United States: SECURE Act Means It's Time To Review Estate Plans

On Dec. 20, 2019, the President signed into law the Setting Every Community Up for Retirement Enhancement Act, commonly referred to as the SECURE Act. Beginning Jan. 1, the SECURE Act substantially revises the income tax deferral opportunities of qualified retirement plans, such as 401(k)s, IRAs, 403(b)s and other qualified retirement plans. This client bulletin summarizes salient points of the SECURE Act and how it may affect a client’s income tax and estate planning objectives. Nearly all estate plans should be reviewed to preserve maximum income tax deferral and avoid unanticipated consequences resulting from estate plans drafted prior to passage of the SECURE Act.

I. Mandatory Distribution of Qualified Retirement Accounts to Beneficiaries Other Than Eligible Designated Beneficiaries.

Prior to passage of the SECURE Act, heirs and qualifying trusts designated as a beneficiary of a qualified retirement account could stretch out the distribution of the qualified retirement account over the applicable beneficiary’s life expectancy. The undistributed portion of an heir’s qualified retirement account would continue to grow income tax free, resulting in substantial income tax savings and untaxed appreciation. The SECURE Act eliminates the ability of most heirs to stretch the qualified retirement account over their life expectancy, and instead requires all beneficiaries, other than “Eligible Designated Beneficiaries,” to receive the full balance of the inherited qualified retirement account within 10 years following the year of inheritance. The SECURE Act eliminates annual required minimum distributions to beneficiaries other than Eligible Designated Beneficiaries, and only requires the full balance of the account to be distributed within the 10-year period. This means a beneficiary could defer the full distribution of the account until year 10 and not receive any required minimum distributions in the interim. This 10-year requirement applies to trusts, including trusts qualifying as see-through trusts with conduit trust provisions.

Example – A dies with an IRA balance of $5 million in 2020 and designates the beneficiary of the account as A’s adult daughter, B. B does not have to receive any required minimum distributions after A’s death and could defer receiving the full IRA balance until 2031. Alternatively, B could receive the IRA balance gradually over the 10-year period to mitigate a large income tax obligation in 2031.

Example – A dies with an IRA balance of $5 million in 2020 and designates the beneficiary of the IRA as A’s revocable trust, whose primary beneficiary is a separate subtrust for the primary benefit of A’s adult daughter, B. Like the example above, the trustee must receive the full distribution of the account by 2031.

Planning Opportunity – Clients could designate a charitable remainder unitrust (commonly referred to as a CRUT) as the beneficiary of their IRA with their children as the income beneficiaries of the trust, which would allow the children to receive the IRA proceeds over a period longer than 10 years. Clients anticipating net operating losses will want to defer the recognition of an inherited IRA until their net operating losses are incurred. Additionally, clients inheriting IRAs close to retirement will want to defer receipt of the IRA account until retirement, when presumably they will be in a lower income tax bracket.

II. Distribution Provisions of Qualified Retirement Accounts to Eligible Designated Beneficiaries.

The 10-year rule explained above will not apply to Eligible Designated Beneficiaries. The SECURE Act excludes five types of Eligible Designated Beneficiaries from the 10-year rule: (A) spousal beneficiaries; (B) minor children of account owner; (C) individuals who are not more than 10 years younger than the account owner; (D) disabled beneficiaries; and (E) chronically ill beneficiaries.

A. Spousal Beneficiaries. Surviving spouses qualify as Eligible Designated Beneficiaries. They are still entitled to spousal rollover of IRAs and receive required minimum distributions over their life expectancy.

B. Minor Children of Account Owner. Minor children of the account owner qualify as Eligible Designated Beneficiaries and can stretch receipt of the inherited qualified retirement account until they reach the age of 18 years,[1] at which point they are forced to receive the entire qualified retirement account within 10 years after attaining age 18. Put another way, upon attaining age 18, the child is subject to the 10-year rule explained in Section I above. This rule, however, applies only to the account owner’s children. Accordingly, minor grandchildren designated by a grandparent as beneficiaries of his or her qualified retirement account would not qualify as Eligible Designated Beneficiaries, and such minor children will be forced to receive the entire qualified retirement account within 10 years following the year of the grandparent’s death.

Example – A dies with a 10-year-old son, B, in a state where the age of majority is 18 years. A designates B as the primary beneficiary of his IRA. B must begin receiving required minimum distributions the year after A’s death. Upon attaining age 18, B will be required to receive the entire IRA account by age 28.

Example – A dies with a 10-year-old grandson, B. A designates B as the primary beneficiary of his IRA. Because B is not A’s child, B is not an Eligible Designated Beneficiary under the SECURE Act and is forced to receive the entire IRA account within 10 years following the year of A’s death.

C. Individuals Not More Than 10 Years Younger Than Account Owner. An individual who is not more than 10 years younger than the account owner qualifies as an Eligible Designated Beneficiary and can stretch receipt of the inherited qualified retirement account by receiving required minimum distributions over his or her lifetime.

Example – A dies without children and designates A’s sibling, B, as the beneficiary of A’s IRA account. B is 4 years younger than A, and therefore qualifies as an Eligible Designated Beneficiary and can receive required minimum distributions over B’s life expectancy.

Example – A dies without children and designates A’s sibling, B, as the beneficiary of A’s IRA account. B is 12 years younger than A, and therefore is not an Eligible Designated Beneficiary and is forced to receive the entire IRA account balance within 10 years following the year of A’s death.

D. Disabled Beneficiaries. Disabled beneficiaries qualify as Eligible Designated Beneficiaries and can stretch receipt of the inherited qualified retirement account by receiving required minimum distributions over their lifetime. A disabled beneficiary is defined pursuant to Internal Revenue Code §72(m)(7), and is an individual “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.” Individuals receiving Social Security Disability Insurance should qualify as a disabled beneficiary. Other disabled beneficiaries filing IRS Schedule R titled “Credit for the Elderly or Disabled” with their 1040s are qualified as the schedule requires a physician’s certification that the individual meets this definition of disability.

E. Chronically Ill Beneficiaries. Chronically ill beneficiaries qualify as Eligible Designated Beneficiaries and can stretch receipt of the inherited qualified retirement account by receiving required minimum distributions over their lifetimes. A chronically ill beneficiary is defined pursuant to Internal Revenue Code §7702B(c)(2), and is an individual that (i) is unable to perform (without substantial assistance from another individual) at least two activities of daily living for a period of at least 90 days due to a loss of functional capacity; or (ii) requires substantial supervision to protect such individual from threats to health and safety due to severe cognitive impairment.

III. Increase in Age for Required Beginning Date for Mandatory Distributions.

Prior to the SECURE Act, account owners were required to begin receiving required minimum distributions from their qualified retirement accounts beginning at age 70½. The SECURE Act increases this age to 72 years, which allows greater income tax deferral to account owners.

IV. Repeal of Maximum Age for Traditional IRA Contributions.

Prior to the SECURE Act, individuals who attained age 70½ could no longer make any contributions to IRAs. The SECURE Act repeals this age prohibition. Individuals over age 70½ can now make contributions to IRAs; however, the requirement that such individual be working and receive compensation remains.

V. Expansion of 529 Benefits.

The SECURE Act expands permissible expenditures from 529 accounts to include apprenticeships, homeschooling, up to $10,000 of qualified student loan repayments (including those of siblings), private elementary school, private secondary schools and religious schools.

Conclusion:

The SECURE Act substantially changes the income tax deferral most clients expected in their estate plans. All estate plans should be reviewed and updated to ensure maximum tax deferral and avoid unanticipated consequences.

Footnotes

1. State law determines the age of majority. Most states' age of majority is 18.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.