Editor’s Note: Special thanks to Aaron Shahan at Atlas Law in Plymouth, MI for contributing to this article.
When the Setting Every Community Up for Retirement Enhancement Act, also known as the SECURE Act, became law last December, it was the biggest thing to hit retirement accounts since the Pension Protection Act of 2006. While the Act brought some positive changes, such as an increase in the age at which IRA owners had to take Required Minimum Distributions, or RMDs, it also eliminated the so-called “stretch” provision as an option for most non-spouse designated beneficiaries of inherited retirement accounts. As I wrote in our blog last year, eliminating the ability to stretch the inherited IRA over the recipient’s lifetime presents some unique challenges, particularly when it comes to taxes.
Spouse Beneficiaries Not Affected
If you plan to leave your IRA to your spouse, the SECURE Act’s changes won’t affect you. The Act did not change spousal IRA rules, which enable a surviving spouse to treat the inheritance in one of three ways according to the IRS:
- The surviving spouse could simply take over the IRA and treat it as his or her own, by becoming the account owner.
- The surviving spouse could roll the inheritance into a traditional IRA, or to the extent it is taxable, into a:
- Qualified employer plan
- Qualified employee annuity plan (section 403(a) plan)
- Tax-sheltered annuity plan (section 402(b) plan)
- Deferred compensation plan of a state or local government (section 457(b) plan, or
- The surviving spouse could act as the beneficiary rather than treating the IRA as his or her own.
Surviving spouses can elect to take all the money at once or just take RMDs according to their life expectancy. Those who choose to take RMDs must begin receiving those distributions either the year following the death of their spouse or the year the spouse would have reached the age of 72, whichever was later.
Most Non-Spouse Beneficiaries Are Affected
Under the old rules, if you left your IRA to someone other than your spouse, that beneficiary had the option to “stretch” the distributions over his or her life expectancy. That ended under the SECURE Act. Now, most non-spouse beneficiaries (think adult son or daughter, or nieces and nephews) must take distribution of the entire inherited IRA balance by the end of the 10th year after the year of your death. If you have retirement accounts with a large balance, compressing the timeline for distribution could cause your non-spouse beneficiary to shift to a higher tax bracket, causing him or her to receive less of an inheritance and pay more in taxes. If you are in this situation, you should consider talking to your adviser or estate planning attorney to discuss the potential for these unintended consequences for your loved ones!
Not every non-spouse beneficiary will be subject to the 10-year rule under the SECURE Act. Those considered to be “eligible designated beneficiaries” can still qualify to use the “stretch” provision if they meet certain qualifications. These eligible designated beneficiaries include:
- A minor child of the IRA owner (until the age of majority)
- Individuals who are within 10 years of the IRA owner’s age
- A disabled person meeting the criteria under IRS Tax Code Section 72(m)(7)
- A chronically ill person meeting the criteria under IRS Tax Code Section 7702B(c)(2)
When someone leaves retirement assets to a trust, the trust is a non-designated beneficiary, because it is an entity instead of a person. Different types of trusts are affected in different ways under the SECURE Act.
In the past, when someone directed retirement assets to a trust, the beneficiaries of the trust could stretch the distributions if the trust was set up with language creating a “see-through” trust (meaning it would see-through to the beneficiaries). There are two types of see-through trusts: “conduit” and “accumulation” trusts. The SECURE Act affects conduit trusts in a major way, but a conduit trust may be the best choice dependent on the goals you have as the trust grantor and circumstances of beneficiaries and gifts of retirement assets to charities.
Under the SECURE Act, conduit trusts have a big drawback: the amount of the IRA or retirement plan needs to be distributed to the trust beneficiaries subject to the 10-year rule,, unless the beneficiary may also be considered an “eligible designated beneficiary.” Many conduit trust provisions were designed to protect inherited IRA and retirement plan assets from beneficiary creditors, divorce proceedings, or other circumstances and to prevent spendthrift or exacerbating health issues for beneficiaries. As such, many older trusts were written to limit the beneficiary to receiving only the required minimum distribution of an IRA thereby preserving the IRA for as long as possible. With the SECURE Act, this strategy is no longer viable because there Is no longer a required minimum distribution, other than the 10-year-rule. As a result, the only distribution your IRA beneficiary Is entitled to receive under an outdated conduit trust is a lump sum of his or her share of the IRA in the 10th year after death. Meaning, the entire IRA will become taxable to that beneficiary in a single year, which will likely push the beneficiary into a much higher tax bracket. Additionally, a compressed distribution timeframe also likely causes the trust beneficiaries to pay more in taxes if the distribution boosts them into higher tax brackets instead of “stretching” the inherited retirement assets over the beneficiaries lifetime while in lower brackets. The impact is similar to naming the beneficiary directly (they would also have to take out the distributions in 10 years)
With an accumulation trust (sometimes called a discretionary trust), the trustee has the discretion to decide whether to payout or retain any inherited IRA distributions within the trust. This limitation creates protection for these assets and reduces the risk of creditors gaining access to those assets. According to the National Law Review, many estate planning attorneys consider accumulation trusts to be a better option. The major drawback is that accumulation trusts accumulate income after distribution from inherited IRA assets, which are then taxed at trust rates and brackets. This asset protection comes at a cost — the increased cost in tax over what the beneficiary may have paid individually.
The SECURE Act also created something called an “applicable multi-beneficiary trust.” With this type of trust, a disabled or chronically ill person who meets the IRS guidelines can stretch their portion of the retirement funds they inherit from the trust, even if other trust beneficiaries are not eligible designated beneficiaries.
Other types of trusts, considered to be non-see-through, or, more specifically non-designated beneficiaries, are subject to even shorter distribution times. Trusts, such as conduit or accumulation trusts, that do not meet the definition of a designated beneficiary are required to distribute over 5 years.
If you don’t have a trust right now, you may want to consider creating one if your beneficiary has unique circumstances, or you have other specific estate planning goals, like asset or spendthrift protection While designating a beneficiary individually on a form may have served your needs in the past, those forms don’t contemplate more complex situations that may require a trust designation.
Review how your trusts are structured, especially if you name a trust as beneficiary and most importantly if you have an eligible beneficiary to ensure your beneficiaries will receive their inheritance in the most tax efficient manner. If your trust is over a year old, it is important to have It reviewed so you do not leave you’re heirs with an unexpected tax disaster.
Why Act Now?
For those who have been diligent about saving for retirement, a retirement account such as an IRA or 401(k) will likely represent the largest asset you have when you die, so don’t leave this to chance, especially if a lack of attention on your part could lead to a higher tax burden or loss of other benefits for a loved one. Acting now will ensure peace of mind for both you and your beneficiaries, and you won’t have to worry about updating your estate plan at a less convenient time.
Several months ago, our firm was working with a client who needed to make updates to a trust. Although we had the changes drafted and ready for the client’s signature, the client became ill and delayed meeting with us and the estate planning attorney on the updates. The client’s health improved in the short term but took a turn for the worse within a few weeks. Ultimately, the client passed away without ever making the needed updates, and the beneficiaries will likely face higher taxes as a result.
As Benjamin Franklin reportedly said, “You may delay, but time will not, and lost time is never found again.” If you have plans to leave the proceeds of your retirement plan to someone other than your spouse, or to a trust, don’t put it off. Make an appointment to review your estate plan today. Leaving the legacy of a tax burden on your loved ones is nobody’s idea of good planning. As always, if AMDG Financial can be of assistance, please contact us.