By: Rebecca G. M. Krehbiel
The SECURE Act1 makes sweeping changes to the required minimum distribution (“RMD”) rules for retirement accounts. Except for a few types of beneficiaries, it eliminates the most popular tax-advantaged planning feature – the ability of a retirement beneficiary to stretch RMDs over the beneficiary’s life expectancy. The elimination of the stretch fundamentally changes how beneficiaries are taxed on inherited retirement assets, altering incentives for those currently saving for retirement and those looking to find a tax efficient way for their families to benefit from years of hard-earned retirement savings. Individuals and their advisors should revisit their retirement beneficiary designations and estate plans to assess the SECURE Act’s impact on estate planning, tax, and retirement savings goals, particularly if the owner does not wish for a beneficiary to receive large distributions.
DEATH OF THE STRETCH
Prior Law
Before the SECURE Act, a non-spouse individual beneficiary of a retirement account could stretch RMDs over his or her life expectancy, allowing the account to grow tax-deferred over the beneficiary’s life. A surviving spouse could execute a tax-free rollover of the account and treat it as his or her own (commonly referred to as the “spousal rollover”). The worst tax outcome was for a non-spouse, non-individual beneficiary (typically an estate or non-qualifying trust) which had to withdraw the account over a 5-year period, unless the decedent was already taking RMDs, in which case RMDs could be stretched over the decedent’s remaining life expectancy.
Current Law – Narrowing the Applicability of the Stretch
The SECURE Act leaves the favorable spousal rollover in place, but a non-spouse individual beneficiary must now withdraw the retirement account within 10 years of the account owner’s death regardless of whether the owner was taking RMDs at death. A limited exception allows the stretch to remain in place for a beneficiary who qualifies as an “eligible designated beneficiary” (“EDB”). The Act defines an EDB as a surviving spouse, a minor child, a disabled or chronically ill individual, or an individual not more than 10 years younger than the owner. For minor children, the 10-year rule kicks in once the child reaches the age of majority, a threshold yet to be clearly defined under the new law.
If an EDB dies before his or her share of the retirement account is fully distributed, any beneficiary named by that EDB must withdraw the balance over 10 years. For example, the child of an EDB cannot step into the EDB’s shoes using the remainder of the EDB’s life expectancy but must withdraw the balance over 10 years.
The Act affects all retirement accounts inherited in 2020 and beyond but does not spare pre-2020 inherited accounts. A successor beneficiary to someone who inherited a retirement account before 2020 is subject to the new 10-year rule on the original beneficiary’s death. How the Act applies to successor beneficiaries of pre-2020 trusts named as beneficiaries of retirement assets is still unclear.
Illustration of the Tax Impact of the 10-Year Rule
A 75-year-old mother dies with no surviving spouse and with a $2M IRA naming her 2 adult children as equal beneficiaries. Each child must now withdraw his or her $1M share of the IRA within 10 years of the mother’s death. This could be done by taking an amount each year, such as $100,000 a year (the best result from a tax perspective assuming a steady annual income), or by taking larger sums over fewer years. Either way, the distributions are ordinary income. Prior to the SECURE Act, each child could take much smaller annual RMDs each year based on the child’s life expectancy under the IRS tables. If the child was 40, the first-year distribution would be approximately $23,000. Smaller RMDs made it less likely the RMD would bump the child into a higher tax bracket. Thus, more money could remain in the IRA to grow tax-deferred.
Planning After the Elimination of the Stretch
Individuals and their advisors should revisit beneficiary designations and estate plans, particularly if the owner is concerned about the beneficiary receiving large distributions. Individuals in second marriages or those with children unable to handle their affairs due to young age, disability, addiction, financial irresponsibility, etc., will need to ensure that plans originally set up to accommodate such beneficiaries will still serve the desired goals.
Those especially concerned about beneficiaries receiving larger distributions under the 10-year rule may want to consider a qualifying trust that can accumulate income. An accumulation trust gives the Trustee greater discretion over distributions, as opposed to conduit trusts, popular under the old regime, which are required to distribute all assets received from a retirement account to the beneficiary. Conduit trusts worked well with the stretch (and will still work if the beneficiary is an EDB), but for non-EDBs who should have restricted access to their inherited retirement funds, an accumulation trust may be the only option. Accumulating retirement distributions in a trust, however, comes a hefty income tax cost since federal income tax brackets for trusts are compressed and reach the highest marginal rate at just $12,950 of income in 2020. Advisors should weigh whether the added tax is worth the asset protection.
Individuals with significant retirement assets may also want to consider gradual Roth conversions to spread the income tax out over time. Roth IRAs are still subject to the 10-year rule, but the distributions are not taxable to the recipient. Or, if charitably minded, those with significant retirement assets should revisit their charitable goals and consider using their retirement accounts to fulfill them, both to reduce the amount of taxable assets to the beneficiaries and because the charity won’t pay tax on the distribution. Additionally, if done correctly, naming a charitable remainder trust as a beneficiary of a retirement account may provide an alternative way to stretch distributions over a beneficiary’s life.
BENEFITS TO INDIVIDUALS
The elimination of the stretch will raise an estimated $15.7 billion over the next 10 years to fund other provisions of the Act aimed at adapting the current retirement scheme to the realities of the American workforce – more self-employed, part-time, and gig economy workers, longer life expectancies, and more people working past age 65. These benefits to individuals include:
- Kiddie tax back to Pre-TCJA rates. The Act repealed the changes to kiddie tax rates made by the Tax Cuts and Jobs Act of 2017. Following the passage of the SECURE Act, a child’s unearned income is taxed once more at the parents’ rates (if higher than the child’s rates) rather than at the more compressed trust and estate tax rates.
- Fellowships and stipends count as compensation for retirement purposes. Tax-deductible fellowships and stipends (e.g. those earned by graduate students or postdocs) are now treated as compensation for retirement purposes. This allows recipients of such income to contribute to IRAs.
- Contributing to retirement beyond age 70 ½. The Act repealed the maximum age for contributions to traditional IRAs by those who have attained age 70 ½. This change allows individuals working past the traditional retirement age to continue saving for retirement.
- No RMDs until 72. Whereas before the Act, required minimum distributions (“RMDs”) had to be taken by April 1 of the year following the year an account owner turned 70½, the Act increased this threshold age to 72. This generally would not affect rank-and-file employees, who may postpone RMDs from their employers’ plans until they retire.
- Withdrawals for birth or adoption. The Act allows penalty-free withdrawals of up to $5,000 per individual in the year a child is born or the adoption finalized. This amount is per individual, so a married couple could withdraw $10,000 ($5,000 from each spouse’s respective retirement accounts) for such purposes. This is an optional provision that may be adopted by a plan sponsor through a plan amendment.
- 529 distributions for apprenticeship programs and student loans. Qualified distributions from 529 plans now include fees, books, supplies, and equipment required for a beneficiary’s participation in an apprenticeship program as well as distributions of up to $10,000 per beneficiary (a lifetime cap) to pay off student loans. Distributions to pay off student loans can also be made from a 529 for the beneficiary’s siblings without having to change the beneficiary on the account.
The attorneys at Jackson Kelly PLLC are ready to assist you with questions about how the SECURE Act affects you and how best to plan under its new rules.
1 Setting Every Community Up for Retirement Enhancement Act (the “SECURE Act” or the “Act”, H.R. 1865, P.L. 116-94).