In January of this year, a new law came into effect known as the SECURE Act, which is the most impactful legislation affecting retirement accounts in decades. You may have read politicians applaud the bill but be very weary — what Congress cloaked under the guise of “freebies” turns out to be nothing more than a wolf in sheep’s clothing. It’s the classic Washington bait-and-switch, and now there’s a whole lot to be insecure over, after SECURE.
While the new law indeed brought many tax-favored changes on the front end, it came at a high cost on the back end. Specifically, SECURE drastically changes the way your beneficiaries can inherit your retirement account when you die, and this well-kept secret is the way Congress is able to afford to give us all the “freebies.” Put simply, as Congress giveth, so too shall they taketh away.
To understand the change, you need to understand the way Congress feels about retirement accounts. The ability of retirement plans to accumulate funds on a tax-deferred basis (or tax-free, in the case of a “Roth” plan) scares Congress, as the government does not want to allow retirement plans to become estate-building, tax-free vehicles that pass wealth from one generation to the next. Mind you, this is baffling, since Congress itself wrote these laws into being. To ensure the government would collect its taxes, Congress early on enacted §401(a)(9) requiring that certain annual “required minimum distributions” (RMDs) be withdrawn annually from plans beginning at a certain age (now 72) or at death, whichever comes first. This means that for most retirement plans, when you turn 72, whether you like it or not, the tax shelter ends and you need to begin emptying out your retirement account, by taking these RMDs and paying taxes on them. (Note: Beginning at 59 ½ and under certain other exceptions, you are able to withdraw money tax-free even earlier).
Prior to the SECURE Act, when you died, your beneficiaries would essentially take over your account and pay tax on the RMDs generally according to their own life expectancy. This meant that the younger your beneficiary, the longer the retirement account could grow tax-free and the smaller the RMD (and the tax Congress collected).
So in January 2020, when its own Frankenstein-esque creation became too much to bear, Congress finally put the kabosh on retirement accounts. Now, for the most part, when an account owner dies, her beneficiaries need to withdraw the entire balance of the retirement account within 10 years of the account owner’s death and pay all applicable taxes. The shorter 10-year time frame for taking distributions means the acceleration of income tax due, possibly causing your beneficiaries to be bumped into a higher income tax bracket in their peak earning years, thus receiving less of the funds contained in the retirement account than you may have originally anticipated. And in certain situations, the taxes are due in 5 years instead of 10 years. So with few exceptions, lifetime stretch is now gone.
Wait, wait, wait! Did you say “with few exceptions”?
That’s right, for those who were listening!
This means, we can still take advantage of the old lifetime stretch in certain situations. Like what? Well, for those of us who want to leave our retirement accounts to our spouse, our minor children, our loved ones who are not more than ten years younger than us, or any disabled or chronically ill individuals, we can still maximize tax-free growth for these new “eligible designated beneficiaries.” But we may need to rewrite our trusts now in order to update these “conduit” provisions, and we may need to redesignate our retirement beneficiaries in a special way to ensure the greatest amount of lifetime stretch.
And even if you don’t fit into one of those exceptions, there’s still hope. We can draft your living trust to contain accumulation provisions rather than conduit trust provisions. This means that instead of your trustee distributing the entire account balance to your beneficiary within ten years of your death, we can create an alternative trust structure through which the trustee can take any required distributions and continue to hold them in a protected trust for your beneficiaries beyond 10 years, which will shield your beneficiaries from creditors, lawsuits, and divorce!
Under the SECURE Act, there are three possible payout periods for IRA beneficiaries:
- 5 years for “non-designated beneficiaries”;
- 10 years for “designated beneficiaries”;
- Life expectancy stretch for “eligible designated beneficiaries”
The life expectancy stretch refers to the retirement account growing tax-free for as many years as the beneficiary’s life expectancy, as determined by the Single Life Expectancy Table. However, for minor children of the account holder, the life expectancy payout lasts only until the child reaches the age of majority, which in California is 18 years old, after which point, the 10-year rule then kicks in. Thus, a 5-year old beneficiary can stretch their payout for at least 23 years.
The problem of course is that naming an individual as a beneficiary on a retirement account, many times, is riddled with challenges. First, if the child is a minor, you don’t want to name them directly as a beneficiary. Doing so may cause the plan administrator not to release the benefits to anyone other than a legal guardian of the minor, which subjects the property to legal guardianship proceedings. This is not only time consuming and expensive, but it also restricts how the money can be spent for the minor’s benefit, and many times gives full control of the account to a minor at age 18. Second, even adult beneficiaries will mismanage their inheritances by cashing out the retirement accounts immediately, thereby owing large amounts in unnecessary taxes, rather than allowing the account to grow tax-free for another decade.
Therefore, naming a trust as a beneficiary is a common desire and strategy, which offers controls over investment decisions for young or immature beneficiaries. Moreover, a trust offers asset protection in protecting the inheritance from lawsuits, creditors, and even divorce. However, in order for a trust to qualify under the 10-year rule as a “designated beneficiary” or under the life expectancy rule on behalf of “eligible designated beneficiaries,” the trust must first be regarded as a “see-through” trust.There are two types of “see through trusts”: conduit trusts and accumulation trusts. You should speak with your lawyer about which is better for you and your family.
Let’s Meet Conduit Trusts
As one practitioner noted, a conduit trust “serves as a hard-wired conduit between the IRA and the primary beneficiary.” In other words, it’s a trust that requires its trustee to distribute all amounts from the IRA to the trust’s primary beneficiary as soon as the trustee receives such funds. If a single individual beneficiary receives all IRA distributions from the trust, and if no IRA proceeds accumulate in the trust, then the IRS recognizes this as a conduit trust. The primary beneficiary is deemed to be “the sole designated beneficiary” of the IRA for purposes of determining the IRA payout period, and this “applicable distribution period” is set as the life expectancy of the primary beneficiary beginning the year after the death of the owner.
The conduit trust presents certain unique advantages over an accumulation trust.
First, the remainder beneficiaries of the conduit trust can be anyone or anything. The IRS disregards them as “mere potential successors” to the primary beneficiary’s interest. Who benefits from this? Charities, generally, and those who are charitably inclined to name non-profits as their contingent beneficiaries. You can’t do this in an accumulation trust, otherwise it will be regarded as a “non-designated beneficiary.”
Second, conduit trusts allow for a primary beneficiary to be able to exercise a testamentary power of appointment in favor of a charity or the primary beneficiary’s own estate (in order to avoid generation-skipping transfer tax as a result of a taxable termination that may otherwise occur at the primary beneficiary’s death). Again, these features cannot be done within an accumulation trust.
Third, under prior law, the remainder beneficiaries only in a conduit trust could be older than the primary beneficiary — this remains the case after SECURE. No matter who the remainder beneficiary is in a conduit trust (e.g., a charity, the estate, an older person), the primary beneficiary’s life expectancy will be used in determining life expectancy for the “stretch” payout. It is unclear whether this is true of accumulation trusts after SECURE, but I would expect the IRS to change existing regulations that currently require the individual with the youngest life expectancy to be identifiable in an accumulation trust in order to qualify as a see-through trust.
Say Hello to Accumulation Trusts
There are a few ways to define an accumulation trust, but the broader one is a trust that allows the trustee to accumulate RMDs and other IRA distributions within the trust, instead of mandating that such amounts be distributed right away to the beneficiaries.
Moreover, an “accumulation trust” requires that all the beneficiaries are individuals. Confusion is created because in certain situations, successor beneficiaries are not necessarily “counted” in the determination. “A person will not be considered a [countable] beneficiary for purposes of determining who is the beneficiary … merely because the person is a [mere successor beneficiary and] could become the successor to the interest of one of the employee’s beneficiaries after that beneficiary’s death.”
The difference between a “countable” beneficiary and a “mere successor beneficiary” is critical to understand, because if a charity is a countable beneficiary, then none of the other beneficiaries will be treated as a “designated beneficiary,” and the trust will become a non-designated beneficiary, thus using the 5-year payout. On the other hand, if the charity is a “mere successor beneficiary,” the trust is a see-through trust and qualifies under the 10-year payout. Per the IRS, we need to look at all possible future beneficiaries, with the inquiry ending when the IRA proceeds would be distributed to an individual outright and immediately after the death of the primary beneficiary. The analysis is limited to beneficiaries who are actually living as of the IRA owner’s death. Unborn beneficiaries are not counted. Thus, if the trust instrument provides that upon the death of all living current and remainder beneficiaries, the IRA proceeds would pass outright to a person’s heirs at law or other individuals, the trust would qualify as an accumulation trust.
To recall, an accumulation trust may not grant a beneficiary a lifetime or testamentary power of appointment which is exercisable in favor of a non-individual. Moreso, if the trustee may distribute trust assets to a non-individual, even as a remainder beneficiary upon termination of the trust, the trust will fail to qualify as an accumulation trust.
There is a decent chance that the IRS will fix some of its regulations as it relates to accumulation trusts, which may allow for the addition of non-individual beneficiaries to not be countable.
Which Trust is Right for Me?
The major downside of a conduit trust is that all the proceeds from an IRA must pass to the beneficiaries outright by the end of the 10th year following the IRA owner’s death. Prior to SECURE, thanks to the lifetime stretch, the majority of the proceeds were still held in the IRA, growing tax-free, with only the smaller RMD amounts being distributed and taxed. The result was a simple, safe, guaranteed, and flexible outcome.
The deal breaker for many is that the conduit trust now offers virtually zero creditor protection. In 2014, the US Supreme Court held in Clark v. Rameker that inherited IRAs are not protected under the federal bankruptcy exemption. “With an accumulation trust, even though the trustee must withdraw the entire IRA by the end of the 10th year following the IRA owner’s death, the IRA proceeds may then be accumulated in the trust, reinvested, and distributed only in the trustee’s discretion, thus putting a lifetime obstacle between the beneficiary’s creditors and the IRA proceeds. Similarly, though state law varies, a trust will generally provide significantly better protection in the event of divorce as compared to a beneficiary’s outright ownership of an inherited IRA or receipt of proceeds from an inherited IRA.”
Additionally, for those whose beneficiaries are chronically ill or disabled, accumulation trusts are a much better outcome and will also offer lifetime stretch to such persons.
To be fair, accumulation trusts are associated with a decent amount of sticker shock, given the income tax rates in which they operate. For example, under the Tax Cut and Jobs Act (TCJA), in 2020, the 37% income tax bracket applies only to a single individual earning $518,400 or more and to a married couple earning $622,050 or more. However, an accumulation trust earning more than just $12,950 would be taxed at the 37% tax bracket! The saving grace here is that a trustee can distribute IRA proceeds to the beneficiaries, in which case the beneficiary would receive a K-1 and would be taxed on that distribution at their own tax rate, with the trust receiving a corresponding income tax deduction. Additionally, a trustee can pick and choose between different beneficiaries in order to make efficient distributions, managing each beneficiary’s respective state and federal tax brackets and their needs.
As mentioned, accumulation trusts do not permit the ability to add charities as contingent beneficiaries nor will they allow for a general power of appointment to be exercised in favor of non-profits.
As a final note, minor children can receive lifetime stretch until the age of majority, plus ten years, under a conduit trust. However, many individuals with existing trusts should revisit their trust documents to ensure that their conduit provisions will abide by the rules put into place by SECURE. Furthermore, “a child may be treated as having not reached the age of majority if the child has not completed a specified course of education and is under the age of 26.” If this becomes reality, some IRA accounts under conduit trusts can last until the child turns 36 years old!
What if I’m married?
It still remains the case that if you are married, your spouse will likely be named as your primary beneficiary instead of your trust. To put it briefly, a surviving spouse: (i) remains eligible for a complete rollover to his own IRA, (ii) can “elect” his deceased wife’s inherited IRA as his own, or (iii) can take RMDs like any other beneficiary as an inherited IRA. Therefore, there are more options available to a surviving spouse when named directly as the primary beneficiary.
If the surviving spouse does a rollover to her own IRA, the spouse is treated as the “participant” instead of as the “beneficiary.” This means the spouse can defer the RMDs until she turns 72. Upon taking RMDs, the surviving spouse will use the (more favorable) Uniform Life Table rather than the Single Life Table.
A surviving spouse also has the option to elect to treat a traditional or Roth IRA that she (as sole beneficiary) inherited from the deceased spouse as her own traditional or Roth IRA. The advantage this may have over the rollover is if the decedent died after his RBD, then the election is always preferable to a plain “rollover” because the election is retroactive to the beginning of the election year, using the surviving spouse’s RMD as a participant (rather than a beneficiary), therefore producing a smaller RMD when compared to a rollover election made the year after the participant’s death (wherein the RMD for the rollover year will be determined based on the surviving spouse as beneficiary of the account, rather than a participant).
Finally, if a surviving spouse needs RMDs and/or is under 59 ½, it may be better to treat herself as a beneficiary under an inherited IRA. If the owner died before his RBD, the surviving spouse will be able to defer taking RMDs until the decedent would have turned 72 years old. If the owner died after his RBD, the surviving spouse would not be allowed to defer the RMDs. In this option, the surviving spouse still can do a rollover prior to 59 ½. If the surviving spouse does take RMDs, she will use the Single Life Table, but it will be annually recalculated in each subsequent year (rather than simply reducing the applicable distribution period by 1 in each subsequent year).
What are some other options outside of conduit or accumulation trusts?
Three other tools have been discussed after SECURE: standalone retirement trusts, Roth conversions, and Charitable Remainder Trusts.
Standalone retirement trusts are generally accumulation trusts that own nothing except your retirement accounts. This is especially helpful in a few situations. First, when you want different people to inherit your trust and different people to inherit your retirement assets, setting up a separate IRA trust makes things easier. Secondly, an IRA trust offers much more flexibility in creating as much asset protection as needed. Third, administration of these trusts at death is very easy and plan administrators need only be bothered about the retirement accounts, as opposed to a trust that owns your other assets.
A Roth conversion may be particularly useful where the IRA owner is very likely to have a taxable estate. The conversion from a traditional IRA to a Roth will cause income tax to be due on the entire value of the IRA. However, the payment of income taxes will reduce the size of the decedent’s estate for estate tax purposes, and it will eliminate the need for a conduit trust or accumulation trust. Because all proceeds from the Roth IRA will be received tax-free by the trust or beneficiaries, there is no tax benefit to be gained by a 10-year payout versus a five-year payout. However, advisors should also consider factors such as the time value of money and the relative rate of income taxes versus estate taxes, because the Roth conversion will cause income taxes to be immediately due, as compared to a potential postponement of taxes up to 11 years after the IRA owner’s death. In situations where the IRA would likely be held in a non-GST exempt trust, or where a charity is a desired remainder beneficiary, the Roth conversion may be a particularly useful tool. Consider that by not creating a Roth, the tax ramifications of your conduit or accumulation trust can be enormous, especially given that 10 years after your death (assuming life expectancy), will put most beneficiaries right at the peak of their earning potential, with the inheritance of the IRA of course pushing them to possibly the highest tax bracket.
A Charitable Remainder Trust (CRT) may also be desirable in the right situation. A CRT is not a designated beneficiary, so all of the IRA proceeds must be withdrawn under the 5-year rule. However, the CRT is not subject to income taxes. Thus, the IRA proceeds can be withdrawn and reinvested, tax-free, inside the trust. The annuity or unitrust payments to the individual beneficiaries of the CRT will carry out taxable income. In practice, this will allow the beneficiaries to spread the income taxation of CRT payments over a period of 20 years or life. The CRT will also provide an estate tax charitable deduction equal to the actuarial value of the charitable remainder interest. However, the CRT should only be used where the IRA owner has a significant non-tax charitable motivation, because the inherent nature of a CRT makes it very likely that significant value will pass to the charitable remainder beneficiary upon termination of the trust.
For many Americans, retirement accounts comprise the largest asset they will own when they pass away. It’s important to get it right.
Make an appointment with us, and we will discuss your situation to see if a change is helpful.