On December 20, 2019 the President enacted legislation that significantly changed the rules that govern passing retirement accounts on to beneficiaries. For how dramatically the new law alters the previous regime of rules and regulations, it is almost ironic that Congress in its infinite creativity and boundless marketing savvy named it the SECURE Act (Setting Every Community Up for Retirement Enhancement Act, if you’re not into the whole brevity thing). In short, what this means from an estate planning perspective is that virtually everyone should review how their current retirement accounts will pass upon their death under their current plan.
Prior to the SECURE Act, spouses and individual non-spouse beneficiaries (i.e., children) could stretch out required minimum distributions (RMDs) from retirement accounts inherited via beneficiary designation or through a properly drafted “see-through” or “conduit” trust over their, or someone else’s, lifetime. This “stretch-out” rule allowed beneficiaries to minimize the potential income tax consequences of taking those required distributions. Beneficiaries could also take more than RMDs if they wanted. Now under the SECURE Act, generally individual non-spouse beneficiaries more than 10 years younger (“non-eligible beneficiary”) than the plan participant (“account owner”) must withdraw the full amount of the inherited retirement account within 10 years of the account owner’s death. During this 10-year period, these beneficiaries do not have to take RMDs, but the retirement account must be liquidated by the 10-year deadline.
It is important to note that, the prior lifetime withdrawal rules still apply to certain other “eligible” beneficiaries:
- Surviving spouses of the account owner
- Minor children of the account owner until they reach age 18. Once they become adults, the new 10-year rule applies
- Disabled and chronically ill beneficiaries—this includes certain trusts for these beneficiaries (i.e., supplemental needs trusts and special needs trusts)
- Beneficiaries who are less than 10 years younger than the account owner—i.e., siblings.
The loss of the lifetime withdrawal rules for non-eligible beneficiaries could have significant tax consequences. To use a simple example: if a non-eligible beneficiary inherits a $500,000 IRA they will be faced with the prospect of withdrawing an average of roughly $50,000 each year in order to liquidate the IRA by year 10. Those withdrawals will, of course, be treated as income to the non-eligible beneficiary and will vault them into a (potentially much) higher tax bracket. If that beneficiary is relatively young—say, 18 or 21—they may not have much if any other sources of income so the tax consequences may be unduly onerous. But the more pressing question is: what are they going to do with that amount of money? Even if (usually a BIG if) they are wise enough to minimize their tax burden, are they going to spend the money wisely? Most parents and anyone who remembers being a young adult would say, without hesitation and perhaps with a glaze of fear in their eyes: “NO.” Levity aside, that amount of money could be potentially disastrous to a beneficiary with more harmful proclivities. Fortunately, there are options to avoid those adverse consequences.
So, what options does one have if they want to pass a retirement account to a beneficiary with assurance that it will be managed and distributed prudently?
Under the old rules, the answer was often a properly drafted “conduit” or “see-through” trust. Retirement accounts in these types of trusts could be withdrawn based on the life expectancy of the oldest beneficiary. Instead of treating the trust as the beneficiary—which would trigger a rule requiring the account to be liquidated in 5 years from the owner’s death (“5-year rule)—the IRS would calculate RMDs based on the oldest beneficiary’s life expectancy. For a younger beneficiary RMDs would be relatively small and could be managed by a trustee (an older, wiser relative, perhaps). This made them very attractive estate planning tools for people who didn’t want a young adult without a fully formed cerebral cortex to have unfettered access to a $500,000 account.
Under the new rules, in that scenario the account has to be liquidated in 10 years. A conduit trust drafted under the old rules probably does not give a trustee proper authority to do that effectively because it likely allows them to only withdraw RMDs, which you’ll recall are now suspended under the new rules. What if you want the money in that IRA or 401(k) to be meted out more gradually than 10 years—say until a beneficiary is 40 or 50?
A conduit trust that gives the trustee authority to accumulate income (an “accumulation trust”) may be the answer. However, these types of trusts need to drafted carefully to avoid triggering the 5-year rule (if a trust is deemed the beneficiary of the retirement account without being a conduit trust the retirement account must be liquidated in 5 years). This can be done, but it requires diligent drafting. The result will be a trust that allows the trustee to liquidate the retirement account within 10 years as required by the SECURE Act, but not have to distribute all the money to a beneficiary within that time. The trustee will have the added responsibility of considering the tax consequences of accumulating income in a trust subject to significantly compressed tax brackets compared to individuals, versus making distributions to the beneficiary. It may be that paying more income tax at trust tax rates is preferred over distributing money outright to a potentially imprudent beneficiary with less of a tax burden. The benefit to this approach is added flexibility for the trustee to decide based on the circumstances.
There are, of course, other options that don’t involve using a trust. For someone that is only concerned about the potential income tax burden for beneficiaries, one option is annually converting a portion of a pre-tax account to a Roth IRA. The conversion will trigger income tax for the account owner, but they lessen that hit by spreading conversions out over time. Distributions from a Roth IRA are not taxable, so a beneficiary won’t have to pay when they take distributions.
Folks that want to provide for disabled beneficiaries should seriously consider utilizing a Supplemental Needs Trust with conduit trust language. Because disabled beneficiaries are “eligible” as mentioned above, distributions from a retirement account or portion of it that flows into such a trust could be stretched out over the disabled beneficiary’s life expectancy. Supplemental Needs Trusts can be established during the life of the grantor/creator of the trust, or upon death per the terms of a will or revocable trust.
Finally, for those that are charitably inclined there remain many opportunities to support causes and organizations with gifts from retirement accounts. The most straightforward approach is designating a charity or Donor Advised Fund (DAF) as beneficiary. Alternatively, folks over 72 that are currently taking distributions from an IRA can make Qualified Charitable Distributions (QCD). Provided all the requirements are met, that distribution is not taxable. For clients that want to provide a lifetime income stream to a beneficiary, but ultimately provide a gift to a charity, Charitable Remainder Trusts (CRTs) can be an attractive option.
The scenarios and options outlined above are just a fraction of those our clients encounter and we consider for passing on retirement accounts. Each situation is different and there is far from one Swiss Army-style tool for everyone. You should consult with a financial advisor and tax professional about the particulars of your situation.
Please contact us if you want to discuss your estate planning options in more depth and understand how we can help you achieve your goals.