On December 20, 2019 the “Further Consolidated Appropriations Act, 2020” became law. As part of the Act and in part to pay for the over 1.7 trillion in spending that the Act contemplates, Section “O” sets forth the Setting Every Community Up for Retirement Enhancement Act (the “SECURE Act”). The SECURE Act significantly changes the distribution rules for beneficiaries of tax-deferred retirement plans and individual retirement accounts, that in turn have a major impact on the estate planning landscape for retirement benefits.
This article briefly summarizes key changes and new distribution planning possibilities as a result of SECURE. However, there are a host of exceptions to the new regimen and planning options that are beyond the scope of this article. In addition, clarifying regulations and guidance from the Internal Revenue Service will be necessary determine to the full scope and implications of the provisions. Careful review of the SECURE Act, any clarifying regulations, and client estate planning documents is critical for estate planning practitioners and retirement plan account owners alike to determine what changes, if any, are necessary under SECURE.
As a preliminary matter, the SECURE Act applies only to “certain defined contribution plans”. Defined benefit plans, including certain annuity payouts from an IRA or other defined contribution plan that were already finalized prior to the enactment of SECURE are not affected. In this article, “account owner” is used to mean the employee in a qualified defined contribution plan or the owner of an individual retirement account.
The Prior Rules
Prior to SECURE, the distribution rules for retirement plan death benefits were set forth in section “B” of § 401(a)(9) of the Internal Revenue Code. Section “B”, as substantially enhanced by the Treasury Regulations, provides for several benefit payout methods depending on whether the account owner had started taking distributions from the plan prior to death and whether the beneficiary is a “designated beneficiary”
Under the rules, a “designated beneficiary” is an individual, or group of individuals, specifically named by the account owner. A trust can also qualify as a designated beneficiary if it meets certain requirements. Any other beneficiary, such as a charity, or an estate, is, for the purposes of this article, referred to as a “non-designated beneficiary”.
The prior rules are generally as follows:
- If the retirement account owner named a designated beneficiary of his or her plan, upon the death of the account owner, the balance of the account could be distributed in annual installments over the life expectancy of the designated beneficiary, unless taken sooner as elected by the designated beneficiary or as otherwise required under the plan.
- If the plan is distributed to a non-designated beneficiary and the account owner had not yet started taking distributions from the plan at his or her death, the non-designated beneficiary is required to withdraw the benefits within 5 years after the owner’s death.
- If the account owner died after his or her required distribution beginning date, a non-designated beneficiary takes distributions in annual installments over what would have been the remaining life expectancy of the account owner if he or she had not died.
Additional rules applied if the designated beneficiary was the surviving spouse of the account owner. Further, under the prior rules, if a designated beneficiary died before the end of his or her life expectancy payout period, the next beneficiary in line (whether or not qualifying as a designated beneficiary) could withdraw over the remaining life expectancy of the original designated beneficiary.
The Addition of SECURE
SECURE does not amend or replace section “B” nor does it change the definition of “designated beneficiary”. Instead, SECURE adds a new section “H” to § 401(a)(9) of the Internal Revenue Code. On top of the existing rules, “H” layers a new payout period requiring designated beneficiaries to withdraw all plan funds within 10 years. This new 10 year payout period replaces the life expectancy payout method under the prior rules, with the exception of five categories of “eligible designated beneficiaries” (“EDBs”).
As a result of the new section “H”, there are now three classes of retirement account beneficiaries: 1) designated beneficiaries, 2) EDBs and 3) non-designated beneficiaries.
The new class of EDBs include the surviving spouse of the account owner, a minor child of the account owner, a disabled or chronically ill beneficiary, and a beneficiary who is less than 10 years younger than the account owner. For each of these EDBs, the life expectancy payout method will still apply, with some exceptions. Notably, the life expectancy payout method expires when a minor child of the account owner reaches the age of majority, at which time the 10-year payout rule will apply.
The specific language in SECURE implements the 10-year rule by referring to the 5-year rule (see discussion under Prior Rules above). To date, this has been interpreted to mean that the new 10-year rule will be applied in the same manner as the 5-year rule. As such, the inherited retirement account must be liquidated by December 31 of the year in which the 10th anniversary of the account owner’s death occurs. This means if the account owner dies early in the year, there are close to 11 tax years over which the designated beneficiaries may take withdrawals and liquidate the account.
Importantly, the only minimum distribution that is required under the 10-year rule is the liquidating distribution at the end of the 10th year. However, a beneficiary can always take distributions sooner. A beneficiary should work with his or her professional advisors to determine the most effective way to utilize plan distributions.
Upon the death of any EDB, the exception ceases to apply and the 10-year rule will apply for the recipient of any remaining funds.
See-Through Trusts
One common estate planning technique used to control the disposition of retirement account funds is the use of “see-through trusts”. See-through trusts can still qualify as beneficiaries under the new regime created by SECURE. However, retirement account distributions to and from these trusts may not operate in the same manner contemplated when the trusts were created under the prior rules.
There are two types of see-through trusts. One is a “conduit trust” that requires the trustee to immediately distribute funds withdrawn from a retirement account to the individual trust beneficiary or beneficiaries. With SECURE, if the primary beneficiary of a conduit trust is an EDB, generally the life expectancy payout granted to the EDB will apply. If the beneficiary of a conduit trust is not an EDB, then the trust, and that beneficiary, must receive an outright distribution of all of the retirement benefits within 10 years of the account owner’s death.
The other see-through trust is an “accumulation trust” that does not require the trustee to distribute funds withdrawn from a retirement account immediately to the trust beneficiary or beneficiaries. With the exception of certain trusts for the sole life benefit of disabled or chronically ill beneficiaries, an accumulation trust must take distribution of the entire plan balance within 10 years after the account owner’s death. The beneficiary or beneficiary will in turn receive distributions from the trust as determined by the trustee or as required by the terms of the trust.
Estate Planning Considerations
The impact of SECURE on a client’s overall estate plan will depend entirely on the client’s personal situation and goals for the beneficiaries of his or her retirement plan.
A client who simply leaves his or her retirement account outright to various individuals, such as adult children, may have nothing to change. The children will have to pay taxes sooner than was previously expected, but the resulting tax is precisely what SECURE was enacted to address, and as such there is little to be done in this regard.
Similarly, accumulation trusts will still work under SECURE, but the trustee will be faced with a substantially accelerated tax bill, since all benefits must be distributed to the trust, at the trust’s high tax rates, within 10 years. As with outright beneficiary designations, there are limited options to avoid this tax. A major exception are certain trusts for the sole life benefit of a disabled or chronically ill beneficiary. If a client’s estate plan includes a disabled or chronically ill individual, in-depth review of the client’s estate plan and SECURE exceptions is critical to ensure compliance with the new rules.
A conduit trust will also still work under SECURE. However, if a client strongly favored the gradual payment of funds over a trust beneficiary’s lifetime, and created a conduit trust relying on the lifetime expectancy payout method, the client will need to explore other options to avoid distribution of the plan funds to said trust beneficiary within 10 years of the account owner’s death.
While many planning techniques were not specifically invalidated as a result of SECURE, the changes may result in distributions that are contrary to the intent of the account owner. As a result, all beneficiary designations and estate plans should be reviewed to determine what changes, if any, are necessary to effectuate a plan that will accomplish an account owner’s goals.