In December 2019, Congress passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act with the goal of encouraging taxpayers to fund more retirement savings and make it easier for employers to provide retirement plans.
The SECURE Act also changed the way that retirement plans are taxed when transferring to heirs. That change may provide challenges and opportunities within your estate plan. Let's start with an overview of the ways the SECURE Act has changed estate planning.
Here are some of the changes from the SECURE Act:
- It repealed the maximum age limit for contribution to a traditional individual retirement account (IRA). Those who choose to work into their 70s can now continue to contribute to their IRA.
- It increased the age after which taxpayers must start taking distributions from their retirement accounts – known as Required Minimum Distributions (RMD) – from age 70½ to age 72. This may provide additional tax planning opportunities.
- It changed the way non-spousal heirs are taxed on inherited retirement accounts.
- Prior to the change, inheritors of retirement accounts were allowed to withdraw from an inherited IRA over the beneficiary’s life expectancy, called a "stretch IRA." This allowed the beneficiary to receive a lifetime stream of income and spread the income taxes out over a longer period of time. Because of this ability to stretch income and taxes it was common for estate planners to suggest leaving retirement assets to heirs who might benefit from the security of a lifetime income stream.
- With the SECURE Act, non-spouse inheritors are required to distribute (and pay taxes) on the money inherited from retirement accounts over a 10-year timeline. The distributions can happen all in one year or over many years, but the assets must be fully distributed by year 10. For most beneficiaries, this new rule will accelerate withdrawals over the prior rules and likely increase the taxes paid on their inheritance, since larger amounts will be forced to come out over a shorter period of time. Also those distributions may happen when the heir is still working and in a higher tax bracket than they would be later in their life.
There are exceptions to the 10-year rule for fully distributing an inherited retirement account. These exceptions include:
- The surviving spouse of the account owner;
- The minor child of the account owner, until they reach the age of majority;
- A disabled individual;
- A chronically ill beneficiary; or
- A beneficiary who is not less than 10 years younger than the retirement account owner.
These individuals (“eligible designated beneficiaries”) may take required distributions from the retirement account based on their life expectancy if they are named as beneficiaries on the retirement account. However, upon the death of the eligible designated beneficiary, the next beneficiary in line must distribute the retirement account under the 10-year rule.
Question 1: How does the 10-year rule impact trusts and estates?
If you have named a trust as a beneficiary of your retirement account, you should review your estate plan to ensure that it carries out your intent. Under prior law, if a trust was the beneficiary of a retirement account and the trust was drafted as a “see-through trust”, then the trust could take required minimum distributions (“RMDs”) annually based on the life expectancy of the beneficiary. These RMDs would then either be held by the trust and taxes would be paid at the trust’s tax rate, or the RMDs would be distributed to the beneficiary that year and the beneficiary would pay taxes on the distribution. The goal behind these types of trusts was to give the Trustee control regarding retirement account assets held by the trust to assist the beneficiary with money management or offer asset protection over the retirement account assets held by the Trust. The SECURE Act drastically changes this planning strategy.
For trusts that required the Trustee to distribute the RMD to the beneficiary and provided additional distributions to the beneficiary at the Trustee’s discretion, the retirement account must be distributed within 10 years of the death of the account owner, unless the beneficiary is an eligible designated beneficiary (e.g. spouse, minor child of account owner, etc.). If the goal is to preserve and protect assets for the beneficiary or control the amounts that are distributed for the benefit of this beneficiary, the new law provides far less protection than was allowed under prior law because the funds must be distributed at an accelerated rate (10 years rather than life expectancy).
For trusts providing that the RMD must be accumulated within the trust, this greatly increases the realization of income taxes. These types of trusts are known as “accumulation trusts.” An accumulation trust will result in a 10-year payout of an IRA to the beneficiary regardless of whether the beneficiary otherwise qualifies as an eligible designated beneficiary (e.g., spouse, minor child, disabled individual, etc.) or an exception to the 10-year rule. Further, if a RMD is not being paid to the beneficiary, the income tax consequences for the distribution from the retirement account are reported on the income tax return for the trust rather than an individual. Trusts pay income taxes at higher rates because trust tax brackets are compressed compared to individual income tax brackets (e.g. the highest tax rate for a trust, 37%, is applied after $12,750 of income). Due to this, if the retirement account has to be fully distributed in 10 years, rather than based on the life expectancy of the beneficiary, then depending on the size of the retirement account and the years the retirement account is distributed it will likely result in significantly more income taxes on the retirement account than would have been paid prior to the law change.
Despite these issues, it is important to balance asset preservation considerations with tax considerations. You may be more concerned with preserving a beneficiary’s inheritance from their creditors, future lawsuits, or a divorcing spouse than you are with an accelerated recognition of income taxes. It is important to review your wishes with your financial planner, attorney, and accountant so you can customize your plan to best address your concerns.
Question 2: What are some charitable gifting strategies that can still be used to “stretch” the income over the life of an heir that frequently faces financial difficulty?
If clients have charitable intentions, I often encourage them to consider utilizing their retirement accounts to achieve those goals. Charitable planning with retirement assets provides tax advantages to the client during their lifetime and may provide additional tax savings to beneficiaries upon death.
One strategy that estate planners may utilize is a Charitable Remainder Trust. Charitable Remainder Trusts are irrevocable trusts, that are often used when clients are charitably minded. They allow clients to name non-charitable beneficiaries that will receive a percentage of the trust assets for a term of years, but at the end of the term, the assets are distributed to the designated charities. These trusts are specifically designed to reduce income taxation and honor the charitable goals of the client. Charitable Trusts are exempt from the 10-year rule. This means that you could provide a child with an income stream from the IRA assets over the course of their lifetime, then leave the balance to a tax-exempt beneficiary.
Question 3: If I inherited an IRA in 2018 and inherited another IRA in 2020 will they be treated differently?
Yes - IRAs inherited in 2020 will be treated differently from IRAs inherited in 2018.
If you were named as a beneficiary of an IRA in 2018 and you opted to transfer the IRA assets to an inherited IRA, then you will be able to stretch distributions from the inherited IRA over your lifetime. You will be required to take out RMDs each year based on your life expectancy. You will also be able to take additional distributions when you desire.
If, instead, the original account owner died in 2020 and you were named as the beneficiary of their IRA, then the distribution requirements for that inherited IRA would significantly differ. Unless you qualify as an Eligible Designated Beneficiary (i.e., spouse, minor child, disabled individual, chronically ill individual, or beneficiary within 10 years of age from the original account owner), you will need to fully distribute the funds in the inherited IRA within 10 years from the account owner’s death. You will not be required to take a distribution from the account each year.
Let’s not forget about the value of Roth Conversions which involves moving money from a pre-tax IRA account to an after-tax Roth IRA account and paying the taxes now versus later. The growth on those assets grows tax-free going forward. And although your heirs will still have the 10-year distribution requirement, they will not have to pay taxes on those distributions.
What hasn’t changed is the ability to give during your lifetime (subject to $100,000 per year*) or leave any or all of your retirement plans to charity since charities do not have to pay taxes on any money received from an IRA. We typically recommend any charitable giving planning as part of an estate plan come from the IRA since it will reduce the income tax your family will owe on their inheritance.
The SECURE Act has added complexity to many estates and there may be both financial and estate planning opportunities to be explored that may help to customize your plan and add value to your heirs.