On January 1, 2020, the Setting Every Community Up for Retirement Enhancement (SECURE) Act came into effect drastically changing the dynamics of naming beneficiaries of Individual Retirement Accounts (IRAs). The IRS recently issued Proposed Regulations in an effort to provide additional guidance and clarification on the manner in which the SECURE Act applies to IRA beneficiaries. One of the most significant impacts of the SECURE Act is how it affects the timing of required minimum distributions and the length of time in which assets of an inherited IRA can remain in the IRA for the benefit of a designated beneficiary.
Prior to the passage of the SECURE Act, a designated beneficiary of an IRA had the ability to stretch required minimum distribution payments over the beneficiary's life expectancy. This provided favorable tax treatment to the beneficiary. First, this allowed the assets held in the IRA to continue to grow tax deferred for the benefit of the beneficiary over their life expectancy. Second, it generally allowed for smaller required minimum distributions to the beneficiary since it was based upon the beneficiary's life expectancy. These smaller required minimum distributions resulted in the beneficiary paying less in income tax for amounts distributed from the IRA, since amounts distributed to a beneficiary are reported as income each year on the beneficiary's individual income tax return. The SECURE Act changed the ability to stretch required minimum distribution over a beneficiary's lifetime and replaced it with a 10- year payout rule.
The 10-year payout rule applies to a non-eligible designated beneficiary and requires that a beneficiary receive all the assets of the IRA within 10 years from the year following the owner's death. Prior to the issuance of the Proposed Regulations the common belief among practitioners was that a beneficiary was afforded considerable flexibility during this 10-year period. The belief was that a beneficiary could receive payments over the 10-year period in any manner that they wished so long as all the assets were distributed by the 10th year. Under this interpretation, a beneficiary could spread payments over the 10-year period or wait until the final year to take the entire amount of the IRA.
Recently, the IRS issued Proposed Regulations providing guidance on the distributions to a beneficiary during this 10-year period. The Proposed Regulations clarified that a beneficiary does not have as much flexibility during the 10-year period as previously believed. The Proposed Regulations state that for those IRAs in which the owner died prior to age 72, the IRA must be fully distributed within 10 years. However, for IRAs in which the owner died after reaching at least age 72 the beneficiary must annually take at least the required minimum distribution calculated according to the life expectancy rules and, additionally, the IRA must be fully distributed within 10 years. Thus, for those beneficiaries who inherit an IRA from a decedent who attained at least age 72, the Proposed Regulations clarify that a beneficiary cannot simply wait until the final year to take a lump sum distribution but rather, must take required minimum distributions during this 10-year period.
While the 10-year rule applies in many situations, The SECURE Act provides that this rule does not apply to a beneficiary classified as an “eligible designated beneficiary.” An “eligible designated beneficiary” is defined as including: 1) a surviving spouse; (2) a minor child; (3) a disabled or chronically ill person; or (4) a person not more than ten years younger than the IRA owner. Any beneficiary with this designation may continue to stretch required minimum payments from the IRA over the beneficiary's life expectancy, in the same manner that could be accomplished prior to the enactment of the SECURE Act.
A spousal beneficiary continues to enjoy the same flexibility that existed prior to the SECURE Act and may treat the IRA as the surviving spouse's own and roll it into the spouse's own IRA. This provides the tax benefit of deferring distributions until the surviving spouse reaches age 72, also allowing for tax deferred growth of the IRA.
Should an IRA owner wish to name a trust as beneficiary of an IRA, careful consideration must be given to the terms of the trust and whether the beneficiary of the trust qualifies as an eligible designated beneficiary. For example, a trust established for a disabled beneficiary is permitted to stretch the IRA, so required minimum payments are paid over the lifetime of the beneficiary. Thus, the trust generally does not affect the ability for a disabled beneficiary, as an eligible designated beneficiary to stretch payments over the beneficiary's lifetime. However, if a non-eligible designated beneficiary is named as the beneficiary of a trust, then the IRA would have to distribute the assets within 10 years. This can have significant income tax consequences depending upon whether the trust is a conduit trust, requiring mandatory distributions to the beneficiary, or if it is an accumulation trust in which the trust accumulates income. Thus, it is important to closely review all assets in an estate plan to determine the best manner in which to fund a trust.
Given the changes in the law under the SECURE Act, it is vital that you determine how this will apply to your estate plan. Brouse McDowell's skilled attorneys can help you navigate these changes and properly implement them into your estate plan.
Originally Published 21 June 2022
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