As indicated in our last newsletter, we are updating you on the enactment of the Setting Every Community Up for Retirement Enhancement Act (the “SECURE Act”) which was enacted on December 20, 2019 and became effective on January 1, 2020.
Although this update focuses on the death of the stretch IRA/401K and the changes to minimum required distributions resulting from the SECURE Act, the SECURE Act also made changes which make it more attractive for small businesses to provide retirement benefits to its employees and expands the opportunity for part-time workers to participate in 401K plans.
The SECURE Act radically changes the minimum required distribution rules. Starting with a positive change, the Act increases the minimum required distribution age for IRA owners and employees from 70½ to 72 for distributions required to be made to the IRA owner and employee. This change is effective for IRA owners and employees who attain age 70½ after December 31, 2019. Similar to how it was before, minimum required distributions can be delayed until April 1st of the year following the year in which the individual attains age 72. An individual who attained age 70½ on or before December 31, 2019 is subject to the pre-SECURE Act rules for minimum required distributions.
Although this increase in the minimum required distribution age to 72 may benefit individuals who do not need to take distributions from their IRAs/401Ks, the modifications to the minimum required distribution rules for beneficiaries upon the death of the IRA owner/employee have a significant negative impact on the tax planning of the IRA owner/employee and his/her beneficiaries.
With certain exceptions noted below, IRA and 401K beneficiaries can no longer stretch distributions of the IRA/401K over his/her life expectancy and generally will be required to take complete distribution of the IRA/401K by the end of the tenth calendar year following the death of the IRA owner/employee ("Ten Year Rule").
The SECURE Act makes exceptions for certain beneficiaries ("Eligible Designated Beneficiaries"): surviving spouses, minor children, disabled or chronically ill persons, and persons who are less than ten years younger than the IRA owner/employee. These Eligible Designated Beneficiaries (other than minor children) can continue to take IRA/401K distributions over his or her life expectancy. Minor children can receive distributions based on life expectancy until attaining the age of majority after which the child must receive complete distribution under the Ten Year Rule. Note that it is not completely certain whether federal or state law will apply to determine when a child attains the age of majority under these new rules.
The Ten Year Rule and the above exceptions apply to beneficiaries of IRAs and 401Ks of IRA owners/employees dying after December 31, 2019.
There continue to be circumstances where an IRA owner or employee is reluctant to name certain family members as the direct beneficiaries of his/her IRA/401K. This was the case even prior to the SECURE Act when the beneficiary could stretch distributions over his/her life expectancy. Although the IRA owner/employee might hope that the beneficiary will take distributions over his/her life expectancy, there is the possibility that a spendthrift beneficiary will withdraw from the IRA/401K much more quickly. In such circumstances, an IRA owner/employee might prefer to name a trust as the beneficiary of the IRA/401K and give the trustee control over the timing of distributions.
This update does not detail the federal tax requirements for a trust to qualify for favorable tax treatment but generally two types of trusts are/were used to obtain this favorable tax treatment: a "Conduit Trust" and an "Accumulation Trust." Prior to the passage of the SECURE Act, generally if the trust qualified as either a Conduit Trust or an Accumulation Trust, distributions from the IRA/401K could be made over the life expectancy of the trust beneficiary.
The hallmark of a Conduit Trust is that all minimum required distributions from an IRA/401K to the Conduit Trust were required to be distributed to the trust beneficiary. After the SECURE Act, distributions from a Conduit Trust can be made over the life of the trust beneficiary only if the beneficiary is an Eligible Designated Beneficiary. Therefore, if an IRA owner/employee has named a Conduit Trust as the beneficiary of an IRA/401K and the beneficiary of the Conduit Trust is not an Eligible Designated Beneficiary, distributions from the IRA/401K to the Conduit Trust upon the death of the IRA owner/employee will be subject to the Ten Year Rule and the terms of a typical Conduit Trust will require that those distributions flow out to the trust beneficiary.
Prior to the SECURE Act, the IRA owner/employee may not have been concerned with the mandatory flow through to the trust beneficiary since distributions from the IRA/401K could be made over the life expectancy of the trust beneficiary. After the SECURE Act, IRA owners/employees may have concern that distributions from an IRA/401K will now be distributed to the trust beneficiary from a Conduit Trust generally within 10 years (unless the trust beneficiary is an Eligible Designated Beneficiary). Nonetheless, the trustee of the Conduit Trust still controls when distributions are withdrawn from the IRA/401K (subject to the Ten Year Rule unless the trust beneficiary is an Eligible Designated Beneficiary) and the trust beneficiary cannot access the IRA/401K at his/her whim.
Generally, an Accumulation Trust that is/was named as the beneficiary of an IRA/401K can retain distributions required to be distributed from the IRA/401K. Before the SECURE Act, minimum required distributions to an Accumulation Trust were based on the life expectancy of the oldest trust beneficiary. After the SECURE Act, distributions to an Accumulation Trust are generally subject to the Ten Year Rule with the exception for certain trusts for the disabled or the chronically ill. If the trustee, pursuant to the terms of the Accumulation Trust, retains IRA or 401K payments in trust, they will be subject to federal income tax at the rates imposed on trusts. Since the federal income tax brackets for a trust are more compressed than the federal income tax brackets for individuals, retaining IRA/401K distributions in trust could result in greater tax being paid than if such amounts were distributed out to beneficiaries. The IRA owner/employee will need to consider what is of greater importance – minimization of taxes or minimization of certain beneficiaries receiving outright distributions.
Various commentators have suggested alternative strategies to counteract the loss of the stretch IRA/401K, e.g., conversion to Roth IRAs, designating a charity as the IRA/401K beneficiary, designating a charitable remainder trust as the IRA/401K beneficiary, gifting to beneficiaries (even if it is with after tax dollars from IRAs/401Ks) and designating a trust with multi-generational beneficiaries as the beneficiary of the IRA/401K. The application of these strategies requires an in-depth analysis for each IRA owner/employee and is beyond the scope of this summary.
The above summary of the impact of the SECURE Act on distributions from IRAs/401Ks is not intended to be comprehensive to implications or planning strategies. It is intended to alert you to some of the issues and to encourage you to review the impact of the SECURE Act on your IRA/401K beneficiary designations with your financial and estate planning advisors.
Our attorneys are always ready, willing, and able to meet and discuss any questions. Learn more about Mansour Gavin’s Estate Planning & Probate group or contact us today.