.
However, the fees related to the DTC IRA Replacement Trust® will be subject to the published fee schedule at the time the trust is established.
Dunham & Associates Investment Counsel, Inc. is a Registered Investment Adviser and Broker/Dealer. Member FINRA / SIPC. Advisory services and securities offered through Dunham & Associates Investment Counsel, Inc. Trust services offered through Dunham Trust Company, an affiliated Nevada Trust Company.