In-Secure:  New Law Has Profound Impact on Inherited Retirement Accounts

If you are like most people, a significant amount of your net worth is probably tied up in retirement accounts.  Traditional IRAs and 401(k) plans offer a great avenue for pre-tax assets to grow and then be taxed later, usually at a much lower rate when you are past your peak earning years.  Roth IRAs, although funded with post-tax dollars, provide great flexibility for accessing and using funds for specific purposes even before you retire.

In recent years, many families have used retirement accounts as cornerstones of their estate planning.  There are a number of reasons for this, including:

  1. Rapid transfer of assets:  In many cases, the retirement account passes directly to the designated beneficiary(ies) without having to wait for the probate process to be completed. Distributions can be made directly to the individual beneficiary or be routed through a trust.  
  2. Multi-state distributions:  Utilizing a payable on death structure makes it relatively simple to distribute assets to multiple heirs in different states without having to go through each state’s probate process.
  3. Tax deferral:  Although there is no federal estate tax for most families, every dollar earned gets taxed at least once.  So the pre-tax dollars accumulating in retirement accounts are taxed once they are withdrawn.  The law previously allowed named individual beneficiaries of retirement accounts to stretch distributions over their lifetimes, reducing the immediate tax impact and potentially reducing the marginal tax rate over time as their own income decreased.

The SECURE (“Setting Every Community Up for Retirement Enhancement”) Act, signed into law on December 20, 2019 and in effect since January 1, 2020, has, among other things, significantly changed the way inherited retirement accounts are treated for tax purposes.  Without proper planning – or alteration of your existing plan to accommodate the new law – your heirs could face a significant tax burden on your retirement accounts.  According to some estimates, the IRS expects to raise an additional $16 billion dollars in revenue just from these changes in the law. 

Understand the Changes

For the Original Account Holder

The SECURE Act raises two key age thresholds for original holders of qualified retirement accounts:

  • Required minimum distributions now start at 72 instead of 70.5.  
  • Contributions may be made throughout the account holder’s lifetime, instead of stopping at 70.5 years old.

Consequence:  This allows greater flexibility for individuals who may wish to continue working or accumulating assets in their retirement accounts beyond the traditional retirement age.

For Individual Named Beneficiaries

In most cases, the SECURE Act requires individual named beneficiaries to close out inherited retirement accounts within 10 years of the original account holder’s death1.

  • Required minimum distributions are eliminated, so the beneficiary can take as much or as little as they like during the 10-year period.
  • The “stretch” feature is also eliminated for most individual named beneficiaries; the 10-year wind-down period provides a hard deadline. 
  • Exceptions:  three categories of individual named beneficiaries are still permitted to extend the payout of inherited retirement accounts:
  • Spouses:  May extend required minimum distributions over their anticipated lifetimes and retain the ability to roll over inherited retirement accounts into their own existing accounts.
  • Minor children:  The 10-year clock starts only when they reach majority.  However, this provision is only applicable to children of the original account holder and not to grandchildren or other minors.
  • Disabled or chronically ill:  Beneficiaries who meet the IRS’s legal definitions as disabled or chronically ill (awaiting guidance) may qualify for life expectancy payout of inherited requirement accounts; however, if the individual’s health status should change for the better, they may become subject to the 10-year payout rule.  Such individuals frequently inherit assets through a trust structure, for which there are different rules

Consequence:  Adult beneficiaries of inherited traditional IRAs and 401(k)s have lost a significant amount of flexibility in timing constructive receipt of their inheritances and may face tax consequences as a result.

For Assets Placed in Trust

Retirement accounts – like other assets – are often placed in trust for various reasons, including:

  • Protecting the funds from creditors, including ex-spouses
  • Guarding against the beneficiary spending the money too rapidly
  • Facilitating a tiered (usually multi-generational) bequest, where the original beneficiary (often a surviving spouse) receives income generated by the trust during their lifetime and the remainder beneficiary (often children or grandchildren) receives the remaining amount after the death of the first beneficiary

Our blog on trust essentials gives an overview of these and other reasons why trusts can be useful in estate planning.  Depending on how they are set up, trusts can be subject to the top 37% income tax bracket from a fairly low threshold ($12,950 in 2020).  The SECURE Act makes it more essential than ever to be vigilant about this and introduces some other changes in how retirement accounts placed in trust will be treated for tax purposes. Two different categories of trust are usually used for this purpose, and they are subject to different treatment under the SECURE Act:

  • Conduit trusts (and their variant see-through trusts):  serve as channels through which trust income is distributed to beneficiaries.  The trustee makes required distributions to the named beneficiaries when the trust receives the income.  The see-through variant is typically used when the intention is to allow one person to enjoy income from the assets during their lifetime and another person or group of people to receive the remaining principal at the first beneficiary’s death.  These have been considered pass-through entities for tax purposes, and income tax was only payable by the beneficiaries at their applicable income tax rates.  Under the SECURE Act, retirement accounts put in a conduit or see-through trust are subject to the ten-year payout requirement, unless the beneficiary fits one of the exception categories defined above. 
  • Accumulation trusts:  allow the assets to grow within the trust and give the trustee a certain amount of discretion as to when they are to be distributed.  Income generated in the trust is subject to the 37% maximum income tax rate.  When a trust is named as beneficiary of a retirement account, it is subject to the 10-year payout period; however, the trustee’s ability to be flexible in distributing the assets to the beneficiaries could be helpful in reducing unnecessary tax burdens.

Consequences:  The SECURE Act reduces the usefulness of trusts in certain instances and requires greater care than ever in setting up trust structures to receive funds from retirement accounts.
Charities and Institutional Beneficiaries
The law requiring a five-year payout of retirement accounts left to charities and institutional beneficiaries has not changed.

Charities and Institutional Beneficiaries

The law requiring a five-year payout of retirement accounts left to charities and institutional beneficiaries has not changed.

Evaluate Your Options

If one or more retirement accounts is likely to form a significant part of your estate, you should revisit your estate plan with your estate planning attorney.  If your estate “plan” was limited to passing along retirement accounts, it is essential that you act.  There are still plenty of options open to you to ensure that your hard-earned assets are passed to your heirs with minimal unnecessary tax consequences.  These can include:

  • Evaluate any existing trust structures to ensure that they are as tax-efficient as possible, perhaps modifying conduit trusts into accumulation trusts and modifying any accumulation trusts so that the trustee and/or trust protector has more discretion to make distributions tax-efficiently.
  • Reallocate your assets so you spend the money in your retirement accounts and leave other assets to your heirs.
  • Utilize life insurance, either using term insurance as a backstop to pay taxes or using permanent insurance to set up an Irrevocable Life Insurance Trust (“ILIT”), which you can then leave to your heirs with a number of tax advantages.

The estate planning attorneys at Holm & O’Hara LLP stand ready to assist you in reviewing and modifying your current estate plan and in developing a flexible structure that works for you and your family.

1 Some interpretations suggest that this is not tied tightly to the actual date of death, but to the full calendar year in which the death occurred, potentially allowing for a payout over nearly 11 years.



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