Understanding the 10-Year Rule and Conduit vs. Accumulation Trusts in Estate Planning

https://youtu.be/UTbXwNjJ0VoEstate planning is all about making sure your wealth is protected and distributed according to your wishes. While many people focus on wills and real estate, it’s crucial to also pay attention to your retirement accounts. Recent changes to how retirement accounts are inherited have made it more complicated than ever. One key area that’s often misunderstood is the difference between conduit trusts and accumulation trusts, and how they interact with the 10-year rule introduced by the SECURE Act of 2019.

What is the 10-Year Rule?

Before the SECURE Act, non-spouse beneficiaries of inherited retirement accounts could “stretch” the required minimum distributions (RMDs) over their lifetimes. This allowed funds to grow tax-deferred for many years. Now, however, most beneficiaries are required to follow the 10-year rule. This rule states that an inherited IRA or 401(k) must be emptied by the end of the 10th year following the original account owner’s death.
Here’s how it works in practice: Say you inherit a $300,000 IRA. Under the 10-year rule, you have 10 years to withdraw all the funds from the account. The big difference here is that there are no annual RMDs required during years 1-9. You could take out small amounts each year, or you could wait and withdraw the entire balance in year 10. But keep in mind, taking a lump sum at the end could push you into a higher tax bracket, significantly increasing your tax burden.
There are exceptions to this rule for certain beneficiaries, such as surviving spouses, minor children, disabled individuals, and those who are less than 10 years younger than the account holder. These individuals may still be able to stretch distributions over their lifetimes.

Conduit Trusts: Simple but Less Control

Conduit trusts, sometimes called “pass-through” trusts, are relatively straightforward. The trust is named as the beneficiary of the retirement account, and when the trust receives RMDs or other withdrawals, they must be distributed immediately to the beneficiary. The trustee has no discretion here—the money passes directly to the beneficiary.This kind of
trust is useful when you want to ensure that your beneficiary gets direct access to the funds. For example, if you want your child to receive retirement funds every year, a conduit trust guarantees that they will receive those distributions without any delays or obstacles.
However, there are significant downsides. First, after the SECURE Act, the 10-year rule means that the entire retirement account must be distributed by year 10. For some beneficiaries, like those who aren’t great with money or are vulnerable to creditors, this can pose a real risk. Once the funds are in their hands, they are no longer protected by the trust.
Accumulation Trusts: Control with Potential Tax Drawbacks
In contrast, accumulation trusts offer much more flexibility and control. With an accumulation trust, the trustee is not required to distribute the funds immediately. Instead, the trustee can hold onto the funds within the trust and distribute them at their discretion. This is a great option if you want to protect the assets from being spent too quickly or if your beneficiary has creditor issues, struggles with financial management, or is going through a divorce.
The key benefit here is that the trust can accumulate assets, allowing the trustee to make distributions based on the beneficiary’s needs. This is especially useful in protecting assets from outside risks like creditors or lawsuits.
But, like everything, there’s a trade-off. When funds are retained in the trust, they are subject to trust income tax rates, which are typically higher than individual rates. For example, in 2023, trusts hit the highest income tax bracket (37%) on income above $14,450, while individuals don’t reach that rate until they have income over $578,125. So, if you retain significant income within the trust, you could end up paying a lot more in taxes.

Which Trust is Right for You?

Choosing between a conduit trust and an accumulation trust depends on your specific estate planning goals and your beneficiary’s situation. Here are a few key points to consider:

  1. Do you want to control how and when your beneficiary receives the funds? If you’re worried about your beneficiary spending the money too quickly or facing financial trouble, an accumulation trust may be a better fit.
  2. Are taxes a major concern? If minimizing taxes is a top priority, a conduit trust could be the way to go, as the distributions are taxed at the beneficiary’s lower income tax rate.
  3. Is your beneficiary vulnerable to creditors? An accumulation trust offers better protection, as the funds are kept within the trust and aren’t immediately accessible to creditors.
  4. Are you comfortable with the 10-year rule? Both conduit and accumulation trusts must follow the 10-year rule for most non-spouse beneficiaries, but accumulation trusts offer more flexibility in managing when and how distributions are made.

Conclusion

The SECURE Act has reshaped the landscape for retirement account inheritance, making it more important than ever to carefully plan how these assets will be passed on. Whether you choose a conduit trust or an accumulation trust will depend on your goals, your beneficiary’s needs, and the potential tax consequences. Always work with a qualified estate planning attorney who understands these complexities and can tailor a plan to meet your needs. If you’d like to discuss conduit trusts and accumulation trusts with me, please contact my office. I offer a free consultation and would love to talk.

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