New SECURE Act Legislation Brings Big Changes to Estate Planning for Retirement Benefits

Signed into law on December 20, 2019, and made effective January 1, 2020, Setting Every Community Up for Retirement Enhancement (the “SECURE Act”) has radically changed the estate planning landscape for retirement benefits.  Gone for most beneficiaries is the favorable life expectancy payout for inherited retirement accounts (also known as a “stretch IRA”), which has been replaced by a maximum 10-year post-death payout period.  Below is a short summary of this fundamental shift in the rules related to distribution of inherited retirement accounts, along with some other noteworthy changes brought by the SECURE Act.

The Stretch IRA is Wiped Out for Most Beneficiaries

Under the old distribution rules, upon the death of a retirement plan participant, the balance of the participant’s retirement account could be distributed to the beneficiary of the plan in annual installments over the beneficiary’s own life expectancy (based on the IRS actuarial tables).  Commonly referred to as the “stretch IRA”, this allowed the beneficiary of the retirement account (usually younger than the plan participant) to take the required minimum distributions from the account over the beneficiary’s lifetime.  By “stretching” the traditional payout over the younger beneficiary’s lifetime (instead of the plan participant’s lifetime), the bulk of the retirement funds could remain in the retirement account, growing tax deferred for a longer period time.  In this way, the pre-SECURE Act distribution rules allowed the beneficiary to keep the inherited retirement account open for many years and reap the related tax advantages.

Under the SECURE Act, the stretch IRA has been wiped out for most beneficiaries.  As a result, fewer people will be able to “stretch” withdrawals from inherited retirement accounts over their lifetime to help manage taxes.  Instead, there is a new 10-year withdrawal rule for inherited retirement accounts that requires most beneficiaries to pull all of the funds out of the account – and pay the corresponding income tax – by  the end of the 10th year following the year the participant dies.  This is a considerable change.

The following is an example of the effect this change has on a typical retirement plan:

Larry dies and leaves his $2 million IRA to his 45-year-old son, John, who is 35 years younger than Larry.  Under the pre-SECURE Act rules, John could let the $2 million remain in an inherited IRA account for the rest of his life, continuing to grow tax deferred over the course of 40 or more years.  John was only required to withdraw annual amounts from the inherited IRA based on John’s own life expectancy (not his much older father Larry’s life expectancy).  Now, under the new SECURE Act, John is required to withdraw all of the funds from the inherited IRA by the end of the  10th year following the year of Larry’s death, thus missing out on many additional years of tax-deferred growth in the IRA he could have enjoyed under the old rules.

It is not all bad news though.  There are some exceptions to the 10-year rule under the SECURE Act.  A significant exception is that the spousal “rollover” rules still apply:  a surviving spouse who inherits the IRA from a deceased spouse can still rollover retirement funds and withdraw them over the survivor’s own life expectancy. Another significant exception is that a minor child can utilize the “stretch” benefits throughout their minority; however, the 10-year rule kicks in after the child reaches the age of majority.

The other categories of beneficiaries who are excepted from the 10-year rule are: a chronically ill heir; a disabled heir; and a person who is 10-years-or-less younger than the plan participant. Both the “chronically ill” and “disabled” heir categories have very limited definitions.

The SECURE Act also provides some new benefits for plan participants, but these favorable changes only apply to participants who attain age 70½ after 2019.  Beginning in 2020, a plan participant must take required minimum distributions from the plan starting at age 72.  That’s an increase from the old rules where minimum distributions had to start at age 70½.  The SECURE Act also repealed the age restriction on contributions to traditional IRAs.  So, for tax years beginning in 2020 and beyond, a plan participant can make contributions to their IRA even after reaching age 70½ (which was the age cutoff under the old rules).

You Should Review Your Estate Plan

The passage of the SECURE Act requires a re-thinking of your estate plan as it relates to your retirement benefits. This is particularly true if you were planning on leaving retirement assets to your trust and anticipating that your younger beneficiaries would enjoy the “stretch” IRA benefit while the trustee of the trust (and not the beneficiary) exercised  control over the funds held in the retirement account.  Under the SECURE Act, the 10-year rule may interfere with that planning.

Here are a few strategies to consider in view of the passage of the SECURE Act:

1. If you are not charitably inclined and your primary desire is to restrict your beneficiary’s ability to get control over the funds in the account after 10 years, then you can leave the retirement account to your trust, which needs to be structured as an “accumulation” trust. The retirement plan will still have to be fully distributed after 10 years, but the funds will pass to the accumulation trust, not to the beneficiary directly.  The trustee of the accumulation trust would then be able to manage the funds for your beneficiary.
2. If you are charitably inclined and you want to preserve stretch IRA-like tax benefits, then you could consider leaving your retirement plan to a charitable remainder trust. A charitable remainder trust is tax-exempt, meaning that the trust itself does not pay income taxes.  Rather, distributions are taxed to the individual beneficiary as they are made from the trust, and the distributions can be made to the individual beneficiary over their lifetime.  If you name a charitable remainder trust as the recipient of your retirement account, the retirement account would be distributed to the charitable remainder trust upon your death.  Then, whomever you name as the beneficiary of the charitable remainder trust would receive payments from the trust over their lifetime, and income tax is owed only on those distributions as they are made to the beneficiary.  At the end of the term of the charitable remainder trust, the balance of the trust must be distributed to charity.
3. If you want your beneficiary to inherit the retirement account directly, you could elect to purchase life insurance to offset some of the tax burden. The proceeds from the policy, which pass income tax free to your beneficiary, could be used to pay the taxes that are triggered when your beneficiary is forced to pull all the funds out of the inherited retirement account within 10 years.  Additionally, in the case of a retirement plan owner who leaves an IRA to a charitable remainder trust, the balance is required to be distributed to charity at the end of the trust’s term.  A life insurance policy could be purchased on the life of the beneficiary of the charitable remainder trust so that when the beneficiary dies, the proceeds are available for the beneficiary’s children, the retirement plan owner’s grandchildren,
4. If you are in a lower tax bracket than your beneficiary, you could consider a Roth conversion for your IRA. This will result in accelerating the tax on the IRA, but at a lower rate than your future beneficiary will pay.  The downside of this strategy is obvious – you will be paying taxes today that can be deferred until tomorrow.

The Bottom Line

The SECURE Act has brought significant changes to the way inherited retirement accounts are distributed.  Now is a good time to review your estate plan as it relates to your retirement accounts and make sure your plan works the way you intend it to.