Retirement and Estate Planning under the SECURE Act
The “Setting Every Community Up for Retirement Enhancement Act (the “SECURE Act”) in December 2019, introduced a number of new rules and provisions that have a significant impact on retirement and estate planning for individuals with tax-deferred retirement accounts, such as an IRA or 401(k). As a result, the new law may have a significant impact on your current estate plan. We strongly recommend that you review your retirement account beneficiary designations and consult with counsel to determine whether changes to your current beneficiary designations or estate planning documents are necessary or advisable.
Historically, the primary benefit of leaving retirement account assets to heirs was that, upon the owner’s death, the designated beneficiary could receive funds in an inherited account and “stretch” required minimum distributions over their life expectancy. This strategy enabled a beneficiary to withdraw the minimum amount each year while allowing the inherited retirement account to continue to grow tax deferred for the remainder of the beneficiary’s lifetime.
Effective for account owners who pass away after December 31, 2019, the SECURE Act eliminates the option to stretch distributions over a beneficiary’s life expectancy unless they are an eligible designated beneficiary (discussed below). Instead of required annual minimum distributions being based on the beneficiary’s age, the SECURE Act requires that a beneficiary withdraw all inherited funds by the end of the 10th year following the owner’s death (the “10 Year Rule”). This means that the IRA beneficiaries will need to take larger distributions over a much shorter period of time, creating taxable income to be reported over 10 years rather than the beneficiary’s lifetime.
There are five exceptions to the 10 Year Rule if any of the following individuals are named as beneficiary (an “eligible designated beneficiary”):
- Surviving spouses;
- Disabled individuals;
- Certain chronically ill individuals;
- Minor children of the participant;
- Individuals who are no more than 10 years younger than the deceased participant
Generally, an eligible designated beneficiary may still take distributions over their life expectancy, provided that minor children will become subject to the 10 Year Rule upon reaching the age of majority. For example, upon the minor beneficiary attaining age 18, he or she will be required to withdraw all remaining funds by age 28.
The new 10 Year Rule has a significant impact on the use of trusts as designated beneficiaries of retirement accounts. Pre-SECURE Act, a trust could be designed as a “see-through” trust to utilize the stretch over the life expectancy of the beneficiary of the trust. There are generally two types of trusts that qualify as see-through trusts for retirement account distribution purposes –
- conduit trust
- accumulation trust
Under a conduit trust, distributions received from an inherited retirement account must be immediately distributed to the trust beneficiaries. Conversely, an accumulation trust is structured to permit distributions from the retirement account to “accumulate” inside of the trust and the trustee has the discretion to hold and manage the funds without making distribution out to the trust beneficiaries.
Under the 10 Year Rule, the beneficiary of a conduit trust will receive an outright distribution of 100% of the account within 10 years of the participant’s death unless the beneficiary is an eligible designated beneficiary. Thus, conduit trusts may result in required distributions from the trust that are contrary to the intentions of the retirement account owner. Because the retirement benefits will be distributed out over a period of not more than 10 years, a conduit trust may cause all of the retirement assets to be distributed outright to the beneficiary sooner than the account owner had planned and in larger amounts than previously assumed. The account owner’s goal of asset protection is defeated, and a significant income tax burden may be unintentionally created for the beneficiary.
Accumulation trusts are also subject to the 10 Year Rule. Therefore, the accumulation trust-owned retirement account has fewer years of tax deferred growth and the trust could recognize all or a substantial portion of the income tax at the income tax rates applicable to trusts, which generally results in more income taxes being paid than if the benefits were taxed to the individual. For 2020, undistributed trust income over $12,950 is taxed to a trust at the top federal income tax rate of 37 percent. In contrast, for a single individual, the 37 percent tax rate only applies to income over $518,400. An accumulation trust could result in more income tax than was anticipated when past decisions were made to utilize an accumulation trust in the estate plan.
Accordingly, the 10 Year Rule creates a dilemma for clients who want their retirement accounts controlled by a trustee following their deaths for creditor protection or other reasons: either distribute the entire retirement account to the trust beneficiary by the end of the 10-year period, or accept the fact that the value of the retirement account distributions accumulated in the trust is going to be significantly reduced by the income taxes paid by the trust on those distributions.
If you have designated a trust as the beneficiary of your retirement accounts, you should review the drafting of the trust with an estate planning attorney to understand the implications of the SECURE Act. There are other alternatives to consider such as using life insurance to offset accelerated income taxes, leaving retirement accounts to charities (either outright or to a charitable remainder trust) or doing a Roth conversion.