Estate planning is never a one-time event. Not only will your life change in ways that might require updating your plans, but Congress can also change the rules your plans reflect.
While January 2020 may feel like a long time ago, it marked a relatively recent update to the rules governing retirement accounts, especially individual retirement accounts. This means that even if you previously decided how to handle your traditional or Roth IRA upon your death, you may need to revisit your plan to ensure it still works the way you intend.
The SECURE Act And IRA Planning
The Setting Every Community Up for Retirement Enhancement Act, usually shortened to the SECURE Act, took effect in 2020. It continues to reshape retirement planning, including estate planning for IRAs, as estate planning professionals work to understand the full scope of the new regulations.
One of the most significant changes was the end of “stretch” IRA rules. Before the SECURE Act, if you left your traditional or Roth IRA to someone other than your spouse, that beneficiary could spread account distributions over his or her lifetime. Annual required minimum distributions for inherited IRAs depended on the recipient’s life expectancy. This meant that naming a young beneficiary could maximize tax-free or tax-deferred growth for assets in the account.
The new law limits most beneficiaries to a 10-year window following the original account owner’s death. The distributions need not be annual, but all the assets must be distributed by Dec. 31 of the 10th year after the original owner died. In general, the beneficiary’s age no longer matters. The law makes exceptions for five particular types of beneficiaries: spouses, minor children, beneficiaries who are disabled, beneficiaries who are chronically ill, and beneficiaries who are fewer than 10 years younger than the original account owner.
This change is inconvenient for estate planning for a couple of reasons. Younger beneficiaries lose the potential for greater tax-deferred or tax-free investment growth. In addition, a shorter distribution period will necessarily result in larger distributions. Depending on the timing, these distributions could push a beneficiary into a higher income tax bracket.
The new 10-year rule mirrors the preexisting rules for IRAs without a designated beneficiary. These accounts were – and are – subject to the “five-year rule” if the owner dies before he or she starts taking required minimum distributions. In this case, whoever inherits the IRA via the rules of probate must withdraw all the assets by the end of the year that includes the fifth anniversary of the original account owner’s death. If the owner dies after beginning to take RMDs, the payout period is shaped by the participant’s remaining life expectancy. The five-year rule remains in effect for IRAs without a named beneficiary.
This change may seem technical, but the SECURE Act has concrete effects for estate planning with a traditional or Roth IRA. Because the SECURE Act is still relatively new, Treasury Department regulations may continue to shape its application going forward. For now, estate planners and taxpayers must work with the law as written. In many cases, this may mean making changes to trusts.
Before the SECURE Act, trusts were a common planning technique to make the most of stretch IRAs. When an IRA was payable to a trust, the trustee would withdraw the required minimum distribution and pass it to the trust’s beneficiary. He or she would pay the income tax on the – usually small – RMD, and the rest of the assets would continue to grow tax-free or tax-deferred. However, the new 10-year limit can also affect trusts, depending on how they are structured, complicating planning done before 2020 and requiring new strategies for future planning.
Under the new rules, a taxpayer faces several questions. First, who is the intended beneficiary, or beneficiaries? Do any of them fall into the special categories that the law carves out? Are any of them charitable institutions?
Second, taxpayers should consider whether lifetime withdrawals will offer more benefit than leaving significant assets in an IRA to pass at death. In the absence of a longer time horizon for tax benefits, other strategies may make more sense.
Third, the taxpayer should consider whether leaving the IRA directly to the beneficiary or leaving it to a trust makes most sense. Trusts can be costly and complicated to set up and administer, so they are not always the best option. But certain circumstances may make a trust worth the extra time and expense.
An IRA Planning Example
To make all of these questions a bit clearer, let’s consider a fictional family who may have used stretch IRA planning prior to the SECURE Act. Both before and after the law passed, the family hoped to defer income taxes on IRA assets. But whether that deferral is still possible, or worthwhile when compared with other estate planning goals, will very much depend on the family’s particular circumstances.
John wants his IRA to benefit three people: his wife, Maureen; his daughter, Judy; and his son, Will. Maureen is John’s second wife, while Judy and Will are the adult children of John’s prior marriage. None of the three intended beneficiaries is disabled or chronically ill.
John has five principal options for benefitting his family members with his IRA. First, he could take the common route of naming Maureen as his sole IRA beneficiary. Because she is John’s wife, Maureen could roll the entire IRA over into her own IRA. She would thus eliminate the need to take any distributions at all until she reaches age 72 and becomes subject to her own IRA’s RMD requirements. Depending on when John dies and the age difference between John and Maureen, this can create a small benefit or a very large one; either way, it is a straightforward approach. However, it means that nothing passes to Judy and Will from John’s IRA.
The second option looks the same from John’s perspective. He again names Maureen his IRA’s sole beneficiary, and again there is no benefit for Judy or Will. In this second scenario, however, Maureen does not roll the IRA over into her own. This approach allows Maureen to access the assets sooner, at the cost of forgoing some of the previous option’s tax benefits. As the deceased account owner’s spouse, Maureen does have the option to take distributions over her lifetime, rather than facing the 10-year cutoff on distributions that applies to most beneficiaries. Her life expectancy for this purpose would be recalculated annually. If any assets remain in John’s IRA when Maureen dies, the 10-year rule kicks in at Maureen’s death.
If she is younger than 59 ½ when John dies, Maureen can also delay the rollover. Since inherited IRAs are not subject to the 10% penalty for early distributions, this still gives her access to John’s IRA assets until she reaches 59 ½, at which point she can roll the remaining assets over into her IRA. This option, however, is mainly planning for Maureen; it doesn’t help John with his goal of benefitting all three family members.
This leads to his third option. John has the option to set up a “conduit trust.” In this type of trust, the trustee would be required to pass all IRA distributions to Maureen during her lifetime. RMDs are delayed until one year after John’s death or the year John would have turned 72, whichever is later. A conduit trust removes the option for a rollover, and can allow John to name Judy and Will as secondary beneficiaries. However, because of the way RMDs are calculated, if Maureen lives to or past her life expectancy, few assets (if any) will remain for John’s adult children.
In option four, the trust becomes more complex in order to address federal estate tax concerns. In a combination conduit-qualified terminable interest property trust, the trustee would be required to distribute not only RMDs but also any IRA income to Maureen during her lifetime. The trust, by design, makes the most of the IRA’s potential for tax-free or tax-deferred growth while also qualifying for the federal estate tax marital deduction. But while this arrangement has benefits for estate tax purposes, it still potentially leaves Judy and Will with no benefits, depending on how long Maureen lives.
The fifth option for John is a trust that is not a conduit trust or a conduit-QTIP hybrid. In the two previous examples, the IRA in trust is subject to the same rules as it would have been if John left it to Maureen outright. In non-conduit trusts, however, this is not true even if Maureen is the sole beneficiary. Depending on how the trust is structured, it may be subject to the 10-year rule or the five-year rule. Either would mean forgoing the tax-free or tax-deferred growth a longer time horizon would offer.
Prior to the SECURE Act, John could have set up a QTIP trust that would pay Maureen during her lifetime and pass any remaining benefits to Judy and Will after Maureen’s death. A common approach would be to structure the trust so that Maureen received the IRA’s income, plus principal at the trustee’s discretion for health or support needs. Any principal Maureen didn’t need would thus be saved for Will and Judy.
However, in a post-SECURE world, this approach has significant drawbacks. Distributions from a QTIP trust are subject to the 10-year rule. All retirement benefits will be distributed, regardless of Maureen’s age, within 10 years after John dies. These distributions will be subject to tax at the trust’s tax rates (with a few exceptions). Trust income tax rates may well be higher than the beneficiaries’ income tax brackets. In addition, Maureen will not have the option to roll over these benefits or defer them until age 72; nor will she have the option to base payouts on her life expectancy, as she would with a conduit trust.
Even in the QTIP trust scenario, Will and Judy likely face a long wait for relatively little money. If Maureen is in good health, and especially if she is significantly younger than John, it could be decades before John’s IRA benefits his children in any way. And if Maureen faces a long illness or the need for other long-term care, the terms of the trust could significantly eat into the IRA’s principal.
Given the SECURE rules, John may ultimately decide it makes more sense to take another estate planning approach. For example, he could leave the IRA to Maureen outright as in the first two options above, and buy life insurance as a replacement asset to support Judy and Will. This alternative approach supports all three family members, though it does not use IRA assets to do so.
John may be tempted to leave the IRA to Maureen but add a condition, such as that she name Judy and Will the beneficiaries of her rollover IRA. But from a legal standpoint, this approach is a nonstarter. Such a condition offers no real legal protection for Judy and Will if Maureen chooses not to comply after John’s death. Even if John’s children tried to pursue their claim in court, Maureen has the right to withdraw all the assets from her IRA during her lifetime without anyone else’s consent, or even their knowledge.
Even if Maureen doesn’t object to naming Judy and Will her beneficiaries, however, John’s approach could create problems. If John has left Maureen his IRA assets on the condition that she will not spend them all herself and that she leave either the assets or their proceeds to John’s children, he has created what is known as a “terminable interest.” This means the gift will not qualify for the marital deduction or, in all likelihood, the spousal rollover. John has thus undone all the estate and income tax benefits of leaving the IRA to Maureen in the first place.
John also has the option to simply split the IRA benefits between Maureen, Judy and Will. Compared to creating a QTIP trust, this approach would leave all three family members a substantial and relatively immediate financial benefit. An estate planning professional could even estimate how much each beneficiary could have expected from a QTIP trust, using that information to determine how the IRA benefits should be divided. If John leaves his IRA assets to all three beneficiaries, Maureen will be able to roll hers over; Will and Judy will be subject to the 10-year rule.
Alternatively, John could split his IRA into three separate IRAs during his lifetime, and name Maureen, Judy and Will the sole beneficiary of each. As with splitting the IRA between them, this plan allows Maureen to take advantage of the option to roll over the assets she receives. In addition, if Will and Judy have kids of their own, it will be easier for them to name those children contingent beneficiaries in this arrangement. For example, if Will should predecease John, the IRA he was set to inherit can pass to his children, while the IRAs marked for Maureen and Judy would not be affected. Splitting the IRA into three would also allow John to manage each account with an eye toward the projected timeline for each beneficiary’s distributions and allowing for their respective financial situations. This approach, like the previous strategy of naming three direct beneficiaries, gives John the option to easily update his beneficiary designations at any time if his family’s situation changes.
Other IRA Planning Considerations
As the previous example illustrated, there is not one right choice for your IRA in the post-SECURE era. Planning may look different yet again if you hope to benefit minor children, or a beneficiary who is disabled or chronically ill.
If you want to assist a disabled beneficiary, it may be preferable – or, in some cases, essential – to leave the benefits in trust, regardless of any tax consequences. Leaving an IRA to disabled beneficiaries outright could disqualify them from certain government benefits or other need-based assistance. Under SECURE Act rules, taxpayers can leave the IRA to a see-through accumulation trust for the benefit of a beneficiary who is disabled or chronically ill and still secure the exception to the 10-year distribution requirement, even though this sort of trust normally wouldn’t allow it. This arrangement is called an “applicable multi-beneficiary trust.” Even families with sufficient means to ensure lifetime care of a disabled beneficiary may prefer to use such a trust, since it builds in a level of fiduciary care from the trustee. Regardless, it is especially important to consult a knowledgeable estate planning professional when planning for a disabled or chronically ill beneficiary.
For children under the “age of majority” – usually 18, though it varies by state – the SECURE Act’s 10-year rule does not kick in until they reach adulthood. The Treasury Department released proposed regulations earlier this year that, if adopted, would define the age of majority for required minimum distribution rules as 21 regardless of state law. Future regulations may add other considerations, such as allowing an exception until the child has completed his or her higher education. But such future regulation cannot be certain until it arrives, so planning should not rely on it for now.
Finally, you may want to leave an IRA to someone who is not your spouse but who is near your own age, such as a sibling. In this case, be aware that special rules apply to beneficiaries “not more than 10 years younger” than the IRA owner. These beneficiaries are generally exempt from the 10-year rule. This doesn’t provide the traditional “stretch” that made leaving IRAs to younger generations especially appealing prior to the SECURE Act. But depending on your intentions and your beneficiary’s age and state of health, it may still allow for a slightly more beneficial distribution schedule.
In some cases, if you have philanthropic intentions, it may also make sense to leave your IRA to a charitable remainder trust. This strategy can essentially eliminate income tax on the IRA itself, allowing you to pass more assets directly to the charity, while providing a lifetime benefit for family members or other noncharitable beneficiaries.
The Future Of IRA Planning
No tax law lasts unchanged forever. Legislation currently under consideration could create further IRA planning challenges and opportunities.
At this writing, the House of Representatives passed a piece of legislation colloquially known as “SECURE Act 2.0.” The bill passed in March with strong bipartisan support, and a companion bill is pending in the Senate. While the legislation could change before it becomes official, assuming it passes at all, the House version of the bill made several changes that would affect retirees. These included gradually raising the retirement age, for the purpose of required minimum distributions, from 72 to 75; reducing the penalty for failing to take RMDs from 50% to 25%; and increasing catch-up contribution limits for savers over 50 years old.
Whether SECURE Act 2.0 passes in its current form, with changes, or not at all, it will not be legislators’ last word on retirement accounts. Even if you rely on more complex planning approaches such as trusts, you should be ready to revisit your plan in light of significant future changes. Ongoing flexibility is essential to be sure that you, and your beneficiaries, meet your obligations while getting the most out of your carefully saved retirement assets.