On December 20th, President Trump signed the Setting Every Community Up for Retirement Enhancement Act (also referred to as the SECURE Act) which became effective January 1, 2020. Among other things, the SECURE Act made significant changes to the post-death required minimum distribution rules for individuals who die after January 1, 2020—changes which every individual who has an individual retirement plan (“IRA”) or defined contribution plan (such as a 401(k) or 403(b)) should understand when reviewing their estate plans. To that end, this article serves to provide you with a general overview of these changes to the required minimum distribution (“RMD”) rules. This article also provides a few options to consider when reviewing your estate plan.
First, you need to understand that, although most assets inherited by your spouse or heirs are received income free, that is not the case with IRAs or other retirement plans. When a retirement plan (other than a Roth) is distributed, the amount received will be income taxable to the recipient (other than a charity as discussed below) whether it is the original owner of the plan or a designated beneficiary.
Changes to the Post-Death RMD Rules
Although the changes to the post-death RMD rules affect both defined contribution plans and IRAs, this article will refer only to IRAs for simplicity. Importantly, the SECURE Act made no changes to the treatment of beneficiaries who are not “designated beneficiaries.” Thus, such non-designated beneficiaries (such as, your “estate”) continue to be subject to the same rules regarding distributions.
Under the former rules, a common practice was to designate children or grandchildren (who qualify as “designated beneficiaries”) as the ultimate beneficiaries of an IRA, so that upon the participant’s death, the beneficiaries could use their own separate life expectancies to calculate the minimum amount to be distributed each year—that is, they would have the option of “stretching” the inherited IRA over their lifetimes. Stretching the IRA allows more money to remain in the IRA and grow income tax-free.
Under the SECURE Act, however, unless your beneficiary is an “eligible designated beneficiary,” the beneficiary will not be able to stretch the inherited IRA over the beneficiary’s life expectancy. Instead, the inherited IRA must be fully distributed within 10 years (or, in some cases, 5 years) of your death. So, this raises the question: who is an “eligible designated beneficiary?”
In relation to you (the owner of the IRA), an “eligible designated beneficiary” is limited to the following individuals:
- Your surviving spouse,
- Your minor child (but not including any generation below your children),
- A disabled individual,
- A chronically ill individual, and
- An individual who is not more than 10 years younger than you.
Whether a particular individual is an “eligible designated beneficiary” is determined as of your date of death. And if the beneficiary is a minor child of yours, the beginning of the 10-year window within which the IRA must be distributed is postponed until the minor child attains the age of majority (18 years of age in Georgia).
Only those beneficiaries who are “eligible designated beneficiaries” (as defined above) will be able to stretch inherited IRAs after 2019.
Estate Planning Considerations
Your existing estate plan may include one or more trusts which are designed to be the beneficiary of your IRA in lieu of naming an individual directly. Such trusts are often drafted as “conduit trusts” or “accumulation trusts” which are designed to qualify as a “designated beneficiary,” and are utilized for various reasons (such as, protecting the IRA from being wasted by a spendthrift beneficiary).
However, as mentioned above, in some instances, it may be beneficial to name as a beneficiary a trust that does not qualify as a “designated beneficiary” since the distribution rules for such non-designated beneficiaries remain the same.
For example, if a participant dies at age 73, leaving his IRA to a trust that does not qualify as a “designated beneficiary,” the trust may continue to distribute the IRA to itself using the participant’s remaining life expectancy (which is longer than the 10-year window). Note, however, that if the participant dies before age 72, leaving his IRA to a trust that does not qualify as a “designated beneficiary,” such trust must distribute to itself the entire IRA within 5 years of the end of the year in which the participant died.
The discussion below concerning conduit trusts and accumulation trusts assumes that such trusts will continue to qualify as “designated beneficiaries” and are properly drafted to qualify as such. Due to the uncertain nature of each trust’s qualification as a “designated beneficiary” it is advisable that your estate documents be flexible and authorize an independent third-party to make adjustments to the trust to achieve the best income tax result.
When reviewing the remainder of this article, keep in mind that there will generally be a higher federal income tax liability on an IRA distribution retained within a trust than if the same IRA distribution were then distributed by the trustee to the individual beneficiaries. This is because (i) the income tax liability will follow the money if distributed to the individual beneficiary, and (ii) trusts are subject to the highest marginal federal income tax rate on taxable income over $12,950, compared to $518,400 for single individuals in 2020. An exception to this general rule is with charitable remainder trusts (discussed below).
“Conduit trusts” require the trustee to immediately distribute the funds taken from the IRA to the individual income beneficiary of such trust. Although such a distribution will usually reduce the overall income tax liability resulting from the receipt of IRA funds, the outright receipt of the IRA funds by the individual beneficiary will then become subject to the beneficiary’s spending habits and creditors. Applying the lens of the SECURE Act, this now means that an individual beneficiary of a conduit trust (who is not an “eligible designated beneficiary”) will receive the entire IRA within 10 years of the owner’s death which may not be desirable if such beneficiary is a spendthrift or subject to potential creditors’ claims (for example, a medical professional practicing in a field prone to litigation).
“Accumulation trusts,” as opposed to conduit trusts, provide the trustee with discretion to distribute the monies received from an IRA. Accumulation trusts must be carefully drafted as some ineligible remainder beneficiaries may disqualify the trust from “designated beneficiary” status. To avoid this, many practitioners preferred conduit trusts over accumulation trusts. While an accumulation trust provides better creditor protection for the beneficiary than does a conduit trust, the unfortunate trade-off is that the accumulation of the IRA distribution within the trust will, in most cases, result in a higher overall income tax liability. After the passage of the SECURE Act, this means that the trustee of an accumulation trust (except for a trust for the sole benefit of a disabled or chronically ill individual) must receive all of the IRA funds as ordinary income within 10 years of the owner’s death and will have to pay income tax unless the funds are distributed out of the trust to the beneficiary in the same year that they are received. If your family beneficiary is a spendthrift or subject to potential creditors’ claims, you should consider incorporating an accumulation trust into your estate plan even though the accumulation trust will most likely pay a higher federal income tax on the distributions.
It should be noted, however, that if an individual beneficiary’s taxable income (excluding any distributions from the accumulation trust) is already above $518,400 (for a single individual) or $622,050 (for a married couple filing jointly), a distribution of IRA funds from the accumulation trust will not reduce the overall federal income tax liability. For such high-income individual beneficiaries, it is often recommended that an accumulation trust be utilized and the IRA distributions be retained in the trust.
Designating a Charity as Beneficiary of your IRA
If you are charitably inclined, you should always consider your IRA (or a portion thereof) as the preferred asset to leave your favorite charity (or charities). This is because charities are tax-exempt organizations and as such, unaffected by the associated income tax liability.
Charitable Remainder Trust
If you are charitably inclined, and do not mind that your favorite charity (or charities) may not receive any substantial economic benefit until a later date, you may want to consider using a charitable remainder trust (CRT). Generally speaking, a CRT is a trust that provides a non-charitable beneficiary with an income stream each year (often a specified amount or a percentage of the trust’s assets) that continues for a period of time, and after the non-charitable beneficiary’s interest terminates (typically, upon his or her death), the assets remaining in the trust pass to the designated charity.
The normal income tax rules applicable to trusts do not apply to CRTs. When a CRT receives the IRA funds, the income tax consequences are, in a sense, suspended within the CRT. The suspended income tax effect is freed when the trustee of the CRT makes the predetermined distribution to the non-charitable beneficiary, who will pay income tax on the amount he or she receives each year from the CRT. Because the term of the non-charitable beneficiary’s interest is typically his or her lifetime, a CRT could, in effect, stretch the IRA over the life of the non-charitable beneficiary.
When considering the use of a CRT, keep in mind that not all trusts qualify as a CRT. If you are interested in establishing a CRT as a vehicle for the receipt and distribution of IRA funds, you should consult with a qualified tax law professional.
If you would have any questions about the content of this article or would like to review and/or revise your current estate plan:
The attorneys at Cohen Pollock Merlin Turner are happy to help. Contact us for more information.
THE INFORMATION CONTAINED IN THIS ARTICLE DOES NOT, AND IS NOT INTENDED TO, CONSTITUTE LEGAL ADVICE AND SHOULD NOT BE RELIED UPON IN LIEU OF CONSULTATION WITH AN ATTORNEY.