Passage of the SECURE Act Brings Sweeping Changes to Retirement Benefits Planning

 

 

Vanessa J. Skinner, Esq.

Estate, Guardianship & Trust Committee // The Briefs // June 2020, Vol. 88 No. 5

The Setting Every Community Up for Retirement Enhancement (“SECURE”) Act, which had bipartisan support in both houses of Congress, was signed into law by President Trump on December 20, 2019, as part of a larger appropriations bill. The Act implements major changes concerning retirement accounts such as traditional IRA, Roth IRA, 401(k), and 403(b) accounts.

The SECURE Act includes several key provisions designed to assist workers enhance their retirement savings. It raises the age for beginning required minimum distributions (“RMDs”) to age 72 from age 70 ½ for individuals who turn 70 ½ after December 31, 2019, thereby postponing payment of income taxes and providing a longer period of time for tax-deferred growth in the retirement accounts. All IRAs (traditional or Roth) may now be funded at any age, provided the taxpayer has earned income, which helps older workers who want to save while reducing their taxable income. Previously, only Roth IRAs could be funded after age 70½. Individuals who work at least 500 hours per year for three consecutive years will be able to participate in qualified retirement plans. The previous requirement was 1,000 hours and one year of service. The SECURE Act also expands penalty-free early distributions for account owners under age 59 ½, for up to $5,000 within one year for the birth or adoption of a child (although income taxes will still apply), and allows an early distribution to be recontributed to the same plan or IRA and treated as a rollover without any time limit. Additionally, the rules are generally expanded to permit more qualified retirement plans to offer annuity payout options.

The most significant change made by the SECURE Act for estate planning purposes is the elimination of the “stretch” provisions for most non-spouse beneficiaries of retirement accounts. For more than 30 years before the passage of the SECURE Act, designated beneficiaries (generally living human beings and certain qualifying or “see-through” trusts) on retirement accounts were eligible to “stretch” RMDs over their life expectancy (or in the case of a qualifying trust, over the oldest applicable trust beneficiary’s life expectancy), potentially receiving decades of income-tax free or tax-deferred compounding. For example, a child who inherited a parent’s IRA at age 40 could withdraw the benefits gradually over 43.6 years based on the Treasury Regulation’s life expectancy tables. Even more striking, a grandchild or great-grandchild inheriting an IRA could take out the benefits for potentially as long as 80 years.

The new standard under the SECURE Act is the “10-Year Rule.” Under the 10-Year Rule, the entire inherited retirement account must be distributed by the end of the 10th year following the death of the account owner. There is no requirement of annual distributions like there is with the life expectancy payout. Rather, the beneficiary can elect to take distributions at any time or times during end of the period. For someone who dies in 2020, the retirement account is required to be depleted by December 31, 2030. This shorter distribution period could result in larger tax bills for children and grandchildren who inherit accounts. For the 40-year-old beneficiary referenced above, 33.6 years of possible tax deferral or “stretch” is lost due to the SECURE Act, and for the grandchild or great-grandchild referenced above, as much as 70 years of tax deferral could be lost.

There are four groups of designated beneficiaries to which the 10-Year Rule does not apply, and the same rules that applied to them before the SECURE Act continue to apply to them. These beneficiaries, who are collectively referred to as “Eligible Designated Beneficiaries (“EDBs”),” are: (1) the account owner’s surviving spouse, who still has the option to roll over the inherited IRA benefits to his or her own IRA or elect to treat it as his or her own IRA; (2) disabled or chronically ill persons, as defined in the Internal Revenue Code and further outlined below; (3) individuals who are not more than 10 years younger than the account owner, such as siblings; and (4) minor children of the account owner (note – this does not include grandchildren) until they reach the age of majority. It is unclear what the age of majority is for purposes of the SECURE Act. It may be when the child attains the age of majority in his or her state of residence (18 or 21) or it may be as old as age 26 if the child is in a “specified course of study.” Future IRS guidance will be needed to provide clarity on this point. Once the minor attains the age of majority, the 10-year payout period will apply.

In determining whether an individual qualifies as a disabled EDB, there must be a review of Section 72(m)(7) of the Internal Revenue Code, which provides that “an individual shall be considered disabled if he or she is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.” Entitlement to Social Security disability benefits automatically demonstrates “disabled” status.

Similarly, a determination of whether an individual qualifies as a chronically ill EDB requires a review of Section 7702B(c)(2) of the Internal Revenue Code. Such section defines chronically ill as any individual who has been certified by a licensed health care practitioner [i.e., physician, registered professional nurse, licensed social worker] as (i) being unable to perform (without substantial assistance from another individual) at least 2 activities of daily living for a period of at least 90 days that is an indefinite one which is reasonably expected to be lengthy in nature due to a loss of functional capacity, (ii) having a level of disability similar . . . to the level of disability described in clause (i), or (iii) requiring substantial supervision to protect such individual from threats to health and safety due to severe cognitive impairment.

The beneficiary’s status as disabled or chronically ill is determined as of the date of the participant’s death. Therefore, a designated beneficiary who becomes disabled at a later date will not be able to change to a life expectancy payout.

There are two provisions of the SECURE Act uniquely favorable to special needs trusts (“SNTs”), which are used to preserve government benefits eligibility for chronically ill or disabled beneficiaries. If a trust, for example the account owner’s revocable trust, splits on the owner’s death into SNT and other trust shares, the SNT is treated as a separate account for RMD purposes. Further, if the chronically ill or disabled beneficiary is the sole lifetime beneficiary of the properly drafted SNT, then the life expectancy of such beneficiary can be used for the payout of the RMDs to the SNT.

The SECURE Act changes the landscape for estate planning attorneys when advising their clients who have traditional IRAs or other retirement accounts. In particular, clients with significant retirement funds may benefit from alternative planning strategies to help mitigate income taxes when leaving their legacy. A $3 million traditional IRA if cashed out immediately would have a net value of $1.8 million after payment of federal and state income taxes. If the client designates his or her adult children as the beneficiaries of such account, they would have 10 years to withdraw the funds. Such withdrawals could put them into higher tax brackets if they are in lower brackets, or alternatively, if they are already in higher tax brackets as a result of their own personal income, the tax impact can be even more significant for them. Further, if the client wishes to leave the retirement funds in trust for the children for creditor protection purposes, the benefits will be taxed at the highly compressed trust tax rates if not distributed to the trust beneficiaries.

Estate planning practitioners must first determine if the retirement funds are intended to benefit individuals who are EDBs. If the answer is no, and the client is charitably inclined, then the client may want to consider leaving traditional retirement benefits to a charitable remainder trust (“CRT”) to emulate the “stretch” now lost under the SECURE Act. This will essentially eliminate the tax on the IRA itself while providing a lifetime stream of fixed dollar or fixed percentage payouts (taxable) to the human beneficiaries, as long as they are not too young to meet the statutory requirements of the CRTs, which provide that at least 10 percent of the charitable remainder trust assets must be projected to go to the ultimate charitable beneficiary.

Alternatively, the client may want to do Roth conversions during his or her lifetime, particularly if he or she is in a lower tax bracket than the intended beneficiaries of the retirement funds, including a trust. This enables the client to pay some income tax during his or her lifetime so that future distributions will not be subject to income tax under the 10-Year-Rule, since distributions from a Roth IRA are tax-free.

If the client finds neither of these options palatable, the focus should shift to how to pay the tax bill, such as by purchasing life insurance. Since life insurance death benefits are income tax free, the client may want to purchase new or repurpose old life insurance policies to help pay the income taxes or replace the value of the retirement accounts being lost to taxes.

Although there may be limited options for clients to avoid the tax impact of the 10-Year Rule, existing estate plans should be reviewed, particularly where retirement benefits are a significant part of their estate plan and trusts are named as retirement account beneficiaries. Generally, two types of qualifying trusts – conduit trusts and accumulation trusts – were widely used prior to the passage of the SECURE Act, both of which can now prove problematic. If conduit trusts only allow for the RMDs to be disbursed from an inherited IRA to the trust each year, with a corresponding distribution to the trust beneficiary, there is now only one year in which an RMD exists, the 10th year, thus resulting in a “tax bomb.” If accumulation trusts (excluding SNTs) require that all or a substantial portion of retirement account distributions remain in the trust and not be distributed out to the trust beneficiary, significant wealth could be lost to income taxes since such trusts have, at best, 10 years to spread out distributions from inherited retirement accounts, and funds retained in trust are subject to the highest tax rates.

While the full impact of the SECURE Act remains to be seen, one thing is for certain. It presents a prime opportunity for estate planning attorneys to reconnect with their clients, develop new planning strategies and implement them.

Vanessa J. Skinner, Esq., is a shareholder in Winderweedle, Haines, Ward & Woodman’s trusts & estates department, which she co-chairs. She also serves on the firm’s management committee. She practices mainly in the areas of estate planning, special needs planning, elder law, corporate law, probate and trust administration, and litigation and has been a member of the OCBA since 2003.