The Setting Every Community Up For Retirement Enhancement (“SECURE”) Act, which was enacted into law last month, changed the rules governing the payout of inherited retirement benefits and essentially eliminated the “stretch IRA” option for most beneficiaries who inherit retirement accounts. Below is a brief overview of the changes made to the payout of inherited retirement benefits, along with highlights of a few other provisions of the SECURE Act that impact individuals.
CHANGES TO PAYOUT OF INHERITED BENEFITS
Payout of Inherited Retirement Benefits Pre-2020 (Old Law). Prior to the SECURE Act, if an individual or specially designed trust (known as a “see through” trust) had been named as the beneficiary of retirement benefits, the individual or trustee could have withdrawn the minimum required distributions from an inherited IRA gradually over the life expectancy of the beneficiary. For example, a 55-year-old individual (or trustee of a “see through trust” of which a 55-year-old was the oldest beneficiary) could withdraw an inherited IRA over a period of 29.6 years, and a 25-year-old beneficiary could withdraw the retirement account over 58.2 years. This popular planning technique was referred to as a “stretch IRA” and allowed the beneficiary to defer income taxes on the plan proceeds and maximized tax-free compounding while the funds remained inside the retirement account.
Payout of Inherited Retirement Benefits Under SECURE Act (New Law). The SECURE Act creates a 10-year payout period for all but five categories of “eligible designated beneficiaries”. Under the 10-year payout method, the entire retirement account must be distributed by December 31 of the 10th anniversary year of the account owner’s date of death. Withdrawals do not need to be made pro rata, nor do they need to be made every year, though the funds must be entirely withdrawn by the deadline.
The term “eligible designated beneficiary” refers to the five categories of beneficiaries who are still entitled to a life expectancy payout method. They are:
- Surviving spouse. The surviving spouse may withdraw retirement benefits based on his or her life expectancy.
- Minor child of the account owner. A minor child of the account owner may withdraw retirement benefits based on the child’s life expectancy until he or she attains the age of majority, at which time he or she will then have 10 years to withdraw the entire retirement account. Note that this exception applies only to a minor child of the account owner and does not apply to grandchildren, nieces, nephews or other minors.
- Disabled beneficiary. A beneficiary who is considered disabled under the Internal Revenue Code may use his or her life expectancy to determine the payout period.
- Chronically-ill individual. A beneficiary who is considered chronically-ill under the Internal Revenue Code may use his or her life expectancy to determine the payout period.
- A beneficiary who is 10 or fewer years younger. A beneficiary not more than 10 years younger than the account owner may use his or her life expectancy.
What this means for clients who name trusts as beneficiary of retirement plans. Often clients leave retirement benefits to a trust for the benefit of their loved ones rather than naming the beneficiaries directly. The most common reasons for doing so are to control the disposition of the funds, provide creditor protection for the beneficiaries, ensure that a beneficiary will not withdraw the entire account at once, and/or plan for the possibility that a beneficiary may die prematurely. Because the payout period for most trusts has changed dramatically under the SECURE Act, naming a trust as beneficiary of retirement accounts may now produce unexpected results that are inconsistent with the client’s original reasons for naming a trust as beneficiary. For example:
- Some trustees will be required to distribute the retirement benefits outright to the trust’s beneficiary within 10 years after the client’s death.
- Although some trustees may be authorized to accumulate the retirement benefits in the trust, they will need to withdraw the benefits within 10 years after the account owner’s death. This could cause substantial income taxes because trusts reach the highest federal income tax bracket at significantly lower thresholds than individuals. (Trusts in 2020 are taxed at the highest federal income tax rate of 37% on taxable income over $12,950.)
Of course, the effect of the SECURE Act on trusts named as beneficiaries of retirement plans will depend on the terms of each particular trust.
OTHER CHANGES. Other changes in the SECURE Act will impact clients’ retirement accounts during their lifetimes, including the following highlights:
Repeal of Maximum Age for Traditional IRA Contributions. The rule that prohibited contributions to a traditional IRA by taxpayers aged 70 ½ or older was repealed. Any individual who has earned income from wages or self-employment may now continue to contribute to a traditional IRA.
Increase in Age for Required Beginning Date for Mandatory Distributions. Individuals who attain age 70 ½ after December 31, 2019, are not required to begin taking distributions from their retirement plan or IRA until attaining age 72.
CHECKLIST – WHAT TO DO NEXT.
We recommend that clients take the following steps:
- Confirm who is named as beneficiary and contingent beneficiary of your retirement benefits.
- If a trust is the named beneficiary, consider your reasons for naming a trust and discuss with your estate planning attorney to determine if your goals can be accomplished as intended.
- There may be an opportunity to change the beneficiary by “disclaiming” retirement benefits within nine months of the account owner’s death. This could be used to take advantage of the stretch IRA in certain circumstances.
- Contact us if you would like us to review how the SECURE Act impacts how your retirement benefits will be distributed at death.