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Overcoming Retirement Plan In-SECURE-ity

Real Property, Probate and Trust Law
Overcoming Retirement Plan In-SECURE-ity

The SECURE Act (Setting Every Community Up for Retirement Enhancement Act of 2019) (SECURE), which was signed into law on December 20, 2019, and which took effect on January 1, 2020, changes several familiar and fundamental rules governing the administration and taxation of individual retirement accounts (IRAs).[1]

1) IRA participants who are still working may continue to contribute to their accounts past age 70-1/2. The prior age 70-1/2 limit on further employee contributions has been eliminated.[2]

2) IRA participants must take required minimum distributions (RMDs) from their accounts beginning at age 72, up from age 70-1/2.[3]

3) The stretch distribution rules applicable to the beneficiaries of a participant’s IRA have, with certain important exceptions, now been eliminated in favor of a 10-year payout. The result is that many beneficiaries will now be forced to distribute their inherited IRAs sooner and at higher tax cost than would previously have been the case.[4]

Three Classes of Beneficiaries

For decedents dying on or after January 1, 2020, there are three classes of inherited IRA beneficiaries under SECURE:

Designated Beneficiaries — Individuals or trusts that qualify as “see-through” trusts. Designated beneficiaries must withdraw their inherited IRAs over 10 years’ time.[5]

Eligible Designated Beneficiaries — A subset of designated beneficiaries that includes 1) the surviving spouse of the participant; 2) a person who is not more than 10 years younger than the participant; 3) a minor child of the participant; 4) a disabled individual; or 5) a chronically ill individual.[6] Eligible designated beneficiaries may stretch distributions over their lifetimes;[7] but upon the death of the eligible designated beneficiary, the inherited IRA must be paid out within 10 years.[8]

Non-Designated Beneficiaries — Estates, charities, or trusts that do not qualify as “see-through” trusts. Non-designated beneficiaries must pay out the inherited IRA within five years’ time (if the participant died before his or her required beginning date, now age 72) or over the deceased participant’s remaining life expectancy (if the participant died after his or her required beginning date).

Eligible Designated Beneficiaries Can Stretch

Status as an eligible designated beneficiary is determined as of the participant’s death. Surviving spouses of account owners enjoy preferential treatment. As an eligible designated beneficiary, a surviving spouse who takes the IRA as an inherited account may withdraw funds over his or her life expectancy. A conduit trust for the benefit of the surviving spouse will also qualify for a life-expectancy payout. An accumulation trust, in contrast, which does not mandate that all retirement plan assets paid to the trust be distributed to the spouse, does not qualify as an eligible designated beneficiary, and the 10-year rule will apply.

A surviving spouse named as outright IRA beneficiary has the further option to roll the decedent’s IRA into his or her own account, in which case the spouse would not be required to begin taking minimum distributions until age 72. Spouses who may need to access the IRA funds before age 59-1/2 should consider carefully whether to proceed with a rollover. In such cases, it may be best for the spouse to take the account as an inherited IRA; otherwise, a 10% early withdrawal penalty will apply to any rolled-over funds that are accessed sooner than age 59-1/2 (in addition to any income tax due).

A person who is not more than 10 years younger than the deceased account owner is also an eligible designated beneficiary who may stretch distributions. The decedent’s siblings, friends, or significant other might fit into this category, as would any beneficiary who is older than the decedent.

A minor child of the deceased participant may use the life-expectancy method, at least initially; but once the child attains the age of “majority,” the 10-year rule applies. Generally, the state law definition of majority will govern (meaning age 18 in Florida), but certain children may be able to extend the age of majority to age 26, due to an exception for “a child who has not completed a specified course of education and [who] is under the age of 26.”[9] Further guidance from the IRS will be required as to the specific contours of this exception, but it appears that in at least some cases, the payout of a child beneficiary’s share may be extended until that child has attained age 36. Keep in mind that this rule applies only to minor children of the participant, and not to minor grandchildren or to any other beneficiaries who are minors; the 10-year rule will apply to those beneficiaries, regardless of their age.

A disabled or chronically ill person may also take lifetime distributions. An individual is disabled under SECURE if he or she meets the definition of Internal Revenue Code §72(m)(7), which means that he or she is “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.” A person who qualifies for Social Security disability will satisfy this requirement. An individual is chronically ill if he or she meets the definition of I.R.C. §7702B(c)(2), meaning that he or she is unable to perform at least two activities of daily living without substantial assistance from another individual for a period of at least 90 days or if he or she requires substantial supervision to protect him or her from threats to health and safety due to severe cognitive impairment. The secretary of the treasury may require proof of disability or chronic illness.

Because a beneficiary’s status as disabled or chronically ill is determined as of the account owner’s death, a designated beneficiary who is well at the participant’s death but who later becomes disabled or chronically ill may not switch from the 10-year rule to a life-expectancy payout.

SECURE makes clear that a trust for the benefit of one or more disabled or chronically ill eligible designated beneficiaries, even an accumulation trust, will qualify for the stretch distribution payout, provided that no one who is not a disabled or chronically ill eligible designated beneficiary may become a beneficiary until after the death of all disabled or chronically ill eligible designated beneficiaries. Care must be taken when drafting such trusts not to include any beneficiaries who are not disabled or chronically ill.

Pre-2020 Deaths

Because the new rules under SECURE apply only to accounts of decedents dying on or after January 1, 2020, beneficiaries of decedents dying prior to 2020 may continue to apply the prior law and stretch distributions over their lifetimes.

Specifically, SECURE does not affect beneficiaries of inherited IRAs already in payout status from decedents who died years ago. Those beneficiaries may continue to take life expectancy distributions; however, upon the death of each such inherited IRA beneficiary, the 10-year rule will apply to the beneficiaries they name.

Special attention should be paid to estates of 2019 decedents. Beneficiaries of decedents dying late in 2019 should consider the strategic use of disclaimers. For example, if Wife passed away on December 1, 2019, leaving her entire $5 million IRA (as well as the balance of her estate) to Husband, Husband might consider disclaiming all or a portion of Wife’s IRA so that the IRA passes to the contingent beneficiaries (for example, their children or trusts for their children), provided that Husband has sufficient other assets available to him. So doing would permit those contingent beneficiaries to take advantage of the pre-SECURE stretch distribution payout.

Ten-Year Rule: Income Tax Planning for Beneficiaries

When the 10-year rule applies, the entire IRA account must be paid out by December 31 of the year containing the 10th anniversary of the decedent’s death.[10] Although referred to as a “10-year rule,” the actual payout period will in most cases extend over 11 taxable years. Spreading distributions over 11 rather than 10 years may help beneficiaries both to defer payment of the tax and reduce the overall tax rate.

Note also that when the 10-year rule applies, there is no requirement for proportionate payouts over the 10-year period (1/10 in year 1, 1/9 in year 2, 1/8 in year 3, etc.). Nor is there any required minimum distribution that must be made in any particular year of the 10-year period. This creates both an opportunity and a challenge for designated beneficiaries to optimize the payout of their inherited IRA shares from an income tax planning perspective.

As to Roth IRAs, the inheriting beneficiaries will likely do best to defer distribution of their accounts for as long as possible. Not every beneficiary will have the discipline or the financial ability to defer such distributions for the entire 10-year period, but those who can should maximize the tax-free growth of the inherited IRA assets.

As to traditional IRAs, however, depending on the size of their inherited IRA shares, beneficiaries will likely want to spread out their distributions over time, withdrawing some amount each year so as not to cause an undue bunching of taxable income at the end of the 10-year distribution period. That said, each beneficiary has flexibility over the 10-year time horizon to determine what amount to distribute in each particular year, and may elect to take larger distributions in lower-income years when those distributions will be taxed at lower marginal rates and smaller distributions in higher-income years when those distributions will be taxed at higher marginal rates.

Strategies for Advising Clients

The most significant downside to SECURE is the bunching of taxable income it can cause for beneficiaries under the 10-year rule. Whereas previously beneficiaries could have drawn down the account over many years if not decades, now the entire account must be paid out in 10 years’ time. This compressed tax schedule will most likely impact 1) those with larger retirement accounts; 2) those whose accounts are to be divided among a relatively small number of beneficiaries, such that each beneficiary’s share will be relatively large; 3) those whose beneficiaries are in high marginal income tax brackets or who live in high income tax states; 4) those who previously named grandchildren as beneficiaries to obtain the longest stretch deferral under prior law; and 5) those who designate trusts to receive their retirement plan assets at death.

Clients can take steps to mitigate this problem. A few options are:

Contribute Less — Clients who are still working and contributing to their retirement plans may want to contribute incrementally less to those plans going forward.

Draw Down the Taxable Accounts Faster — Clients over age 59-1/2 might consider drawing down their taxable accounts now, a little bit each year, perhaps sooner and at a faster rate than they might otherwise have done but for the changes under the new law. The strategy is to withdraw incrementally more than the RMD, and to use such funds for current consumption, taxable savings, gifting, Roth conversions, or the like.[11] Bracket management will be critically important — this is a strategy to be implemented over many years consecutively (potentially for 20 to 30 years’ time), and clients need not and likely will not wish to venture into significantly higher marginal tax brackets when pursuing this strategy.

Split Up the Account Differently — Frequently, clients will default to naming their surviving spouse as 100% primary IRA beneficiary and their children as 100% contingent IRA beneficiaries. If, however, it is anticipated that the surviving spouse will have adequate assets available to him or her, the client might consider designating a portion of the IRA to the children directly. So doing will allow the children to start a separate 10-year payout period running as to that portion received, and will avoid having 100% of both spouses’ IRAs bunched together to be received by the children at the death of the surviving spouse.

Convert to Roth — Roth conversions may become increasingly popular. Clients might consider making a series of Roth conversions starting now, a little bit each year, year after year. As with the incremental distribution strategy above, the cumulative benefit of staged Roth conversions over 20 to 30 years can be substantial.

Roth conversions make especially good sense for clients who are likely to have taxable estates, for those whose IRAs need to be paid to accumulation trusts, and for those with unused charitable carry forwards, net operating losses, or current-year ordinary losses, which can be absorbed in the Roth conversion.

Benefit Charity — Because charities will pay no tax on IRA distributions received, clients who are charitably inclined may wish to give more to charity from their IRA accounts. Such gifts may be accomplished during the participant’s lifetime as qualified charitable distributions or at death by beneficiary designation.

A second charitable planning option involves designating a charitable remainder trust (CRT) to receive IRA assets at death. The CRT is tax-exempt and can receive the IRA assets with no tax consequence. The trust pays an annual annuity or unitrust distribution (5% to 50%) to the beneficiary for life (or for a term of up to 20 years), and upon expiration of the trust term, the balance of the CRT is distributed to one or more charities. The annual CRT payments to the individual beneficiary are taxed first as ordinary income, to the extent of the trust’s current and accumulated ordinary income, and thereafter as capital gains.[12]

To many clients, the CRT has some appeal. It looks like the prior stretch distribution rule in that a certain amount is paid to the beneficiary each year. But the CRT beneficiary receives only a fixed annuity or unitrust amount each year (and nothing more), and that amount must be paid to the beneficiary outright and not in trust (with a limited exception for special needs trusts). This contrasts with the stretch IRA, where the beneficiary was required to receive at least the RMD each year, but could always take out more in any particular year if needed (subject to additional income tax).

A significant concern associated with the CRT is the risk that the individual beneficiary may die shortly after the trust is funded, thereby causing the charitable remainder beneficiary to receive substantially more wealth than the IRA account owner likely intended. One way to mitigate that risk is to use a two-life CRT (e.g., unitrust to Child A for life, then unitrust to Child B for life, then all to charity); another is to insure the life of the individual beneficiary.

Combination of Strategies — In some cases, it may be appropriate to combine one or more of the foregoing strategies to help relieve the compression of taxable income facing future designated beneficiaries.

Conduit and Accumulation Trusts Still Viable, But Not as Attractive

Many clients create trusts to receive their IRA assets at death. Apart from charitable remainder trusts, most such plans involve the use of either a conduit trust or an accumulation trust.

Conduit trusts are a type of “see-through” trust, which mandate that all distributions paid from the IRA to the trust be distributed promptly to the trust beneficiary. Conduit trusts can still work well under the new law when established for certain eligible designated beneficiaries, such as a surviving spouse, a very young minor child, or a person not less than 10 years younger than the participant. These persons may continue to stretch their distributions (the minor child only until reaching the age of majority, at which time the 10-year rule begins to run). Care should be taken when drafting these trusts to benefit the eligible designated beneficiary as the only beneficiary during his or her lifetime, in order to be sure to qualify for stretch distribution treatment.

For all other types of designated beneficiaries, however, the most significant classes of which are adult children or grandchildren who are not disabled or chronically ill, conduit trusts are no longer appropriate. That is because conduit trusts created for those persons do not qualify for stretch distributions and the retirement plan assets must be paid out — first to the trust and then in turn to the trust beneficiary — within 10 years of the account owner’s death. In other words, those trusts won’t work any longer as previously intended to preserve and distribute the retirement assets over the beneficiary’s lifetime.[13]

As conduit trusts decline in their usefulness, accumulation trusts will gain prominence. Accumulation trusts are more flexible than conduit trusts because they permit the trustee to accumulate or distribute IRA assets to trust beneficiaries as the trustee deems advisable.[14] Under the new 10-year rule, the inherited IRA account will need to be paid in full to the accumulation trust within 10 years’ time, but not necessarily to the trust beneficiary.[15]

The major drawback of the accumulation trust is that retirement plan distributions made to the trust but not distributed to a beneficiary will be taxed at the highest marginal income tax rate of 37% after only $12,950 of accumulated taxable income. This tension may cause trustees to favor a more liberal distribution policy than might otherwise be preferred. On the one hand, the trustee is balancing the need to minimize overall income taxes by paying the retirement funds out to the beneficiary. On the other hand, the trustee is also considering the asset protection advantages and the interests of the presumptive remainder beneficiaries by accumulating retirement plan assets within the trust.[16]

An accumulation trust that benefits many individuals among whom distributions could be sprinkled may offer an attractive alternative. Such a trust offers the chance for the trustee to spread the taxable income among many different taxpayers, each of whom would report his or her share of income on his or her separate individual income tax return, where it would be taxed at the more favorable individual income tax rates (as compared with the compressed trust tax rates). An independent trustee vested with broad discretion to make distributions can help to maximize flexibility to shift income among the trust and its beneficiaries in each taxable year.[17]

Many important questions remain unanswered regarding trust planning to receive retirement benefits under SECURE. These will likely be clarified over time through updated Treasury Regulations and through other administrative authorities, such as Private Letter Rulings, in the coming months and years. In the meantime, practitioners are advised to proceed cautiously and carefully when pursuing IRA trust planning options.

[1] SECURE is found within the 2020 Further Consolidated Appropriations Act.

[2] Previously, contributions were prohibited for taxpayers beyond age 70-1/2. The new law eliminates the age cap for taxpayers who continue to work beyond retirement age. The $100,000 limit on qualified charitable distributions is reduced by the amount of deductible IRA contributions made after age 70-1/2. People who continue to work past age 70-1/2 and who later intend to make charitable contributions could avoid application of this rule by contributing only to their workplace 401(k) plan after age 70-1/2.

[3] Each taxpayer must take his or her first RMD by April 1 of the year after the year in which the taxpayer reaches age 72. Most taxpayers will take this first distribution in the year they actually reach retirement age, and will not wait until the following April 1, in order to avoid a double payment in that subsequent year, given that the RMD for the subsequent year must be taken by December 31 of that year. Taxpayers turning age 70-1/2 on or before December 31, 2019, must start taking their RMDs by April 1 of the year after the year they turned age 70-1/2. Account owners turning 70-1/2 in 2020 or later don’t need to start taking RMDs until April 1 of the year after they turn age 72.

[4] SECURE repeals the 2017 Tax Cuts and Jobs Act changes to the “kiddie tax.” The child is now taxed at his or her parents’ rates rather than at the estate and trust income tax rates.

[5] See I.R.C. §401(a)(9)(H)(i).

[6] See I.R.C. §401(a)(9)(E)(ii).

[7] See I.R.C. §401(a)(9)(H)(ii).

[8] See I.R.C. §401(a)(9)(H)(iii).

[9] See Treas. Reg. §1.401(a)(9)-6, Q&A 15.

[10] See Treas. Reg. §1.401(a)(9)-3, A-2.

[11] Participants over age 70-1/2 have the additional option to make qualified charitable distributions (QCDs) directly to charity.

[12] Because at least some portion of the IRA will ultimately be distributable to charity, it is important that the client have at least some charitable intent for this strategy to be palatable.

[13] If an IRA account owner dies with a conduit trust in place, it may be possible to judicially modify the trust to an accumulation trust. See Fla. Stat. §§736.04113(1)(b) & 736.0416. Under Fla. Stat. §736.04113(1)(b), a court may modify a trust if, because of circumstances not anticipated by the settlor, compliance with the terms of the trust would defeat or substantially impair the accomplishment of a material purpose of the trust (i.e., deferring income taxation and keeping assets out of the hands of the trust beneficiary). Under Fla. Stat. §736.0416, a court may modify the terms of a trust, in a manner not contrary to the settlor’s probable intent, in order to achieve the settlor’s tax objectives (i.e., deferring income taxation of retirement benefits over the beneficiary’s life expectancy rather than over 10 years).

[14] Prior accumulation trust form language can likely be updated to remove provisions restricting the ability to appoint or distribute retirement assets to older adopted descendants or to older individual remainder beneficiaries. Be careful, however, to retain language excluding the ability to appoint to charities. That language is needed to permit the accumulation trust to qualify as a “see-through” trust.

[15] There is, however, one type of accumulation trust for the benefit of a disabled or chronically ill person that can qualify for stretch distribution payout. Most commentators believe that a see-through accumulation trust for the surviving spouse (such as an income-only marital trust) will generally not be eligible for the life expectancy payout.

[16] If a client has a strong income tax minimization objective, consideration should be given to including language favoring distributions that would minimize overall income taxation. In most cases where trust planning is needed for retirement benefits, tax considerations, while important, are not the paramount concern.

[17] Other creative planning options in this area include the beneficiary deemed owner trust (BDOT) and the tax efficient accumulation (TEA) pot trust system. See Ed Morrow, Using BDOTs for Optimal Asset Protection and Income Tax Minimization After Passage of the SECURE Act, LISI Inc. Tax Plan Newsl. 192 (Feb. 18, 2020). See also Alan S. Gassman, Christopher J. Denicolo & Brandon Ketron, Feeling InSECURE with Estate Planning for Your Large IRA? Then Consider the “TEA POT” Trust System, Unless Paying Taxes Is Your Cup of Tea, LISI Empl. and Retirement Plan Newsl. 716 (Jan. 7, 2020).

Alfred J. Stashis, Jr.Alfred J. Stashis, Jr. is a shareholder with Dunwody White & Landon, P.A., in Naples. He is board certified in wills, trusts, and estates and currently serves as co-chair of the section’s IRA, Insurance & Employee Benefits Committee.

This column is submitted on behalf of the Real Property, Probate and Trust Law Section, William Thomas Hennessey III, chair, and Douglas G. Christy and Jeff Goethe, editors.

Real Property, Probate and Trust Law