By Caitlin M. Moon (Associate, Trusts and Estates)
The Setting Every Community Up for Retirement Enhancement Act of 2019, known as the SECURE Act, became effective January 1, 2020. This new legislation has substantial effects on estate planning with retirement plans, most notably on “stretch IRA” strategies, as well as on distribution and contribution ages for IRAs.
In the past, those with 401(k) or IRA accounts could elect to make their qualified retirement plan payable to a “designated beneficiary” (or a see-through trust) and that designated beneficiary (or trust) could leave the plan in its tax-deferred status for years or even decades after the account holder’s death. The designated beneficiary could withdraw the benefits gradually by taking distributions over his or her life expectancy and thereby “stretch” the payments in order to minimize income taxes. In the case of a properly drafted trust instrument, the withdrawals could be stretched over the lifetime of the oldest trust beneficiary, thereby protecting the assets for the beneficiary while also accomplishing tax deferral.
The SECURE Act has essentially eliminated this previously popular option. With some notable beneficiary exceptions that will be discussed later, gone are the days where designated beneficiaries could have their payout periods based on life expectancy. Instead, the lifetime payout periods have been replaced with a 10-year payout rule. This means that the 50-year-old son who inherits Mom’s IRA no longer can use his life expectancy of 34.2 years to stretch out the distribution payments; rather, he now must withdraw the entire account within 10 years. There are no required minimum distributions within those 10 years, but the entire balance must be distributed after the 10th year. This change can be problematic for some designated beneficiaries, especially if they are in their 40s and 50s and at the peak of their earning years. Limiting the time frame in which someone can distribute money from an inherited account means potentially boosting the tax burden those distributions will cause.
Of note are the situations in which the 10-year payout rule does not apply and the pre-SECURE Act rules are largely still in place. Five types of beneficiaries, now called “eligible designated beneficiaries,” still qualify for life expectancy or modified life expectancy payouts:
- Surviving Spouse
- A surviving spouse may still use life expectancy payouts and roll the deceased spouse’s retirement plan over to his or her IRA or other qualified retirement plan of the surviving spouse.
- Minor Child of Account Holder
- A minor child of an account holder may receive life expectancy payments until age of majority. “Age of majority” is not defined but presumably refers to applicable State law. This age may be extended if the child has not completed a specified course of education and is under the age of 26. “Specified course of education” is not defined but likely would encompass college and other higher education and potentially trade and vocational schools as well. However, once the child has reached the age of majority or, for those in a specified course of education, age 26, the 10-year payout rule kicks in. This rule applies to the account holder’s children only; grandchildren or more distant descendants or unrelated minor beneficiaries do not qualify for this modified life expectancy payout.
- Disabled Person
- A disabled person is an individual who is unable to engage in any substantial gainful activity because of any medically determinable physical or mental impairment which may be expected to result in death or to be of long-continued and indefinite duration. A disabled person may still use life expectancy payouts.
- Chronically Ill Person
- A chronically ill person is unable to perform (without substantial assistance from another individual) at least 2 activities of daily living for a period of at least 90 days due to a loss of functional capacity or requires substantial supervision to protect such individual from threats to health and safety due to severe cognitive impairment. A chronically ill person can still use life expectancy payouts.
- A Person Fewer-than-10-years-younger than Account Holder
- If an account owner is not married and has no children, it is common for the account holder to name siblings or other close relatives as the beneficiaries. Such beneficiaries who are fewer than 10 years younger than the account holder may still use life expectancy payouts.
The rules for non-designated beneficiaries (“nonDBs”), such as the account holder’s estate, a charity, or any trust that did not qualify as a see-through trust, have not changed. NonDBs must still withdraw the entire account within 5 years of the account holder’s death.
If you inherited an IRA from someone who died before January 1, 2020, there will be no changes to the current distribution schedule as it will be grandfathered into the new law.
Required Minimum Distribution Age — and Contribution Age
Prior to the SECURE Act, account holders had to withdraw required minimum distributions (“RMDs”) in the year they turned age 70.5. Now, that age has been increased to 72 for individuals born after June 30, 1949. This may have tax implications, depending on the account holder’s tax bracket in the year the RMDs are withdrawn.
The SECURE Act also eliminates the maximum age for traditional IRA contributions, which was previously capped at 70.5 years old. Now, account holders may continue to contribute as long as they are still working.
Other Notable Changes
While this article is not meant to be exhaustive on all provisions of the SECURE Act, there are a few more notable changes being implemented. The SECURE Act now permits penalty-free withdrawals of up to $5,000 for a qualified birth or adoption. The law also expands the definition of what is considered a tax-free or qualified distribution from a 529 account. Withdrawals can now be used for certain apprentice programs and up to $10,000 can be used for the repayment of a qualified student loan.
So What Now, Do I Need to Do Anything?
The SECURE Act may not have any effect on some estate plans while it may have major effects on others. If your spouse is the primary beneficiary of your retirement plan and your capable adult children are the contingent beneficiaries, then you are probably fine. If your beneficiaries are your minor children or disabled or chronically ill individuals or others for whom you have provided via trusts in your estate plan, then you should review the plan with your estate planning attorney to make sure that the trust is crafted to stretch the payout as long as possible. In any event, reviewing your estate plan with an estate planning attorney at least every five years is always a good practice.
You may also want to consult with your accountant to see if a conversion of a traditional retirement plan to a Roth IRA makes sense for you. Because beneficiaries of traditional retirement plans will now experience substantially accelerated taxes than under the previous law, the Roth IRA may become a more attractive option for certain individuals who can afford to pay the income taxes now. With a Roth IRA, the account holder may be able to absorb the tax hit at a lower rate than will apply to his or her future beneficiaries, who can then withdraw the funds from the inherited Roth IRA tax-free.
Overall, the SECURE Act is making waves in retirement planning. Every person’s retirement situation is unique, so stay educated on the changes and consult with a professional if you think your plan may be impacted by this new legislation.
This article was published as part of the Spring/Summer 2020 issue of ke kumu, Cades Schutte’s client newsletter. Read the full publication of ke kumu, which explores some of the laws unique to Hawaii.