The Secure Act, the most significant retirement legislation in more than a decade, was signed into law on December 20, 2019.
Some of the biggest features of the new law include removing the age limit restricting IRA contributions, raising the age at which people need to start taking required minimum withdrawals to age 72, and removing the ability of non-spousal beneficiaries of an inherited IRA to stretch distributions over their lifetimes.
It is the last element of the new law (removing the ability of non-spousal beneficiaries to stretch distributions over their lifetimes) that will affect estate planning.
Prior to the Secure Act, the law allowed beneficiaries who inherit an IRA, 401(k) plan or other retirement account from a non-spouse to take annual distributions over their life expectancy. According to an article in Barron’s, this law has created a loophole that allowed wealthy investors to stretch the tax advantages of an IRA across multiple generations.
The Secure Act changes this paradigm. Going forward (after December 31, 2019) if you inherit an IRA, 401(k) or similar retirement account from someone other than a spouse, you are required to deplete the account (and pay taxes on it) within 10 years. Required minimum distributions are no longer necessary, but again, all funds must be paid out within 10 years. There are some exceptions for beneficiaries who are minors, disabled, chronically ill, or less than 10 years younger than the account owner.
Death of the Stretch IRA
Under the old law, folks with large IRAs would often name a trust as their IRA beneficiary or contingent beneficiary. Doing so allowed them to provide asset protection by controlling distributions to their beneficiaries, and to stretch the IRA for several decades by drafting the trust to qualify as a “see-through trust” as either a conduit trust, or as an accumulation trust. Under the new law however, such plans will no longer accomplish those objectives.
IRAs Held in Conduit Trusts Will Have to Be Paid Out Within 10 Years
With a conduit trust, RMDs were paid to the trust beneficiaries each year. No RMDs remained in the trust to be taxed at high trust tax rates. Instead, the beneficiaries paid tax on the RMDs at their own personal tax rates. After the Secure Act however, there will be no RMDs, but at the end of 10 years the entire balance in the inherited IRA will have to be paid out, leaving the beneficiaries with a hefty tax bill and no more IRA funds protected in the trust.
IRAs Held in Accumulation Trusts Will Be Heavily Taxed
With an accumulation trust, the trustee had discretion on whether to pay out the RMDs to the beneficiaries or to retain them in trust in order to preserve them with asset protection. Under the old law, if the RMDs were retained in trust, they were taxable to the trust at the high trust tax rates (which was the tradeoff for providing asset protection to the RMDs) and the remainder of the account continued to grow tax deferred. Under the new law, all of the inherited IRA funds will have to be paid to the trust by the end of the 10 years. Unlike the conduit trust, however, the trustee of an accumulation trust does not have to pay out all of the funds to the trust beneficiaries after year 10. Therefore, the funds can still remain in the trust with asset protection, but at what cost? All funds remaining in the trust would be taxed at trust tax rates. In other words, keeping the funds in the accumulation trust after year 10 will result in the highest payout taxation of the IRA account funds, which is a high cost for asset protection. It should be noted, however, that with Roth IRAs there is no tax on distributions to the trust (more on that later).
IRA Estate Planning Strategies Going Forward
Below are 5 steps to consider in light of the new law:
1) Select Beneficiaries Mindfully
With the stretch IRA no longer an option, strongly consider naming a spouse as the primary beneficiary so that the assets can be stretched across the surviving spouse’s lifetime. The ability of a surviving spouse to stretch an inherited IRA or elect a spousal rollover was not affected by passage of the Secure Act and therefore ought to be leveraged. At the surviving spouse’s death, the account can be passed from the surviving spouse to other beneficiaries such as children or grandchildren (at which time the 10 year payout rule will apply).
For those without spouses, or for contingent beneficiary designations after a primary beneficiary spouse, it will be important to be extra mindful of who you name as beneficiaries in light of the mandatory 10 year payout. For example, one way to minimize taxes for a family with five heirs is to name each as a beneficiary, so that the tax bill can be paid over a decade by each—or 50 tax returns, says Christian Cordoba, a financial planner and founder of California Retirement Advisors in El Segundo, California.
If you decide to name minor children as beneficiaries, the clock on the 10 year payout required by the Secure Act will not begin to tick until the child turns 18. In other words, they would be looking at a mandatory payout at age 28.
With grandchildren, on the other hand, the clock on the 10 year payout will begin immediately. Therefore, a grandchild age 5 at the time of an account owner’s death will have to empty the entire account at age 15.
2) Review and Reassess Trusts
It is important to review and reassess all trusts of which a retirement account is named as a beneficiary in light of the mandatory, 10 year lump sum payout imposed by the Secure Act. As discussed above, the mandatory withdrawal provisions of conduit trusts (which has been the default strategy for many years) will result in the entire account being distributed to the beneficiary within 10 years, resulting in taxes and a loss of asset protection. That was likely never contemplated at the time the trust was initially drafted and should therefore be reviewed and potentially revised in favor of either individual beneficiary designations such as the example above, or spray trusts that allow for a trustee to distribute the account income to the beneficiaries with the lowest tax brackets.
If asset protection is of utmost importance, as is the case with spendthrift heirs, those with high liability risk, or heirs with special needs who are receiving “means based” public assistance, trust provisions must be reviewed by an estate planning attorney and likely revised to accomplish the goal of asset protection. In that case, revising conduit trusts to qualify as accumulation trusts, or simply removing the conduit trust provisions altogether and causing the trust to fail as a designated beneficiary (resulting in a five year mandatory payout to the trust, as opposed to 10, but allowing the funds to continue to be retained in a discretionary asset protection trust thereafter), are viable options to preserve asset protection.
3) Consider a Charitable Remainder Trust (CRT) as a Beneficiary
Use of the CRT has declined in recent years due to the high federal estate tax exemption. However, they may be poised for a resurgence due to the Secure Act, and the CRT’s ability to mimic some of the favorable stretch provisions of the old law. With a CRT, assets are transferred to an irrevocable trust that “bifurcates” the assets into an annuity stream of income for the beneficiaries of the trust (who can be children or others) with the assets remaining at the end of the trust passing to a charity. The annuity income stream can be for the lifetime of the beneficiary, or the lives of beneficiaries in multiple succession, or for 20 years if there is no measuring life.
Therefore, by making a CRT the beneficiary of a retirement account, the beneficiaries will be entitled to annual annuity payments from the trust for the remainder of their lives. As an asset of the CRT, the retirement funds will grow tax deferred (charities do not pay tax). Income tax will only be paid on the annual payments to the beneficiaries, typically as ordinary income, throughout their lifetimes. As you can see, the CRT does a decent job of mimicking the former stretch IRA rules.
The caveat, because the CRT is, after all, a charitable trust, is that at least 10% of the retirement account funds must eventually pass to a charity when the trust term ends. That being said, if one is comfortable with a charity getting a cut of at least 10% of the pie, and the annuity payments being relatively fixed (no ability to withdraw more than the specified dollar amount or percentage in any given year), using the CRT as a retirement account beneficiary is a way to mimic the former stretch IRA concept after passage of the Secure Act.
4) Use Life Insurance for Estate Planning
According to Ed Slott, a retirement expert and founder of IRAHelp.com, life insurance will emerge as a better, more tax-efficient estate planning vehicle than the IRA. According to Slott, affluent clients who don’t need the money would be better off withdrawing the IRAs now at today’s low tax rates, and investing the balance after tax in life insurance, which can payoff many multiples of the IRA, all tax free!
The life insurance proceeds can then left to a discretionary spendthrift trust to gain the trust’s asset protection. Life insurance is a more flexible asset to leave to a trust, free from the complexities and tax burdens associated with retirement accounts.
5) Roth Conversions
These may become more popular after passage of the Secure Act. According to Vanguard, a Roth conversion refers to taking all or part of the balance of an existing traditional IRA and moving it into a Roth IRA, which allows for a future tax-free withdrawal.
Ed Slott suggests that folks who have accumulated roughly $1 million to $5 million in IRAs consider the following to pass it on to their heirs: Take advantage of the low tax rates until 2025 by doing piecemeal Roth conversions over a number of years to build a tax-free account you can leave to your beneficiaries. That’s an enticing option considering that your heirs will face high tax rates if they are in higher brackets. Those mandatory 10 year payouts from a traditional IRA can amount to a major tax hit when compared to a Roth account which passes tax-free.
If we take it one step further, using the Roth that is paid out to a discretionary spendthrift trust can provide your heirs with a controllable stream of income and lifetime asset protection.
If you have retirement accounts, especially larger ones, the Secure Act may have a significant impact on your estate planning. Now is the time to review what you have done in the past and be sure that it best meets your objectives in light of the new law. If you are just getting started with estate planning for the first time, be sure you work with an estate planning attorney who has a strong working knowledge of the concepts discussed here. Feel free to contact my office and mention this article if you’d like to be scheduled for a personal consultation.