The SECURE Act makes widespread changes to retirement plans and will have an immediate effect on the estate plans of nearly every individual and family. The SECURE Act contains several new provisions, many of which are taxpayer-friendly, but the changes to the rules for inherited retirement accounts will undoubtedly result in significantly higher taxes paid.
We’ll refer to these accounts as IRAs (individual retirement accounts) in this article, but the new rules apply to most retirement plans.
Rule changes for IRA owners
Under the old rules, a beneficiary of a retirement account was able to take annual required minimum distributions (RMDs) based on their life expectancy. Since many retirement accounts are tax-deferred, the ability to “stretch” distributions over a long period of time deferred the tax liability associated with the distribution of those accounts. The SECURE Act has eliminated this advantage for IRA owners passing away after Dec. 31, 2019, and now requires full distribution from an IRA be taken within 10 years of the participant’s death, with limited exceptions.
The SECURE Act now requires full distribution from an IRA be taken within 10 years of the participant’s death, with limited exceptions.
Eligible designated beneficiaries
Four categories of beneficiaries, termed “eligible designated beneficiaries” by the Act, are still able to take distributions from retirement accounts over their life expectancies, although in many cases that benefit is only temporary:
1) Surviving spouse of the participant
Retirement assets may be left to a surviving spouse directly, or to a trust for their benefit. When left to a spouse directly, the spouse may roll the account over into their own IRA or leave it as an inherited IRA and take distributions over their life expectancy. These rules remain unchanged under the SECURE Act, and in most cases, leaving the IRA to the surviving spouse directly makes the most sense. However, some individuals prefer to leave the retirement assets to a trust for the spouse, in order to provide protection against creditors, subsequent marriages, or to ensure the assets are preserved for the participant’s children. Under the new rules, the spouse may only take distributions over their life expectancy if that trust requires all distributions from the retirement account be distributed out of the trust to the spouse.
Many individuals will need to choose between maximizing tax deferral and maximizing the protection for the asset.
Because the trust is only a conduit for the retirement account distributions, it provides minimal protection for those assets. In fact, if the surviving spouse lives to life expectancy, the entire IRA will be distributed out of the trust to him or her. Under the SECURE Act, however, a trust for a surviving spouse that doesn’t require distributions from the retirement account be distributed out of the trust is subject to distribution within 10 years of the participant’s death. This means many individuals will need to choose between maximizing tax deferral and maximizing the protection for the asset, as it’s no longer possible to accomplish both of those objectives generally.
2) Minor children of the participant
Minor children of the participant can take distributions from the IRA based on the child’s life expectancy, but only if the IRA is left to them outright or in a trust that requires all distributions from the IRA be distributed out of the trust to the child. A trust that doesn’t have such a requirement will be subject to the 10-year distribution.
In addition, when the child reaches the age of majority, the 10-year rule is applicable at that point. As a result, parents are now forced to choose between a trust that will push all distributions from the IRA out of the trust to the child (initially based on life expectancy, but within 10 years after the child attains age of majority), or a trust where the 10-year rule will be immediately applicable but the distributions from the IRA could remain in the trust.
3) Disabled or chronically ill beneficiaries
Beneficiaries who are either disabled or chronically ill can stretch distributions from retirement accounts over their life expectancies, whether they receive the assets outright or in trust. The only requirement of the trust is that the disabled or chronically ill individual is the sole lifetime beneficiary of that trust. This is the most generous provision of the new inherited retirement account rules under the SECURE Act, and it will allow families to provide security for these types of beneficiaries in a tax-efficient manner. That said, the beneficiary must qualify under the Social Security definition of disability, which is fairly limited.
Beneficiaries who are either disabled or chronically ill can stretch distributions from retirement accounts over their life expectancies.
4) Less-than-10-years-younger beneficiary
A beneficiary who is less than 10 years younger than the retirement account owner may still stretch distributions over their life expectancy — as long as the asset is received outright or in a trust that requires all IRA distributions be distributed out of the trust to the beneficiary. While this won’t apply to many families, it’s advantageous for unmarried individuals who are leaving their assets to siblings.
Here’s an important point to note: Although the four types of beneficiaries listed above may often still stretch distributions (and therefore taxable income) over their life expectancies, they’ll be subject to the 10-year rule when the original beneficiary dies.
Tax planning for noneligible designated beneficiaries
While leaving an IRA to an eligible designated beneficiary generally will result in less tax being paid on the IRA, the exceptions are limited in scope and won’t apply to many families. For those without an eligible designated beneficiary to receive the IRA, the planning focus may shift from figuring out how to defer the taxes to figuring out how to pay those taxes. For some, the increased income tax may mean that beneficiaries won’t have enough assets to provide for them in the way the retirement account owner intended. In those cases, the dollars lost due to tax erosion will need to be replaced, potentially with life insurance.
For those without an eligible designated beneficiary to receive the IRA, the planning focus may shift from figuring out how to defer the taxes to figuring out how to pay those taxes.
The new 10-year rule does offer one opportunity: No assets need to be distributed from the IRA until the year containing the 10th anniversary of the participant’s death. This means beneficiaries will have a 10-year window in which to do tax planning. For some, this will mean taking small distributions each year to take advantage of lower tax brackets or deferring distributions in anticipation of an expected decrease in income.
For those beneficiaries who will always be in the top income tax bracket, this may mean taking no distributions in the interim and distributing the entire account in the final year.
Because trusts are subject to the top income tax rate for income above $12,950, a trust will almost always pay tax at the top rate. However, if income is distributed out of a trust to a beneficiary, that distribution carries with it the income tax liability. This means trustees of trusts owning IRA accounts will need to work closely with trust beneficiaries to determine if distributions are advantageous from an income tax standpoint, and if so, if such distributions are appropriate and allowable under the terms of the trust.
In addition, to the extent estate taxes are paid on IRA assets, the beneficiary will need to ensure they’re taking advantage of the income tax deduction allowed for estate taxes paid, a deduction often missed by beneficiaries.
Trustees of trusts owning IRA accounts will need to work closely with trust beneficiaries to determine if distributions are advantageous from an income tax standpoint.
Since the inability to defer taxes over the course of a beneficiary’s lifetime may result in more income tax paid on inherited IRAs, many families will now look to leave these types of assets to charity. Charities are tax-exempt and don’t pay taxes on distributions from the IRA, so they have the benefit of the full account value. By contrast, the IRA is worth much less to an individual beneficiary who will see the account depleted by income taxes. Still, it’s important to coordinate any charitable bequests with the rest of the estate plan and to ensure that charitable bequests designated in a revocable trust may be satisfied with tax-deferred assets.
Estate plan options under the SECURE Act
While the SECURE Act certainly has a significant effect on the estate plans of many families, the reality is that few planning options exist under the new rules. That said, several scenarios warrant a second look at your estate plan and potential exploration of other options:
1) Individuals in second or third marriages leaving their IRAs to a trust for their surviving spouse in order to protect the asset for the children of a prior marriage may want to reconsider that arrangement. As mentioned above, many retirement account owners will have to choose between protecting the IRA in trust or deferring the taxes. For those choosing to protect the assets in trust, consider whether the financial independence of the surviving spouse will be jeopardized by the decreased value of the IRA due to taxes. For those in that situation, planning may focus on replacing the lost tax dollars, or reallocating assets under the estate plan so that the IRA may pass them to the surviving spouse to maximize tax deferral while still providing sufficient dollars for the remaining beneficiaries.
2) Individuals who’ve designed trusts that require all distributions received by the trust from an IRA to be distributed out of the trust to the beneficiaries may want to revisit that trust provision. Historically, this requirement was added to trusts to ensure the trust could stretch distributions from the IRA over the life expectancy of the beneficiary. Other than trusts for eligible designated beneficiaries, this provision no longer carries that advantage and will now result in the entire IRA being distributed out of the trust to the beneficiary within 10 years. This greatly diminishes the protection the trust affords and takes control of the asset out of the hands of the trustee.
3) IRA owners who’ve spent a lot of time and effort designing a plan around the ability to stretch IRA distributions over the life expectancies of their beneficiaries will want to revisit their plans to determine if they still accomplish those goals in light of the new SECURE Act rules. Some of these IRA owners may have created separate retirement benefit trusts, which might no longer be necessary. Or owners may have included trust provisions that might not have been ideal but provided an opportunity for maximum tax deferral.
While the SECURE Act certainly has a significant effect on the estate plans of many families, the reality is that few planning options exist under the new rules.
Areas where the SECURE Act will have little effect
In spite of the changes, the SECURE Act will have little effect on a number of families. These include families of individuals who don’t have significant retirement assets and those who are planning to leave their IRAs to charity anyway. In addition, individuals planning to leave their IRAs outright to adult children will likely not need to make any changes since their plan functions the same way as before — except that their children may pay more tax on the IRA. Planning efforts for these families should focus more on how and when to pay the taxes rather than how to defer them. For instance, Roth conversions during the participant’s lifetime may allow for taxes to be paid at a lower rate than the beneficiary would pay, particularly if the IRA owner will have years with significant deductions that will offset the income realized by the Roth conversion.
Retirement account changes under the SECURE Act can have a large impact on your estate plan. Many of the new provisions will reduce your tax burden, but the rule changes related to inherited retirement accounts will undoubtedly result in significantly higher tax paid. It’s important for retirement account owners to understand the nuances and consider a range of planning ideas in order to minimize the impact on your estate plan and beneficiaries.
As always, if you have questions about the SECURE Act and its effects on your family, feel free to give us a call.