Life and Death Planning for Retirement Benefits

In effect, the CRT “remembers” what types of income it has received. Then, when the CRT makes a distribution to the human beneficiary, the distribution is deemed to come out of one of these tiers, and the federal income tax character of the amount is revived. If the distribution to the human beneficiary is deemed to come out of the ordinary income tier, the beneficiary will have to include that distribution in his gross income as ordinary income. Distributions to the human beneficiary are generally assigned to tiers on a “worst -first” basis, so (for example) the human beneficiary cannot receive any capital gain income from the CRT until the CRT has distributed everything it held in its ordinary income tier. Some people mistakenly believe that, if they leave a retirement plan to a CRT, the CRT could take a distribution of the entire plan tax-free (correct so far), reinvest the proceeds in municipal bonds (that’s ok too), and then pay the tax-exempt municipal bond interest annually to the human beneficiary. This maneuver does not work, because the retirement plan distribution to the CRT (to the extent it is ordinary income) all goes into the “ordinary income” tier. Most retirement plan distributions are ordinary income. Even if the trustee did invest the proceeds in municipal bonds, no distribution to the human beneficiary would be treated as coming from the tax-exempt bond interest “tier” until the ordinary income “tier” had been used up. So, although the CRT pays no income tax when it receives a distribution from a retirement plan, the beneficiary of the CRT will have to pay income tax on the distributions from the CRT, to the extent those are deemed to represent the CRT’s regurgitation of the retirement plan benefit (or other taxable income) under the tier system. The 3.8 percent additional tax on “net investment income” ( § 1411 ; see ¶ 7.4.01 ) further complicates life for CRTs and their beneficiaries. Beginning in 2013, the tax-exempt CRT must keep track of an additional category of income, “net investment income” (NII). NII includes interest (other than municipal bond interest), dividends, and capital gains, but does not include retirement plan distributions. Thus the CRT must keep track of a new category of ordinary income, namely taxable retirement plan distributions, as distinguished from investment -income-type ordinary income like interest and dividends. Here’s the real new headache: Post-2012 investment income received by the CRT is NII (subject to the NIIT, if and when distributed to the beneficiary), whereas pre-2013 investment income is not subject to NIIT. Reg. § 1.1411-3(d) explains how a CRT’s NII and excluded income are apportioned with respect to any distribution from the CRT. This section is too complicated for me to read. C. CRTs and the IRD deduction. Generally, when the beneficiary of a retirement plan receives a distribution from the plan, he must include it in his gross income as income in respect of a decedent (IRD), but he is entitled to an income tax deduction for the federal estate taxes that were paid on those benefits. § 691(c) ; see ¶ 4.6.04 . If retirement benefits are paid to a Charitable Remainder Trust, that deduction for practical purposes disappears—nobody gets to use it. There is no mechanism by which a CRT can pass out the IRD deduction to the CRT’s human beneficiaries. The § 691(c) deduction reduces the taxable income of the CRT (i.e., income assigned to the trust’s “first tier”) in the year the distribution is received from the plan. Reg. § 1.664-1(d)(2) . Distributions to the individual beneficiary would be deemed to come out of the “net taxable income” of the CRT (first tier) until it had all been used up. The income of the CRT that was sheltered by the 691(c) deduction would become “principal” that could eventually be distributed