In December 2019 President Donald Trump signed into law the Secure Act, which is a misleading acronym, in that “secure” stands for “Setting Every Community Up for Retirement Excellence,” yet rather than set every community up for retirement excellence, the real purpose of the law is to accelerate the recognition of tax on retirement plan distributions by accelerating the distribution of retirement benefits. The law does this by doing away with the “stretch IRA provision” and mandating that after a person dies their IRA be distributed within ten years of their death.[1] Previously the stretch IRA provision allowed the beneficiary of an IRA to stretch IRA distributions over their life expectancy. For younger beneficiary’s this could mean taking distributions over a 30, 40 or even 50 year period. Now that same beneficiary must take all distributions within ten years. So, the law effectively diminishes the value of inherited IRAs because the IRA can no longer grow tax free over the beneficiary’s life expectancy and taxes are no longer deferred over the beneficiary’s life expectancy.[2] The Secure Act’s effect on estate planning begs two questions: 1. If you have an estate plan, does that estate plan need to be updated? 2. If you do not have an estate plan or your estate plan does need to be updated, how do we best plan for the distribution of your IRA to your beneficiaries in the most tax efficient way possible?
Does My Estate Plan Need to be Updated?
Based on the provisions of the Secure Act, if your estate consists of an IRA you may need to revise your estate plan. Prior to the passage of the Secure Act, a primary planning objective with IRAs was to stretch IRA distributions after death for as long as possible. The typical way that was done was by placing the IRA into a conduit trust upon passing. A conduit trust basically mandated that the IRA be paid out over the life expectancy of the beneficiary. Prior to the passage of the Secure Act conduit trusts worked to stretch the IRA distributions over many years. With the Secure Act’s new ten year rule, a conduit trust would mandate that the IRA be paid out to the beneficiary fully over the ten years. This may not be ideal.
The ten year rule states that the IRA must be paid out in ten years, not over ten years. The beneficiary can allow the IRA interest to grow over the ten years and take a full distribution of the IRA assets at year ten. For this reason you may want to revise your estate plan to convert the conduit trust to an accumulation trust, which accumulates the IRA income and does not have to distribute it to the beneficiary each year, and then pays out at year ten or holds the IRA distributions for the beneficiary’s life, but this may have its own problems, as will be discussed below.
How Do I Best Plan for Distribution of my IRA to my Beneficiaries?
First, the rules for transfers of an IRA to a spouse remain, for the most part, unchanged from prior to the passage of the Secure Act. So, upon your death your spouse will still be able to stretch distributions over their life expectancy.
When naming a spouse as beneficiary of an IRA there are three possible methods to consider. The first method is naming your spouse as the outright beneficiary of the IRA. Your spouse can then roll your IRA over into their own IRA and defer tax for their life expectancy. Second, you could leave the IRA to a conduit trust for the benefit of your spouse. Since your spouse can still stretch distributions out over their life expectancy, and would not be subject to the ten year rule, the trust would only distribute the required minimum distribution to your spouse each year. The benefit of this is you can dictate how anything left in the trust passes upon your spouse’s death. However, be forewarned, if your spouse lives to their life expectancy, the whole IRA will have been paid out and there will be no assets left for whomever you designate as the beneficiary of the trust after your spouse’s passing. Third, you can designate an accumulation trust as beneficiary of your IRA. In an accumulation trust your spouse would receive all of the trust income, but would not be entitled to the IRA distributions. Upon your spouse’s passing the trust assets would pass to whomever you designated as the trust beneficiary after your spouse’s passing. Accumulation trusts are a popular estate planning tool for second marriages, because the person establishing the trust could benefit their spouse during their life and then have the trust assets ultimately pass to their own children, rather than to their spouse’s family.
The Secure Act has made accumulation trusts for spouses much less appealing. An accumulation trust is subject to the ten year rule, regardless of whether your spouse is beneficiary or not. So, the IRA would be paid out to the trust over ten years, but the spouse would not get all of the IRA distributions. So, the accumulation trust would be taxed on the distributions. The issue with the trust being taxed on the distributions is that trusts hit the top tax bracket of 37% after the trust has income of $13,000, whereas individuals do not hit the top tax bracket until their income reaches $518,401 (and married couples do not hit the top bracket until their income reaches $622,051). The effect of hitting the top tax bracket much earlier is that accumulation trusts will pay taxes much sooner and at higher rates. So, there is a tax cost to secure the IRA for the next generation via an accumulation trust. The two most common scenarios when naming a spouse as a beneficiary will be to leave the IRA outright to your spouse or in a conduit trust. However, depending on your family situation an accumulation trust and taking the tax hit may make the most sense.
What about distributions to children? Distributions to children are the primary change under the Secure Act. Prior to the passage of the Secure Act, a parent could leave an IRA to a child in a trust and the child could take distribution for their lifetime. The theory being that the child would have money for a longer period of time. Additionally, leaving the IRA to a trust gave the child some asset protection, in that in the event of a divorce the IRA in the trust would not be subject to equitable distribution. Now, the IRA must be paid out in ten years.
When leaving an IRA to a child the same three options are available as with the spouse, discussed above, namely, 1. Leaving the IRA to the child outright; 2. Leaving the IRA in a conduit trust; and 3. Leaving the IRA in an accumulation trust. However, with a child the conduit trust would pay out within ten years of death. So, the asset protection value will in turn only last ten years, at which point the IRA will have been paid out to the child. As with a spouse, an accumulation trust is an option, but it brings with it a tax cost to preserving the assets. If you are concerned about a child’s spouse and the potential for a divorce, or if the child has a spending issue, or substance abuse problem, the tax cost may be worth it to preserve the assets over a longer period of time to protect that child.
Other Considerations
Two other considerations, which are beyond the scope of this article, are the creation of a charitable remainder trust and the conversion of the IRA into a Roth IRA.
For people who a charitably inclined, leaving the IRA to a charitable remainder trust may somewhat replicate the stretch IRA provision. Instead of leaving the IRA to your child, you would leave the IRA to a charitable remainder trust. The charity you name within the trust will ultimately get the full IRA value, and no income tax will be paid by the IRA. However, prior to the charity receiving the funds, a beneficiary you designate, likely your child, will receive the trust income. This could be a good scenario for someone who is concerned that their child will spend all of the money, because it can provide income to the child for life. However, the major caveat is that ultimately a charity will get the IRA principal.
Converting your IRA to a Roth IRA may make sense in some situations. One, if you are in a lower tax bracket than your children, it may make sense for you to pay the tax on the IRA now and leave a Roth IRA for them to inherit, where they would not pay any tax. Two, if you have a year where you have large medical expenses, charitable gifts, or similar deductions, you can use those to offset some of the tax of converting the IRA to a Roth IRA.
The Secure Act was supported by both Republicans and Democrats, so the November election is not likely to have an effect on or cause the repeal of the Secure Act. If you own an IRA now is an excellent time to review your estate plan to ensure that your heirs will not be left with any unintended consequences due to the Secure Act. The estate planning attorneys at Twomey, Latham, Shea, Kelley, Dubin & Quartararo are available at your convenience to answer your questions about the Secure Act, estate planning with retirement assets, or any other estate planning question you may have, and to review your current estate plan to make sure it continues to best represent your wishes and maximize tax savings in your estate.
[1] There are certain “eligible designated beneficiaries” who may still stretch distributions out throughout their own life expectancy, including surviving spouses.
[2] For a more detailed explanation of the Secure Act and its other provisions, please see my colleague Christina Noon’s article entitled “SECURE ACT – SETTING EVERY COMMUNITY UP FOR RETIREMENT ENHANCEMENT”
