Feel SECURE Joining a Pooled Trust

By Guest Author, Evelynn Passino, J.D. – Executive Director of Pooled Trust Services

Editor: Jason D. Lazarus, J.D., LL.M, MSCC, CSSC

Last year we told you about how the Tax Cuts and Jobs Act (TCJA) impacted trust taxation and how clients could use a structured settlement to mitigate the effects. On January 8, 2020, President Trump signed into law the Setting Every Community Up for Retirement Savings (SECURE) Act. This new law has received attention for the change it made regarding “stretch IRAs,” which we will review briefly for their impact on trusts and people with disabilities. Prior to the SECURE Act, the beneficiary of an inherited IRA or 401k could mitigate tax liability and potentially pass on some of the inherited funds by taking required minimum distributions (RMDs) over their own lifetime. The SECURE Act has limited the “stretch” option to spouses, people with disabilities, and those who are less than 10 years younger than the person who created the retirement account. Minor children also have this option but must withdraw all funds within 10 years of reaching adulthood. Everyone else must now withdraw all funds from the account within 10 years, which is likely to put them in a higher tax bracket.

The SECURE Act & Trusts

The SECURE act also made changes which impact trusts. As a quick review, trusts are generally taxed in the same way that individuals are taxed. Distributed income is taxed at the beneficiary’s tax rate and results in an income deduction for the trust. Accumulated income is taxed at the same rate as the trust. Injury victims with a resulting disability and public benefits, such as SSI or Medicaid, may find it necessary to place their funds in a Special Needs Trust (SNT) to protect benefit eligibility. Injury victims without needs-based benefits may wish to use a settlement management trust to preserve funds for the future. First-party trusts (those funded with the beneficiary’s own funds, like those from a settlement) are considered grantor trusts. All income and expenses of a grantor trust are attributable to the “grantor,” who is often the beneficiary. For this reason, an injury victim who has or is considering setting up a first-party trust must understand how the new tax laws impact taxation of their trust.

Trusts for People with Disabilities

A trust created for someone with a disability qualifies for the stretch option, but only if that person is the only beneficiary of the trust. If there are multiple beneficiaries, then all funds must be withdrawn from the retirement account within 10 years. In cases where a trust’s balance is dwindling, this may be a good thing for liquidity purposes. Alternatively, this may present a kind of Hobson’s choice. The beneficiary will either have the higher tax liability based on the higher balance, or they will have to spend the funds on permissible items as they come in.

Prior to the TCJA, the so-called “kiddie tax” provided that the income earned in a minor child’s trust was taxed at the parents’ tax rate. The TCJA changed that, taxing this income at the trust’s rate, effectively placing any trust earning over $12,500 per year in the highest tax bracket. As you can imagine, this had a significant impact on some beneficiaries, adding thousands of dollars to their tax bill or doubling the prior year’s tax bill in some cases.

The final section of the SECURE Act has reversed the TCJA’s rule, reinstating the rule that unearned income for minors is taxed at the parents’ rate going forward. Further, the change is retroactive to apply to the 2018 tax year. This means parents can file an amended return and seek a refund.

One section of the TCJA the SECURE Act has not modified was the part that eliminated certain available deductions. Prior to the TCJA, certain expenses associated with maintaining a trust were deductible from the trust’s income, reducing tax liability. Section 11045 of the TCJA made “miscellaneous itemized deductions” unavailable until 2025, which was somewhat unclear. This was later clarified in IRS Notice 2018-61, which differentiated between expenses incurred only when a trust was created versus expenses which would have been incurred regardless. For example, investment management fees would be incurred whether the funds were in a trust or a bank account, so those fees became non-deductible after the TCJA and remain so after the SECURE Act.

Pooled Trusts & Structured Settlements

There appears to be no special treatment of pooled trusts versus standalone special needs trusts under the SECURE Act; however, it remains a good option for mitigating or reducing the cost of creating and maintaining a trust. In addition to the cost of investment management and administration being lower than a standalone trust, pooled trusts provide K1s or grantor letters for the trust beneficiaries to use in their own tax filings, which pooled trusts can do inexpensively by taking advantage of volume discounts. Finally, the option to fund a pooled trust with a structured settlement remains a good strategy for mitigating tax liability. While the proceeds of a personal injury settlement are tax-free, the income produced by the trust is not. If a trust is funded with seed cash and future periodic payments from a structured settlement, the result is a lower tax burden and as an added bonus, lower overall trustee fees.  Pooled Trust Services offers a variety of pooled trust options designed especially for injury victims. Whether your client has public benefits they need to preserve or just needs help making sure their settlement lasts, we are here to help.