With only a few days remaining in 2019, Congress passed the groundbreaking SECURE Act, which affected many changes to the retirement planning landscape, most notably the elimination of the traditional “stretch IRA.”
As many estate and financial planning professionals know, the stretch IRA is an invaluable tool that allows non-spouse beneficiaries of retirement plans (401(k), 403(b), IRAs, etc.) to take required minimum distributions (RMDs) over the course of their life expectancies. Now, with the passage of the SECURE Act, most of those non-spouse beneficiaries will be forced to distribute their inherited retirement plans within ten (10) years of the account owner’s passing. Yikes! (Note: while the life expectancy stretch provision remains intact for surviving spouses, disabled or chronically ill beneficiaries, minor children of the account owner, or beneficiaries not more than 10 years younger than the account owner, most inherited IRA beneficiaries will not fall into either of these “eligible designated beneficiary” (EDB) categories.)
To put this into perspective, even for a 40 year-old “non-EDB” beneficiary inheriting a retirement plan, under the old laws, that beneficiary would have had over 40 years to take distributions from the account, allowing them to maximize the tax deferral benefits of an inherited retirement plan.
Additionally, many individuals designated a trust as a beneficiary of their retirement plan, often times for the benefit of a child or grandchild. These trusts were either set up as a “conduit trust” or an “accumulation trust.” In a conduit trust, the trustee is required to withdraw the RMD from the plan, distribute to the trust and then pass out the distribution to the beneficiary. Any additional distribution requests for that year would be made at the discretion of the trustee, adding a level of protection against excessive withdrawals by the beneficiary.
In an accumulation trust, the trustee still collects the annual RMD into the trust, but has the discretion as to how much, if any, of the RMD proceeds are to be paid out to the trust beneficiary. Any proceeds not passed out could be accumulated in the trust. While the accumulated proceeds are subject to trust income tax rates (typically unfavorable as compared to individual income tax rates), these trusts offer benefits for many different non-tax scenarios:
- Provide a level of creditor protection over the assets;
- Utilize strategic asset management through a professional fiduciary;
- Can be structured to preserve beneficiary’s eligibility for SSI/Medicaid (i.e. Special Needs Trust)
- Enable assets to be managed for the benefit of a minor; and
- Limit excessive withdrawals and mismanagement of the assets by the beneficiary.
With the passage of the SECURE Act, the viability of both types of IRA trusts was immediately questioned. With only 10 years available to strategically withdraw the IRA, larger sums of money will be required to pay into the trust over that time period, causing larger tax bills as a result of these accelerated distributions (regardless of whether the trust is a conduit or accumulation trust).
The trustee who collects the distributions then has the decision each year to distribute some or all of the proceeds to the beneficiary (who would then be responsible for paying the tax for that distributed amount on their personal income tax return), or retain the proceeds in the trust (and pay the tax at the trust tax rate on its fiduciary income tax return). Trust income tax rates are extremely compressed relative to individual income tax brackets: The trust pays at the top income tax bracket of 37% after the trust’s annual income exceeds just $12,950 (2020). Alternatively, if the income is passed out to the beneficiary, they don’t reach the 37% bracket until $510,301 of taxable income for a single individual ($612,351 for married, 2020).
Clearly the decision to retain retirement plan income in trusts will very often result in an unfavorable tax situation in a given year, but it doesn’t mean accumulation trusts are not a viable solution: I will argue they are more useful than ever before. Ultimately, if the trustee determines it is best to retain income in the trust for a given year, typically there are numerous non-tax reasons for doing so, i.e. preserving governmental benefit eligibility, creditor protection, and/or protecting a spendthrift or financially inexperienced beneficiary.
The SECURE Act has changed the distribution rules from a simple RMD system to a dynamic, strategic 10-year system. Remember, it is no longer as simple as having the IRA custodian/financial advisor calculate the RMD amount each year, and distribute the amount to the beneficiary or trust: There are no more RMDs within the 10-year rule! This will require the financial professional to weigh a number of factors each year to determine the optimal withdrawal amount from the IRA each year, including current and future income tax brackets, available deductions, and the financial needs of the beneficiary.
Ultimately the professional needs to compare the financial factors versus the beneficiary’s needs and restrictions. An accumulation trust gives the IRA owner and the fiduciary more clarity as to the grantor’s intentions and the beneficiary’s needs, and it gives more options to achieve all goals.
As a true fiduciary, professional trustees already take on these discretionary responsibilities when managing trust funds. They serve as more than just an asset manager: They are a lifestyle manager. Trust beneficiaries rely heavily on the assets managed in the trust, and it’s the trustee’s job to consider numerous factors in determining the optimal strategy to provide for their benefit. With the passage of the SECURE Act and the new 10-year rule, beneficiaries of inherited IRAs will need a true fiduciary on their side to help navigate this new and complex landscape.