The Setting Every Community Up for Retirement Enhancement (“SECURE”) Act became effective January 1, 2020. The effect of the changes on your estate plan depends on the type of assets you own. If most of your wealth is in tax-deferred retirement accounts, the changes could mean that your estate plan won’t work as expected.
Background
To understand these changes, you must first understand some background. The spouse of a retirement plan participant may roll the deceased spouse’s retirement account over to his or her IRA. However, the rules for non-spouse beneficiaries are more complicated.
When a plan participant dies naming someone other than a “designated beneficiary,” the assets in the account must be distributed within five years. Designated beneficiaries get special treatment. Federal law defines designated beneficiary to mean any individual designated as a beneficiary. However, Treasury Regulations provide that the beneficiaries of certain Trusts also qualify as designated beneficiaries if we can “see through” the Trust to the individual.
There are two types of see-through Trusts. “Conduit trusts” are drafted such that required minimum distributions (“RMDs”) must be disbursed directly to the beneficiary. This simplifies the drafting and administration to ensure that the Trust qualifies as a see-through Trust. But in many cases, we need to protect RMDs as well as the remaining principal. Accumulation Trusts do not require RMDs to be disbursed. The RMDs may instead be held inside the Trust and re-invested. Accumulation Trusts that do not qualify as see-through Trusts must withdraw all assets from the IRA within five years.
The Rules for Spousal Roll Overs Remain Consistent
The options for leaving benefits to the surviving spouse have changed little. If a surviving spouse is named as an outright beneficiary, he or she still has the option to roll over the inherited benefits to his or her own IRA. The election and rollover rules are not affected by the SECURE Act. However, there will be some changes to Trusts for spouses. The SECURE Act will not affect a conduit Trust for the surviving spouse while he or she is living. However, what happens after the surviving spouse’s death could change. Accumulation Trusts will not be exempt from the new rules.
Changes for Non-Spouse Beneficiaries
Before the SECURE Act, when a plan participant left his or her retirement account to a non-spouse “designated beneficiary,” the account had to be distributed over the life expectancy of the beneficiary. The SECURE Act requires most designated beneficiaries to withdraw the entire balance of an inherited retirement account within 10 years of the account owner’s death. There are no RMDs during this 10-year period. The beneficiary may wait the entire 10 years or may take out a certain amount each year. Minimizing taxes will require some math.
The Exceptions to the 10-Year Rule
There are several exceptions to the 10-year withdrawal rule. Spouses, beneficiaries who are not more than 10 years younger than the account owner, the account owner’s children (not grandchildren) who have not reached the “age of majority,” and disabled and chronically ill beneficiaries are all exempt. These are called “eligible designated beneficiaries.” The old rules apply to eligible designated beneficiaries. It also appears that conduit Trusts for eligible designated beneficiaries will still receive a life expectancy payout. However, accumulation Trusts will only be eligible for a life expectancy payout for beneficiaries who are disabled or chronically ill.
Implications for Estate Plans
The tax issues related to these changes are obvious for large accounts. If a 40-year-old inherited a $1M IRA from a parent in 2019, the principal and growth would have been taxed over approximately 43 years. Under the new rules, it will all be taxed within 10 years. This could also push the beneficiary into a higher income tax bracket. Therefore, these changes will not only speed up the time frame for payment of taxes, but will also minimize tax-deferred growth, and increase the total tax burden. As the amount of tax-deferred assets left to each individual increases, the effects become more dramatic.
This change will also reduce asset protection. North Carolina is one of eight states that has statutory creditor protection for inherited IRAs. However, the SECURE Act has drastically reduced that protection. When most of the account could be protected for several decades, protecting the RMD was less of a concern. Creditor protection is now limited to 10 years. If you leave an IRA to your son in year one and a judgement is entered against him in year two, he must withdraw all the money before the judgment expires. Then pay taxes. Then pay the creditor. Consider the effect of a distribution from a large IRA when a child is going through a divorce, has a tax lien, or is in the middle of a lawsuit. The possible negative consequences are endless.
When You May Wish to Change Your Trusts
Conduit Trusts were often used as a middle ground. They were easy to draft and could be used to protect principal. We could put conduit Trust language in a Trust created for children under your Will or Revocable Trust and be confident that the Trust would qualify as a designated beneficiary without having to draft a separate Trust. If a child died at a young age, we could ensure that the remaining balance went to grandchildren. Conduit Trusts still work. But they will only work for a maximum of 10 years. They were more useful when they could last for decades. If asset protection is important, an accumulation Trust should be considered. In many cases, we may be able to simply remove conduit provisions from your Will or Revocable Trust.
Other Strategies to Consider
Many of the strategies that could result in better asset protection and lower tax rates will require interaction between your financial advisor, accountant, and lawyer.
Leaving Roth IRAs to an accumulation Trust will give maximum tax and asset protection. Non-spouse beneficiaries will be able to hold inherited IRAs in trust and pay no income tax for 10 years after your death. After that 10-year period, the assets will still be protected from creditors. This tax-free growth, held in trust and protected from creditors, divorce, and other problems, is a powerful way to transfer assets at death.
The new rule may result in the amount of cash available to beneficiaries being less than originally anticipated. In order to help offset this shortfall, some people may wish to consider using funds from their retirement accounts during their life to purchase additional life insurance that is payable to asset protection Trusts. This can be done several different ways. This life insurance can be paid to the same Trust as other accounts. For clients who wish to protect assets from the cost of long-term care, it may be more important than before to create a separate Trust to hold life insurance. With estate tax exemptions set to be cut in half in 2026, this may also be an appropriate time to reconsider irrevocable life insurance Trusts.
If you are charitably inclined, a charitable remainder Trust (“CRT”) may be the right solution to plan for the disposition of retirement accounts. A CRT would allow your named beneficiaries to receive an income stream from the retirement account with the remainder going to a charity named in the trust agreement. Upon your passing, your estate will receive a charitable deduction for distributing the retirement account to the Trust, and the distribution from the retirement account to the CRT is not taxed. However, distributions from the CRT to the beneficiaries will be subject to income tax.
Conclusion
Given these significant changes, if your estate is comprised primarily of tax-deferred retirement plans, you should review the plan with your financial advisor, attorney, and accountant.