The SECURE Act, signed into law last December, brings important benefits for Americans, both retired and not yet retired. The Act will influence how you save money for retirement and how you withdraw money from retirement accounts in the future. It also includes rule changes that will cause distress for some.
Given that none of us know when we’ll die, there’s a good chance that when it happens, there will be money left in one or more pre-tax retirement accounts. The Act changes how those remaining funds will be treated. This post is not about good changes, but about changes that, for some, will trigger financial pain.
Every retirement account these days requires named beneficiaries in it’s documentation. The tax consequences for some of those beneficiaries has now changed, not always for the better.
Before January 1, 2020, named beneficiaries were essentially given the ability to “stretch” the incremental distribution of those funds over their statutory life expectancy. If, as a beneficiary, you didn’t need the money for some reason, you could leave it alone, let it grow, and only withdraw a percentage every year. Following the death of the original participant, the money transferred to what is known as an Inherited IRA with it’s own special rules. The funds, and resulting taxable income, could be “stretched” over the beneficiary’s life expectancy. With the exception of these five classes of beneficiary, the lifetime “stretch” option is gone.
The five classes are as follows:
- A surviving spouse,
- Minor children until they reach majority, usually age 18,
- Disabled individuals as defined by the IRS,
- Chronically ill individuals, also as defined by the IRS, and
- Individuals less than 10 years younger than the deceased, typically siblings.
For everyone else, within ten years of the decedents death, 100% of the account proceeds must be withdrawn and reported as current income. It’s uncertain yet whether it’s precisely ten years from the date of death; most likely it’s December 31st of the tenth year following the year of death.
For those beneficiaries reluctant to add more taxable income to their annual tax bill, the “stretch” option was helpful. It can now be avoided for ten years but at that point, 100% must be taken and accounted for. It’s estimated the elimination of the “stretch” provision has the potential to generate about $15.7 billion additional dollars for the treasury, according to an organization known as the Congressional Research Service.
Not all named beneficiaries are individuals. In many cases, it’s a trust, established by the account owner, in an effort to limit negative consequences for the trust beneficiaries or to exert an element of post-death control over the eventual outcomes. Keep in mind I’m not a professional accountant or a lawyer, so if any of this applies to you, take it with a grain of salt and seek professional advice.
Here are two things I do know. Trusts as beneficiaries of qualified money (not yet taxed money) come in two flavors, conduit trusts and discretionary trusts. Under the old rules, a conduit trust became the owner of the Inherited IRA and under the “stretch” rules, would receive annual Required Minimum Distributions (RMDs), the amount of which was based on the IRA approved life expectancy table for each named beneficiary of the trust. No funds remain in the trust itself. Everyone is taxed at their own personal tax rates.
With a discretionary trust, before 1/1/2020, the same RMDs would be paid to the trust but the trustee had discretion when it came to forwarding those funds to others. It gave the person establishing the trust some control over those assets. It allows you to speak from the grave. Imagine a father not wanting his son or daughter to get a huge chunk of money just when they turned 18.
The SECURE Act does away with RMDs with respect to trusts and those not already excepted as named above, and simply declares 100% of an Inherited IRA must be distributed by the end of ten years. To the extent the trust does not make distributions to it’s named beneficiaries, the trust now becomes responsible for income taxes. Such a trust, sometimes referred to as an accumulation trust, hits the highest tax bracket at only $12,950 of income compared with $622,050 for a married couple and $518,400 for single tax payers.
If you anticipate having a significant sum inside your qualified accounts, so named because they ‘qualify” for tax deferral, you have already thought about who should receive those funds at your death. You did this when you identified your beneficiaries and filled out the paperwork used to open those accounts. Here is how this might all play out:
- You may live a long time and exhaust those funds before you die. No problem.
- You may not live a long time and don’t have much money to worry about. No problem.
- You may have heirs who live normal lives, can be trusted with extra money and since you’re now dead, it’s their problem. No worries.
- You may have heirs whose judgement you question or whose circumstances suggest it would be in their best interest for you to retain some control over this money. As of 1/01.2020, you may now have a problem.
Mind you, some of the named beneficiaries of the trust could qualify for one of the five exceptions listed above, but at the end of ten years, all bets are off. Couple that with the tax rates for accumulation trusts, you might see a need to make some changes. Here’s what you might do:
- Change the beneficiary designations from children and grandchildren to a spouse. Just be aware the spouse could die leaving the same problem.
- Take distributions, pay income taxes at today’s relatively low rates, and deposit the after tax funds to a ROTH IRA. Your beneficiaries are still subject to the 10 year rule but the taxes disappear.
- Take distributions, pay tax on them, and use the net proceeds to buy a life insurance policy. You know you’re going to die someday, so effectively leverage today’s after-tax money into a life insurance policy that pays a tax-free death benefit. And it could include an LTC rider that pays benefits tax-free if you qualify.
- Made a gift to charity. These gifts give you current tax benefits and potentially benefit society. They just can’t directly benefit your heirs.
Several years ago, a client of mine made a significant gift of art to a local charity. In the same year he withdrew a sum of equal value from his qualified accounts. It went into a ROTH IRA. The tax bill for the withdrawal was largely offset by the charitable gift that cemented his legacy in the community. I just wish I’d been the one to suggest that idea to him.
In summary, there are a lot of good things about the SECURE Act. There are also some not so good things. Those create opportunities for financial professionals and attorneys to come up with creative ways to solve problems. Only you know your personal circumstances and if these changes strike a chord with you, I encourage you to find a remedy.
Tony Kendzior \ 17 FEB 2020