The Power of Beneficiary Deemed Owner Trusts for Retirement Assets

If you have a large retirement asset that you intend to pass to your beneficiaries in trust, consider updating your estate plan to include Beneficiary Deemed Owner Trusts (BDOT) provisions.

In the wake of the SECURE Act, BDOTs offer significant tax advantages for trusts holding income-producing retirement assets, helping to mitigate the impact of the Act’s accelerated distribution requirements. This article explores how BDOTs can optimize tax savings and asset protection for retirement assets held in irrevocable trusts.

In this article, we will discuss:

What is a Trust?

A trust is a fiduciary relationship where one party, called a trustee, holds assets for one or more beneficiaries. Instead of distributing property outright, the trust’s creator (the grantor) can appoint a trustee to manage assets for the beneficiary.

Trusts can be revocable or irrevocable.

• Revocable trusts: These are trusts that grantors often create for their own benefit. Because the grantor retains broad control over the trust assets, all the assets in a revocable trust remain part of the grantor’s estate and accessible to creditors.
• Irrevocable trusts: In contrast, irrevocable trusts can provide significant asset protection for the beneficiaries of the trust. Once a grantor transfers assets into an irrevocable trust, the trust itself, not the grantor, owns those assets. This effectively shields them from both the grantor’s and beneficiaries’ creditors. Although a beneficiary’s creditors can reach assets that the trustee distributes to the beneficiary, spendthrift clauses protects assets that remain in the trust from the beneficiary’s creditors.

Tax Considerations for Trusts

Revocable trusts are transparent entities for income tax purposes. Because makers of revocable trusts retain significant power to revoke and amend the trust, they report all income generated by the trusts’ assets on their personal tax return.

Irrevocable trusts can be designed so that the IRS treats the grantor as the owner of the trust’s assets for income tax purposes. This arrangement means the grantor reports any tax liability, not the trust, which allows the trust assets to grow without direct income tax liabilities. After the grantor’s death, the income generated by the trust is taxed either at the trust level if the income is retained in trust, or the beneficiary level if the income is distributed to the beneficiary.

Trust Tax Rates

Irrevocable trusts face compressed income tax rates. They reach the highest income tax rates at much lower levels of income compared to individuals.

For the 2024 tax year, for instance, the highest income tax rate (37%) applies to trusts with income over $15,200. In contrast, individuals do not pay that rate until their income exceeds $600,000. As a result, irrevocable trusts holding income-generating assets can quickly find themselves in the highest tax bracket with a relatively modest amount of taxable income.

Impact of the SECURE Act on Trusts as Named as Beneficiaries of Retirement Accounts

The Setting Every Community Up for Retirement Enhancement (SECURE) Act, enacted in December 2019, introduced significant changes to the rules governing retirement assets. One major change was the modification of the required minimum distribution (RMD) rules.

Before the SECURE Act, designated beneficiaries of retirement plans, including trusts, could stretch the distributions from an inherited retirement account over the beneficiaries’ lifetimes. This allowed for more tax-deferred growth and the potential to minimize income tax liabilities by spreading out the taxable distributions.

Under the SECURE Act, most non-spouse beneficiaries must withdraw the entire balance of an inherited retirement account within ten years of the account holder’s death. This accelerated distribution schedule poses a problem for trusts that hold retirement assets. Since most beneficiaries must deplete the retirement asset within ten years, trustees of trusts that hold retirement assets face with a dilemma. They must either distribute the income to beneficiaries to leverage their typically lower tax brackets, which depletes the trust and removes asset protection, or retain the income in the trust and incur higher tax rate.

The Benefits of a Beneficiary Deemed Owner Trusts

A BDOT gives a beneficiary the power to withdraw all of the trust’s taxable income annually, including accounting income, distributable net income, and capital gains. 

Under Internal Revenue Code Section 678, if a beneficiary has the power to withdraw all taxable income, they are treated as the owner of the portion of the trust from which they can withdraw the income for income tax purposes. This means the beneficiary reports the taxable income on the beneficiary’s personal tax return rather than the trust’s return.

Giving the beneficiary the power to withdraw all taxable income shifts the income tax burden to the beneficiaries without requiring actual distributions that deplete the trust. Beneficiaries can withdraw the necessary amount to cover the additional income tax liability, while most of the distribution remains in the protective trust.

Risks of Granting a Trust Beneficiary a Right of Withdrawal

BDOTs provide tax advantages by shifting income out of compressed trust rates. However giving the trust beneficiary the right to withdraw all taxable income from the trust also carries some risks:

1. Potential gift tax consequences: There could be gift tax consequences if the withdrawal right lapses or the beneficiary releases it. To mitigate this, the trust can grant the beneficiary a “hanging” withdrawal right that carries over year-to-year, or a springing withdrawal right for the prior year’s taxable income not withdrawn.
2. Estate tax inclusion risk: If the beneficiary dies while holding the withdrawal right over the undistributed taxable income, all funds subject to the right of withdrawal will be included in the beneficiary’s taxable estate. This can be mitigated by limiting the duration of the withdrawal right period.
3. Asset protection concerns: In some jurisdictions, undistributed taxable income subject to the withdrawal right may be accessible to the beneficiary’s creditors.

Conclusion

BDOTs represent a powerful estate planning tool, particularly for those with significant income-producing or retirement assets. By leveraging IRC Section 678, BDOTs offer a strategic approach to wealth transfer, combining tax efficiency with asset protection and control.

You can read more about this strategy by clicking on the following link: Using BDOTs for Optimal Asset Protection and Income Tax Minimization After Passage of the Secure Act.

If you’d like to discuss how BDOT provisions could help you achieve your estate planning goals, schedule your free consultation now and take the first step in maximizing your family’s legacy.