In the last addition of our newsletter, my colleague Chris Blackmon covered some of the tax implications of the newly-enacted SECURE Act. As you may know, the SECURE Act (which stands for “Setting Every Community Up for Retirement Enhancement Act”) was signed into law in late December and became effective January 1st of this year. As Chris outlined, the Act makes significant changes to how retirement accounts can be funded, drawn down, and passed on to the next generation. While many of these changes have obvious tax ramifications, in this article we want to explore further the less obvious estate planning impact of these changes.
If you own an IRA or a retirement plan, you have likely named an individual or a trust as the beneficiary of your account or plan. Most married individuals name their spouse (if they have one) as the primary beneficiary, since a spouse is able to rollover any proceeds received into a spousal IRA with no tax consequences. The SECURE Act doesn’t make any changes to spousal rollover rules, so this strategy is still effective. The primary issues come into play when a non-spouse or a trust receives funds from an IRA as either the primary or contingent beneficiary. Under the new Act, in these instances most estate plans will not work in the way they were initially designed.
The End of the Stretch IRA
Prior to the SECURE Act, if someone other than a spouse inherited an IRA or qualified retirement plan, the Required Minimum Distributions (RMD’s) were based on the beneficiary’s remaining projected lifetime. This allowed beneficiaries to “stretch” the IRA distributions over their lifetime, allowing more money to remain in the account growing income-tax free—hence the name “Stretch IRA.” For example, a 25-year-old beneficiary (with a life expectancy of 58.2 years) would have a relatively small required distribution. What happened if you preferred to name a trust to provide some control and protection of the assets, perhaps due to youth or financial inexperience of the beneficiary? Under the “Stretch IRA” we could still utilize the lifetime of the underlying trust beneficiary to calculate the required distributions. There was no negative tax impact from naming a trust as the beneficiary, and the desire for control and protection could be achieved.
Under the SECURE Act, beneficiaries other than a spouse must now remove ALL funds from the IRA and pay tax at their own ordinary income tax rates within 10 years of receiving the inheritance. There are only a few exceptions: a surviving spouse (as mentioned above), beneficiaries who are less than ten years younger than the original owner, a minor child, and a disabled or chronically ill beneficiary. For all other beneficiaries, this requirement to distribute all funds within 10 years will accelerate when taxes are due and may result in a larger overall tax burden. The loss of tax-deferred growth over many years may also mean non-spousal beneficiaries receive a meaningfully smaller after-tax inheritance from IRA’s and qualified plans than they would have under the old rules. In a nutshell, IRA’s inherited by anyone other than a spouse will not provide the same benefits as before.
What Steps Should You Take Now?
First, we are recommending that all clients review their beneficiary designations as a result of the SECURE Act. For example, if you have named a trust as a primary or contingent beneficiary of your IRA (as I have), we will want to review the language of the trust with you and your estate planning attorney to see whether modifications are needed. For example, does the trustee have the flexibility to make the IRA distributions required under the new tax law and to consider differences in individual and trust tax rates? For example, if the Trustee is allowed to distribute “part, all or none” of the income of the trust, this flexibility should allow the Trustee to make good decisions based on the child beneficiary, the tax rates and the circumstances. For example, it would allow the Trustee to distribute all of a particular IRA distribution to the child to obtain lower income tax rates…or it would conversely allow the Trustee to hold and accumulate an IRA distribution (and pay the higher trust income tax rates) if it is advisable not to make the distribution to the beneficiary. Therefore, if it is critical to be sure the plan you put in place previously will work as you planned with no unintended consequences under the new law.
Secondly, if your beneficiary is a non-spouse, you may want to consider other changes to your estate plan, such as utilizing IRA’s to satisfy charitable bequests. And depending upon the differences between your tax bracket and that of your beneficiary, some changes to your retirement income strategy could possibly be warranted.
Since all clients have unique lives, objectives and concerns, these changes won’t impact everyone in the same way. Some clients may need to make no changes, and some may need an adjustment to their estate plan.
Rest assured your team at AFA will be reviewing all accounts we manage with non-spousal beneficiaries and will be prepared to discuss this at your next review. However, if you have concerns you prefer to discuss in the interim, please feel free to reach out to your trusted advisor at Atlanta Financial for assistance with these important decisions.