Written by: Davis Barry
The SECURE Act of 2019 resulted in many well-documented changes to retirement planning, but often overlooked is its impact on estate planning. Some have referred to one of the biggest enacted changes as “The Death of the Stretch IRA”! But beneficiaries’ ability to stretch retirement account distributions didn’t actually die – it just changed!
The SECURE Act states that there are no required minimum distributions (RMDs) for inherited retirement accounts (when the account owner’s death is after December 31, 2019). However, now the entire account must be distributed by the end of the 10th year following the death of the original account owner. This rule is often referred to as the 10-Year Post-Death Payout Rule or the 10-Year Rule. The 10-Year Rule doesn’t just apply to inherited Traditional IRA and 401(k)s, but Roth accounts as well. For deaths in 2019 or prior years, the old rules remain in place (i.e., allowing stretch distributions over the beneficiary’s lifespan).
While the hassle of taking annual RMDs from inherited accounts is no more, the tax planning considerations have increased. The size of the inherited retirement account(s), your current tax situation and when you plan to retire, as well as how that might change over the next decade, dictate the planning options to consider.
Of course, over the course of the 10 years of distributions, funds from inherited accounts can be reinvested into taxable accounts. And as a financial planner, I can’t help but recommend reinvestment, rather than, say, splurging on that boat or sports car. (Just sayin’….)
SECURE Act: Eligible Designated Beneficiaries
There are five classes of Eligible Designated Beneficiaries (EDBs) who are exempt from the 10-Year Rule:
- Surviving spouses
- Minor children until the age of majority (but not grandchildren)
- Disabled individuals
- Chronically ill (unable to perform two or more activities of daily living, ADLs, for 90 days to “an indefinite one which is reasonably expected to be lengthy in nature”)
- Beneficiaries not more than 10 years younger than retirement account owner
Also, annuities in which, prior to January 1, 2020, an individual irrevocably annuitized amounts over a life or joint-life expectancy, or in which an individual elected an irrevocable income option that will begin at a later point, are exempt entirely. Governmental plans, such as 403(b) and 457 plans sponsored by state and local governments, and the Thrift Savings Plan sponsored by the Federal government are not impacted until January 1, 2022.
The new 10-year window in which a beneficiary must fully distribute an inherited retirement account has made naming a ‘see-through’ revocable trust as beneficiary more complicated and, in some cases, not worth it.
See-through trusts are treated as a designated beneficiary (by “seeing through” to the underlying beneficiaries) of an inherited retirement account. They come in two basic forms – a “conduit trust” and a “discretionary trust”.
Conduit trusts require that all distributions from an inherited retirement account received by the trust be passed out (i.e., “conduited”) to the trust beneficiaries each year. Discretionary trusts allow for the build-up of distributed dollars within the trust. Under certain circumstances, each type of trust can still take advantage of the stretch provision if the underlying beneficiaries can be considered eligible designated beneficiaries (EDBs), but see-through trusts will generally be subject to the 10-Year Rule if the underlying beneficiaries are non-eligible designated beneficiaries.
The Problem with Discretionary Trusts
Discretionary Trusts that state specific ages at which beneficiaries receive distributions/trust assets are particularly problematic.
The 10-Year Rule only impacts the time that the trust beneficiary has to empty an inherited retirement account, but not the time that the trust, itself, has to distribute funds to the trust beneficiaries. That remains dictated by the trust’s terms.
Trust income is subject to the same maximum 37% ordinary income tax rate as the highest income earners. A joint filer does not hit the top 37% Federal income tax bracket until they have more than $622,050 of taxable income, but a trust reaches the same 37% bracket at just $12,950 in 2020.
Let’s give an example: The Sebastian Coe Trust
The Sebastian Coe Trust is a discretionary trust established for the benefit of 29-year-old Sebastian Coe. It was recently funded with a $500,000 inherited IRA.
The trust requires that all distributions be held inside the trust until Sebastian reaches age 40, at which time he is entitled to the trust’s assets. Trust tax rates will apply on the distributions.
Prior to the SECURE Act, the trust would have been able to stretch distributions over Sebastian’s single life expectancy. The overall tax would likely have been lower and there would have been more flexibility.
Conduit Trusts will be completely useless by the end of the 10th year after death
The entire IRA will have been distributed to the trust within 10 years of the benefactor’s death, and the trustee will have been required under the conduit provisions to distribute those assets out from the trust to the trust beneficiaries.
It’s highly unlikely that most people would want to go through the time, expense, and effort to create a Conduit Trust, when it would only help protect beneficiaries for a maximum of 10 years and potentially accelerate the dollars out at the end of that 10-year window.
More often than in the past, retirement account owners will likely opt to name individuals as beneficiaries versus a see-through trust.
The SECURE Act has changed the way Financial Planners, CPAs, attorneys and clients are looking at estate plans. Questions to consider include:
- Have I optimized my beneficiary designations? Am I leaving the right accounts to the right heir?
- Is a trust really necessary for my retirement accounts? If so, is there enough flexibility to allow my trustee to uphold my wishes, but also allow for flexibility when it comes to tax planning?
- Are any of my heirs disabled and/or chronically ill? If so, do I need to incorporate an Applicable Multi-Beneficiary Trust to preserve their government benefit eligibility?
- Should I do more Roth conversions during life based on my tax rate, my heirs’ tax rate(s) and trust tax rates? Should I give my trustee power to consider Roth conversions for my heirs after I’m gone?
- Does distributing some of my retirement account to purchase life insurance make sense in order to provide a guaranteed and tax-free death benefit to my heirs?
- Am I able to obtain life insurance at a reasonable cost? Am I able to obtain life insurance at all?
These questions and many more can be answered with the help of your Agili financial strategist. Please reach out to us at any time to discuss the SECURE Act’s 10-Year Rule and other estate and financial planning matters.