The SECURE Act recast the rules for leaving retirement assets to heirs, creating challenges for beneficiaries and conflicts with certain trust strategies.
Under the SECURE Act, a new 10-year rule eliminates the possibility of most non-spousal beneficiaries from using a stretch distribution strategy. As a result, owners of IRAs with large balances may want to reconsider beneficiary designations. There are exceptions to the new 10-year rule including a spouse, beneficiary who is disabled or chronically ill, a minor child of the account owner (until age of majority is reached), or a beneficiary who is not more than 10 years younger than the deceased account owner. These are referred to as eligible designated beneficiaries.
Challenges for account owners and heirs
Taxes. Instead of being able to stretch required distributions over decades (depending on the age of the beneficiary), those who inherit IRAs (other than spouses) generally have to fully distribute the IRA within 10 years following the year the IRA owner dies. This acceleration of income may pose significant income tax challenges for heirs.
Control. Prior to the SECURE Act, owners of large IRAs looking to pass wealth to younger generations may have designated a trust as beneficiary of the IRA to control how quickly IRA distributions are paid out to heirs, and also provide legal protection from potential creditors. For example, this type of trust strategy may be applicable if leaving an IRA to much younger beneficiaries such as grandchildren.
Trust strategies must be reviewed
Historically, account owners who wanted to control distributions to heirs following their death may have designated a trust as the beneficiary of an IRA. This strategy could address the concern of passing significant wealth too quickly to a young beneficiary.
Before the SECURE Act, these trusts — often referred to as "look through" or "see through" trusts — had to meet certain requirements to ensure that required distributions could be stretched based on the remaining life expectancy of the beneficiary. For example, trust beneficiaries designated to receive IRA assets had to be clearly identified to determine the life expectancy factor for stretch distributions (Treasury Regulation 1.401(a)(9)-4, Q&A-5).
Typically, these trusts fall into two categories: conduit and accumulation trusts. Conduit trusts generally require that all distributions from the inherited IRA are paid out to the trust beneficiary. Accumulation trusts allow flexibility (per the trust language) to retain distributions within the trust.
Both types of trusts are impacted by the SECURE Act.
- All IRA distributions are paid out to the trust beneficiary who reports any income on his or her tax return; no income is retained within the trust
- Typically designed to ensure heirs do not draw down the inherited IRA too quickly; for example distributions can be limited to required minimum distributions only
- If the beneficiary is an eligible designated beneficiary (EDB), then the trust is considered an EDB, and it is eligible for life expectancy distributions
- If the beneficiary is not an EDB, the 10-year rule applies
- Trustee has discretion to retain distributions within the trust based on terms outlined in the trust document
- Retained distributions are taxed at trust tax rates
- May qualify for life expectancy distributions for certain EDBs, specifically if the trust beneficiary is disabled or chronically ill (In this case, the disabled or chronically ill beneficiary must be the sole lifetime beneficiary under the trust)
- Other EDBs (e.g., spouses) will not generally qualify for life expectancy distributions
- Although the IRA is still subject to 10-year rule, distributions do not have to be paid to trust beneficiaries as the trustee has discretion on having income accumulate within the trust
Both trust strategies face challenges
The new law creates potential issues for both types of trusts, assuming an exception to the new 10-year rule doesn't apply. This also assumes that the IRS will continue, following passage of the SECURE Act, to treat beneficiaries of conduit and accumulation trusts as individuals. For conduit trusts, the requirement to distribute all of the IRA funds to heirs within 10 years conflicts with the objective of many IRA owners. The conduit trust may have been drafted to control the amount of funds the beneficiary receives.
In this case, the IRA owner should consult with an attorney on what options exist, if any, to modify the trust arrangement. In some instances, the conduit trust may be modified to an accumulation trust (if the account owner is still living), which can provide some control over payments from the trust to beneficiaries.
While accumulation trusts may offer the flexibility to control payments to trust beneficiaries and retain income inside of the trust, the IRA must still be distributed within 10 years after the year the owner dies. This may accelerate taxable IRA income retained inside the trust, which is taxed at higher trust tax rates (e.g., the highest marginal tax rate on trust income applies on taxable income exceeding $12,950 for 2020).
Trust law is complex, and it is critical for account owners or beneficiaries to consult with an attorney.
Advisors can join me and my colleague, Chris Hennessey, on February 13 when we will be live discussing the SECURE Act and taking your questions on planning implications. Register for the event here.
For informational purposes only. Not an investment recommendation.
This information is not meant as tax or legal advice. Please consult with the appropriate tax or legal professional regarding your particular circumstances before making any investment decisions. Putnam does not provide tax or legal advice.