Feb. 19, 2020 – A new federal law, effective Jan. 1, 2020, changes rules regarding post-death distributions from retirement accounts and impacts how lawyers should advise their existing and future estate planning clients.
The Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) includes a number of important changes to the law applicable to retirement accounts, such as 401(k)s and Individual Retirement Accounts (IRAs).
Some of these changes are beneficial. For example, the age at which individuals must begin taking required minimum distributions from their retirement accounts was increased from age 70 1/2 to age 72 (the “required beginning date”). The age cap for contributing to a traditional IRA was removed.
However, the SECURE Act made a significant change to how retirement accounts will be paid out following the owner’s death. Pre-SECURE Act, a retirement account could be paid out over a designated beneficiary’s life expectancy.
The SECURE Act provides that, in most cases, the entire retirement account must be paid out within 10 years of the account owner’s death. This is going to often result in a much more rapid distribution and taxation of the retirement account.
Pre-SECURE Act Provisions
Prior to the SECURE Act, the following distribution rules applied on the death of a retirement account owner:
com ldanielson ruderware Linda M. Danielson (U.W. Law 1988) is an attorney with Ruder Ware, L.L.S.C., Eau Claire. She has been practicing in the estate planning area for over 30 years. Reach her by com ldanielson ruderware email or by phone at (715)-834-3425.
Designated Beneficiary Named. If the owner named one or more “designated beneficiaries” (defined as one or more individuals, or certain trusts, referred to as “see-through trusts,” created for one or more individuals), then the retirement account could be paid out over the designated beneficiary’s life expectancy, based on a table published by the IRS.
Example: If a 40-year-old beneficiary inherited a retirement account from a parent, that beneficiary would have to begin taking distributions by Dec. 31 of the year following the year of the parent’s death, and the minimum payout rate would be based on the beneficiary’s 43.6 year life expectancy. The undistributed portion of the retirement account could continue to be invested on a tax deferred basis. Special rules apply where a surviving spouse is named as primary beneficiary. For example, a surviving spouse is the only beneficiary who can roll over a retirement account into his or her own name and defer distributions until the spouse’s required beginning date.
Designated Beneficiary Not Named. If the owner did not name a “designated beneficiary” (for example, if the owner’s estate or a non-see through trust was the beneficiary), then the retirement account had to be distributed in full by Dec. 31 of the year containing the five-year anniversary of the owner’s death (if the owner died before his or her required beginning date) or over the owner’s remaining life expectancy (if the owner died after his or her required beginning date).
Planning Before SECURE Act
An important estate planning goal for a client with retirement accounts was to structure the client’s estate planning documents and beneficiary designations to make sure the client named one or more “designated beneficiaries” so the payout rate would be based on the beneficiaries’ life expectancies.
Of course, in many cases clients do not want to leave assets outright to beneficiaries, so retirement accounts were made payable to a trust so that a trustee could control them. If the trust met certain requirements, then the trust beneficiary’s life expectancy could be used to determine the payout rate from the retirement account.
Two types of trusts were used:
Conduit trust. A conduit trust required that all distributions from a retirement account to the trust (net of expenses) be paid out to the trust beneficiary. Using this type of trust ensured that the trust beneficiary’s life expectancy could be used to determine the payout rate.
Accumulation trust. An accumulation trust is any trust that does not require retirement account distributions received by the trust to be paid out to the trust beneficiary. The payout rate was based on the life expectancy of the oldest trust beneficiary who could receive the accumulated retirement account distributions, not just the current trust beneficiary, and all of the trust beneficiaries had to be individuals.
SECURE Act Webcast: What Every Trusts and Estates Lawyer Needs to Know
Provide the best estate planning advice: Understand the impacts of the Setting Every Community Up for Retirement Enhancement Act (SECURE Act), which took effect Jan. 1, 2020. An upcoming State Bar of Wisconsin PINNACLE® webcast seminar will help you advise clients with estate plans to address the SECURE Act changes.
The 50-minute (1 CLE) lunch-hour program will run on selected dates from March 31 through May 22, from 12-12:50 p.m. Register now.
SECURE Act Changes
The SECURE Act did not change most of the rules described above, with one significant exception: it creates a new category of designated beneficiaries, called “eligible designated beneficiaries,” and provides that only retirement account distributions to them (or certain trusts for them) can be based on their life expectancies.
A retirement account payable to any other designated beneficiary must be completely distributed by Dec. 31 of the year containing the 10-year anniversary of the account owner’s death. The distribution to non-eligible designated beneficiaries does not have to be made in annual installments. For example, the beneficiary could receive a single lump sum distribution at the end of the 10 years.
An eligible designated beneficiary is one of the following:
Children of the account owner (not grandchildren, not stepchildren, etc.) who have not reached majority. Upon reaching majority, the account balance will be distributed under the 10-year rule;
Chronically ill beneficiaries; or
Beneficiaries less than 10 years younger than the owner (e.g., siblings, an unmarried partner).
The life expectancy payout method only applies during the lifetime of the eligible designated beneficiary. On that beneficiary’s death, the 10-year payout rule applies to the balance of the retirement account.
Additional guidance from the IRS is needed in order to determine exactly how these exceptions will apply in practice. For a more detailed discussion of these SECURE Act rules, see attorney Natalie B. Choate’s recent article “SECURE’s Changes to Retirement Plan Distribution Rules Applicable to Participants and Beneficiaries.”
Impact of SECURE Act on Using Trusts to Manage Retirement Accounts
The SECURE Act’s substitution of the 10-year payout rule for the life expectancy payout rule for a beneficiary who is not an eligible designated beneficiary impacts both conduit and accumulation trusts.
Conduit trusts for these beneficiaries can no longer use the life expectancy rule to determine the payout rate from a retirement account to the trust and from the trust to the beneficiary. This will result in the trust having to distribute the entire retirement account to the beneficiary by the end of 10 years, making conduit trusts less appealing from a creditor protection and asset management standpoint than they were pre-SECURE Act.
Retaining retirement account distributions in an accumulation trust will come at a significant income tax cost (this was also the case pre-SECURE Act).
For 2020, undistributed trust income over $12,950 is taxed at the top federal income tax rate of 37 percent. In contrast, for a single individual, the 37 percent tax rate only applies to income over $518,400.
Thus, the new 10-year payout rule creates a dilemma for clients who want their retirement accounts controlled by a trustee following their deaths for creditor protection or other reasons: either distribute the entire retirement account to the trust beneficiary by the end of the 10-year period, or accept the fact that the value of the retirement account distributions accumulated in the trust is going to be significantly reduced by the income taxes paid by the trust on those distributions.
Advising Clients Moving Forward
Estate planning attorneys should modify their estate planning forms as necessary to reflect the changes made by the SECURE Act. They may also want to contact existing clients with significant retirement accounts, especially clients with conduit trusts, to explain the new rules and determine whether any changes need to be made to their estate planning documents and beneficiary designations.
Other planning options may include:
Purchasing life insurance to offset the accelerated income taxes resulting from the 10-year rule.
Leaving retirement accounts outright to charities or to a charitable remainder trust.
Doing a Roth conversion of some or all of the retirement account if it makes sense economically (while a Roth IRA is subject to the same 10-year payout rule, the distributions may be income tax free).
Unfortunately, for most clients, the 10-year payout rule is the new reality. Other than appropriate planning if one of the “eligible designated beneficiary” exceptions apply, the focus will be on managing the income tax consequences of the 10-year payout rule.