Overview

For many years, the name of the game in retirement planning for income and estate tax purposes has been to maximize the tax deferral of qualified retirement and IRA accounts while preserving the ability to payout distributions over the longest period of time possible, i.e. the so-called Stretch IRA. Truth be told, the majority of wealthy taxpayers do not need and never did need these deferred compensation assets in order to maintain their lifestyle. The Stretch IRA was highly effective to say the least! Congress over the years has imposed a combination of income and estate taxes at death upon the death of the participant to minimize the benefit of tax deferral over multiple generations.

Finally, Congress delivered the knockout punch in the recently passed the SECURE Act. Most high net worth taxpayers, IRA accounts need to be paid out within ten years of the participant’s death with some exceptions applying. Most taxpayers given the opportunity would defer retirement plans until the end of time plus ten years.

Many indications point the taxpayer towards a conversion from a traditional IRA to a Roth IRA. However, the conversion does not come without some “bite” due to taxation on the lump sum distribution or alternatively, conversion over several years.

This article focuses on the ability to use a customized pooled income fund (“PIF”) as an alternative to the Roth conversion or alternatively charitable remainder trust. Why the PIF? This article focuses on the unique attributes of the PIF including the income deduction for the contribution which tends to be tw0-three times greater than the charitable remainder trust (“CRT”) which is an important consideration in our fact pattern.

Life After the SECURE Act

Under the SECURE Act, all retirement and IRA benefits will be required to be distributed within ten years of the participant’s death. The law allows for one exception for payments for Eligible Designated Beneficiaries – 1) The participant’s surviving spouse; 2) Persons with disabilities and chronic illnesses; 3) Minor children. Unfortunately, most trusts will fail to satisfy the requirements for minor children and disabled beneficiaries. Under the Act, the age to begin required minimum distributions is increased to Age 72. Unfortunately, the proposed changes also adversely impacts Roth IRAs. Benefits left to a non-spousal beneficiaries will be subject to the ten year payout requirement. If the beneficiary defers the income during that ten year period, all of the benefits become taxable at the end of the ten year period.

My 600 lbs. IRA

I admit that I am as equally perplexed as the next person as to how an IRA grows to $50 million or $100 million (Mitt Romney). I have heard of self-directed IRAs as high as $600 million. My theory is that it is not the magic of compound interest or disciplined monthly investment through dollar cost averaging, but rather a private equity investment that benefits from an initial public offering. If you move in the same circles as Richie Rich, you get presented many investment opportunities that don’t extend to the average investor.

Since most high net worth investors do not and never will need the money in their IRA account to live on, these IRA funds are “throw away” money to some extent. These funds get used to invest in start-up and private equity deals that high net worth investors do not need now or most likely in the future. On occasion these investments pay off. In some cases, it is more than once. When this occurs, the high net worth investor has a unique problem. The “throw away” money suddenly takes on new importance and represents a significant portion of the taxpayer’s net worth. However, these funds are like quicksand. The taxpayer cannot get out without the loss of most of the tax deferred income. On the one hand, the gains and reinvestment are tax deferred. However, the tax deferred gains on subject to income and estate taxation, a so-called double whammy (a tax term). The combination of these taxes can amount to 75-80 percent of the IRA account. The “stretch” in the Stretch IRA just lost its elasticity.

Example 1

Richie Rich, age 65, and a California resident, has a self-directed IRA worth $10 million. It used to be an ordinary self-directed IRA with $100,000 until Richie invested in the pre-IPO shares of Acme, Inc. which discovered the hunting trap for roadrunners. Richie invested $100,000 in these shares which subsequently went through an initial public offering. The shares rose to $10 million when Richie sold the shares within the IRA without gain. He has a taxable estate of $40 million. He is recently divorced and has three adult children. In the event of Richie’s death, he is facing the following tax erosion to his self-directed IRA without any planning:

Planning Impact of a Roth Conversion

Richie Rich as the name implies is wealthy. He is currently in the highest marginal tax bracket in California and expects to remain in the highest federal and states marginal brackets moving forward. The conversion to the Roth offers a number of important benefits despite income taxation on the lump sum distribution from his self-directed IRA. For starters, the Roth IRA is not subject to require minimum distributions ate age 72. Distributions from the Roth IRA receive tax-free treatment providing distributions are made after age 59 ½ and the taxpayer has owned the Roth IRA for at least five years. Investment earnings within the Roth IRA receive tax deferred treatment. The Roth IRA is included in the taxpayer’s estate. If the Roth beneficiaries are not the taxpayer’s spouse, required minimum distributions must begin in the year following the taxpayer’s death.

Example 2

Richie Rich receives a tax-free distribution from his traditional IRA and pays the taxes on the distribution from an existing taxable investment account. The combined federal and California income taxes are $4.8 million. The pre-tax growth investment return assumption is 10 percent. The after-tax investment return assumption is 6 percent. Richie has a combined marginal tax rate of 48 percent. The Roth account is included in Richie’s taxable estate.

What is a Pooled Income Fund (PIF)?

Historically, pooled income funds have been the poor man’s version of the charitable remainder trust. Pooled income funds were regularly sponsored by larger public charities and have largely been wound down in recent years and eliminated as the charitable remainder trust proliferated in popularity. The Pooled Income Fund (PIF) that we are discussing is a customized version for the high net worth taxpayer and his family.

The magic of the customized PIF lies in the method used to calculate the value of the remainder interest which passes to a public charity at the death of the taxpayer and any additional income beneficiaries. If a pooled income fund has existed for less than three taxable years, the charity is able to use an interest rate in calculating the charitable deduction by first calculating the average annual Applicable Federal Midterm Rate (as described in IRC §75200 for each of the three taxable years preceding the year of the transfer. The highest annual rate is then reduced by one percent to produce the applicable rate. That rate has risen over the last several years to 2.2 percent for 2020 tax year.

A pooled income fund is a trust that is established and maintained by a public charity. The remainder interest of the PIF may be the taxpayer’s donor advised fund. The pooled income fund receives contributions from individual donors that are commingled for investment purposes within the fund. Each donor is assigned "units of participation" in the fund that are based on the relationship of their contribution to the overall value of the fund at the time of contribution.

Each year, the fund's entire net investment income is distributed to fund participants according to their units of participation. Income distributions are made to each participant for their lifetime, after which the portion of the fund assets attributable to the participant is severed from the fund and used by the charity for its charitable purposes. A pooled income fund could, therefore, also be described as a charitable remainder mutual fund.

Contributions to pooled income funds qualify for charitable income, gift, and estate tax deduction purposes. The donor's deduction is based on the discounted present value of the remainder interest. Donors can also avoid recognition of capital gain on the transfer of appreciated property to the fund.

IRC §642(c)(5) defines a pooled income fund as a trust:

1. to which each donor transfers property, contributing an irrevocable remainder interest in such property to or for the use of a public charity while retaining an income interest for the life of one or more beneficiaries (living at the time of the transfer,
2. in which the property transferred by each donor is commingled with property transferred by other donors who have made or make similar transfers,
3. which cannot have investments in securities which are exempt from taxes imposed by this subtitle,
4. which is maintained by the public charity to which the remainder interest is contributed and of which no donor or beneficiary of an income interest is a trustee, and
5. from which each beneficiary of an income interest receives income, for each year for which he is entitled to receive the income interest determined by the rate of return earned by the trust for such year.

The trust instrument of the pooled income fund requires that property transferred to the fund by each donor be commingled with, and invested or reinvested with, other property transferred to the fund by other donors.

Community foundations and other public charities often receive contributions that are maintained for the benefit of other charitable organizations selected by the donor. A donor may designate the donor’s donor advised fund administered by the public charity as the recipient of the reminder interest.

Each beneficiary of a pooled income fund receives a pro rata share of the total rate of return earned by the fund for such taxable year. When a donor transfers property to a pooled income fund, one or more units of participation are assigned to the beneficiary or beneficiaries of the retained income interest. The number of units of participation assigned is obtained by dividing the fair market value of the property by the fair market value of a unit in the fund at the time of the transfer. Like a CRT, the PIF may make distributions on a monthly, quarterly or annual basis to meet the income requirements of the taxpayer.

Tax Benefits of PIFs

The taxpayer does not recognize gain or loss on the transfer of property to the PIF. In practice, this feature makes pooled income funds ideal for use by persons who desire to dispose of highly appreciated, low yielding property free of capital gains tax exposure in favor of assets that will produce higher amounts of cash flow. It is important to note the double tax leverage that can be accomplished by avoiding recognition of capital gain and creating an immediate charitable income tax deduction.

If a pooled income fund has existed for less than three taxable years, the charity is able to use an interest rate in calculating the charitable deduction by first calculating the average annual Applicable Federal Midterm Rate (as described in IRC §75200 for each of the three taxable years preceding the year of the transfer. The highest annual rate is then reduced by one percent to produce the applicable rate. That rate has risen over the last several years to 2.2 percent for 2020 tax year.

This interest rate provides a significantly larger deduction than a comparable contribution to a CRT. The following chart compares the percentage of deduction based upon a charitable deduction. The CRT assumes the minimum CRT payout of five percent for the taxpayer’s lifetime. Deductions for cash contributions are subject to the thirty percent of adjusted gross income threshold. Deductions of appreciated property are subject to the thirty percent of AGI threshold. The taxpayer may carryover excess deductions for an additional five tax years beyond the current year.

PIFs do not have a requirement to distribute at least five percent of the CRT’s fair maker value must be distributed each year. The PIF does not have a distribution requirement. In that respect, the PIF has a greater ability to mimic the stretch IRA by being able to accumulate income during periods where a distribution is not desired. Another key distinction is the tax treatment for cash contributions. A cash contribution to a CRT where the charitable remainderman is a public charity is limited to a deduction threshold of thirty percent of adjusted gross income (“ÄGI”). PIFs are not subject to thirty percent of AGI threshold. A cash contribution to a PIF is able to enjoy to the sixty percent of AGI for cash contributions to a public charity. As a result, a combination of the higher contribution deductions for PIFs versus the CRT and the higher deduction threshold, make the PIF, a stronger alternative to the CRT as an alternative to straight forward conversion to a Roth IRA.

The chart below compares the income tax deduction of a PIF to a CRT designed with the minimum five percent annual distribution. The IRC Sec 7520 rate is 2 percent. The interest rate for the newly created is 2.2 percent.

Unlike charitable remainder trusts, which are conditionally exempt from income taxes, pooled income funds are, with one important exception discussed below, taxed as complex trusts. Pooled income funds seldom pay any tax, however, for several reasons. First, pooled income funds receive an unlimited deduction for all amounts of income distributed to fund participants. Because pooled income funds are required to distribute all income earned each year, there remains no income to be taxed.

Second, pooled income funds are permitted a special deduction for long-term capital gains that are set aside permanently for charity. In essence, long-term capital gains produced by a pooled income fund are allocated to principal. Because principal is earmarked for charity, such amounts escape income taxation. For purposes of tracking income and gain attributable to contributed assets, pooled income funds take on the donor's holding period and adjusted cost basis in the contributed property.

Nevertheless, the trust document for most pooled income funds defines income as that term is defined in IRC Sec 643(b). Under this section, the term income, when not preceded by the words taxable, distributable, undistributed net, or gross, means the amount of income of the trust for the taxable year determined under the terms of the governing instrument and local (state) law. The Uniform Income and Principal Act or Revised Uniform Income and Principal Act adopted by most states defines income to include interest, dividends, rents, and royalties. Unless otherwise defined, income does not ordinarily include capital gains. Provided that such definition is compatible with state law, however, pooled income funds can expand the definition of income to include capital gains. Pooled income fund beneficiaries are required to include in their gross income all amounts properly paid, credited, or required to be distributed to them during the taxable year or years of the fund ending within or with their taxable year.

Distributions from pooled income funds are taxed under the conduit theory applicable to IRC Sec 661 and 662. Because pooled income funds distribute all income earned during the taxable year, the tax character of amounts distributed to each income beneficiary is directly proportional to the tax character of investment income earned within the PIF. The taxpayer also receives a charitable deduction for gift tax purposes and the remainder interest is not included in the taxpayer’s taxable estate.

A Comparison of the Roth Conversion and the PIF – An Extended Example

An extended example using the same facts and assumptions as the prior examples may be the best method for determining the results. The extended example assumes a Roth conversion in 2020 and Richie Rich’s death in 18 years. The PIF assumes a plan design with Richie’s three children as the beneficiaries with successive lifetime incomes from the PIF, e.g. at Richie’s death, the PIF will continue for the lifetime of the three children. His children are respectively ages, 40, 38 and 35. Richie will design the investment strategy during his lifetime for growth. At his death, the PIF investment advisor will focus on a balanced strategy of growth and income. The growth rate during his lifetime is 8 percent. At his death, the portfolio assumption is 3 percent income and 5 percent growth. The income tax deduction is 33 percent of the initial contribution.

At Richie, death the Roth IRA is subject to certain distributions. Assuming the Roth IRA has been in effect for at least five years, the children have the option of taking a tax-free lump sum distribution or as a rollover to their own Roth IRA with distributions based on at least the required minimum distribution calculation over the beneficiary’s life expectancy.

1. No Planning - At Richie’s death in the Year 2038, the projected value of the IRA is $21,899,000. The balance of the estate is projected to be worth $166,998,000. The projected income tax attributable to the IRA is $6,412,000 and federal estate tax attributable to the IRS is $12,044,000. The combined taxes amount to $21,900,000 which is approximately 84 percent of the total balance.

Alternatively, under the new SECURE Act rules, the IRA balance could be deferred for an additional ten years and distributed to Richie’s children. The projected balance at the end of Year 10 is $46,069,000. After distribution and taxation at a combined marginal tax rate of 48%, the balance remaining is $23,626,000.

2. Roth Conversion in 2020

The conversion to the Roth IRA in 2020 assumes that the income tax liability for the lump sum distribution is paid from plan assets. The projected Roth IRA balances is $21,998,000. The projected balance at the time of Richie’s death in 2038 is $26,270,000. The Roth distribution requires required minimum distribution (RMD) in the year following death – 2039. The amount of tax-free distributions of the required minimum distribution amount from 2039-2070 is $149,020,000 tax-free.

3. Pooled Income Fund

The conversion to the Roth IRA in 2020 assumes that income tax liability for the lump sum distribution is paid from other investment assets is paid from other investment assets and a contribution of $10 million is made to a newly formed pooled income fund (PIF). The PIF provides for successive beneficiary interests for his three children – 40,38, and 35. The PIF will incorporate a growth strategy assumed to be 8 percent until Richie’s assumed death in 2038. The projected value is $39, 960,000. After Richie’s death, the portfolio is switched to a balanced portfolio with a projected income of 5 percent and growth rate of 3 percent.

The projected account balance in 2038, Richie’s year of death is $152,601,000. At this point the portfolio is rebalanced to provide an income of 5 percent per year. The initial income split between the brothers is approximately $7,30,000. The projected income grows 3 percent per year. The projected account balance in in 2070 is $468,047,000. This amount will pass to Richie’s donor advised fund at the death of the last living beneficiary. Based on the investment assumptions, the projected income is $23,403,000 in 2070. The cumulative projected distribution of income to the beneficiaries, Richie’s three sons, is $405, 921,000 until the assumed death of the last surviving beneficiary in 2070.

An additional asset is the reinvestment of the tax savings from the PIF contribution in 2020. The tax savings are reinvested in a private placement life insurance policy insuring the lives of the two youngest sons. The projected tax deduction of $3,301,000 provides tax savings of $1,584,000 in 2020. The policy is a designed as a single premium modified endowment contract (MEC). The policy has a death benefit of $10 million initially and is designed to replace some of the assets passing to charity. The projected cash value in 2070 assuming an 8 percent growth rate is $46,660,000. The projected death benefit is $50,000,000.

Summary

The impact of the SECURE Act suggests that most planning that seeks to extend the “stretch” in the old Stretch IRA has merit. Depending on individual planning circumstances, a conversion to a Roth IRA rather that maintaining a taxable traditional IRA makes planning sense. This article suggests that additional tax planning such as incorporating a charitable tax planning strategy and life insurance to relocate assets in a more tax-favored manner. Charitable strategies have the ability to provide an offset on some of the income taxation on the initial lump sum distribution. The PIF provides a significantly larger income tax deduction than a CRT.

The tax deduction to the PIF may be used at the 60 percent of AGI threshold instead of the lower 30 percent AGI threshold for CRTs. The PIF has the ability to mimic most of the benefits of the CRT. The underlying investment strategy can regulate the amount of income payable to the income beneficiaries based on need. A taxpayer without a current need for additional income can defer the income payable for the income needs of younger beneficiaries to the future without any required minimum distributions.

The investment income within the PIF will be tax deferred. Current income is paid to income beneficiaries and tax deductible to the PIF and taxable to the beneficiary and recognized capital gains that are not part of trust income are added to the trust corpus that will ultimately be paid to charity.

The PIF has the ability to stretch out payment to selected beneficiaries over the beneficiaries’ lifetime without the imposition of required minimum distributions or a forced ten-year payout.

Ultimately the legacy left for charity will be the taxpayer’s greatest legacy - Tikunn Olam or repair the World or “On Earth as it is in Heaven.” We face many distractions and much wasted time in our journey through life. In the words of my Eastern German father (of blessed memory) frequently quoting the well-known German adage – “Too soon old, too late smart!” Let’s try harder to leave the World a better place, then when we first arrived!