- March 12, 2020
The Setting Every Community Up for Retirement Enhancement (SECURE) Act, signed into law on December 20, 2019, contains some of the most significant changes to retirement planning in over 16 years for employees, employers who sponsor plans and plan administrators. The most notable changes in the law from the perspective of the employee or account owner are discussed below.
It is especially noteworthy for employees and account owners that, as a result of the SECURE Act, prior financial plan calculations regarding when individuals can or must make contributions and distributions must be updated, and wealth protection strategies adopted as recently as last year may no longer be prudent. Everyone with retirement assets will need to revisit (or use this as motivation to start) their estate plans, including beneficiary designations, to ensure that their plans and designations still meet their objectives and technically comply with the new law.
Accelerated Income Tax Burden – The End of “Stretch” IRAs
Prior to the passage of the SECURE Act, non-spousal beneficiaries of IRAs and other defined-contribution plans such as 401(k)s were required to take incremental Required Minimum Distributions (“RMDs”) from those inherited accounts each year after the account owner passed away. In most cases, the RMDs were stretched out over the beneficiary’s life expectancy, which could be over many years or decades, especially if accounts were left to account owners’ children. The beneficiary had great flexibility regarding the timing and amount of withdrawals each year, as long as the minimum withdrawals were taken. By taking only the relatively low mandatory distributions over the beneficiary’s lifetime, funds remaining in the account could continue to grow on a tax-deferred basis for the beneficiary’s life.
Beneficiaries of account owners who passed away before January 1, 2020 can still take advantage of the “stretch” IRA strategy to defer income tax. However, for accounts whose owners pass away after December 31, 2019, the SECURE Act eliminates the stretch payout period for most beneficiaries. Instead, individual beneficiaries (other than spouses and certain others, discussed below) must now withdraw all assets from their inherited accounts within ten years of the owner’s death (or, in some cases, within five years, if there is no “designated beneficiary” or certain other rules are not met).
While there is no annual RMD requirement during those five or ten years, the economic impact to the beneficiary of paying income tax on the account over a 5- or 10-year period, versus over a lifetime, can be significant, as evidenced by the estimate that this change to “stretch” IRAs is expected to raise around $15 billion in revenue over ten years.
Not everyone is tied to the 5- or 10-year payout requirement. The SECURE Act established some exceptions that allow specific “eligible designated beneficiaries” to continue using stretch IRA strategies no matter when the account owner passes away. “Eligible designated beneficiaries” include individuals who are:
- the owner’s surviving spouse (who can roll the inherited account into his or her own account and use his or her own age as the start-date for withdrawals and his or her own life expectancy for RMDs);
- a minor child of the owner (the 10-year rule applies when the child reaches majority);
- disabled or chronically ill as those terms are defined in the Internal Revenue Code; or
- not more than ten years younger than the owner (e.g., a sibling or unmarried “significant other” or life partner).
Technicalities – A Potential Rude Awakening for Trust Beneficiaries
Naming a trust as the beneficiary of a 401(k) or IRA (instead of naming an individual, outright) has become a common wealth transfer and estate planning approach. Using a trust “wrapper” on retirement accounts can provide creditor protection for beneficiaries, and allows a more seamless integration of the retirement assets within the account owner’s overall estate plan. By designating a trust as the beneficiary of the retirement account, account owners could pass their accounts down to the beneficiaries of the trust and, under the old law, the beneficiaries could “stretch” withdrawals over the oldest trust beneficiary’s life expectancy.
In order for a trust to qualify as a “designated beneficiary,” the trust must be specially designed to meet IRS requirements. Two types of trusts are recognized as “designated beneficiaries” when named as an IRA or 401(k) account beneficiary. These two types of trusts, commonly referred to as “accumulation trusts” and “conduit trusts,” also must qualify as “see-through trusts” under the Internal Revenue Code (although you won’t find any of these trust nicknames in the Internal Revenue Code). Accumulation trusts allow the trustee to retain account withdrawals inside the trust without immediately distributing the assets to the trust beneficiaries. Conduit trusts require the trustee to immediately distribute account withdrawals to the trust beneficiaries. Both types of trusts must be irrevocable upon the account owner’s death. Accumulation and conduit trusts are dubbed “see-through trusts” because they are structured to allow the plan administrator to “see through” the trust to find the “designated beneficiaries.”
Because the SECURE Act eliminated life expectancy calculations for non-spouse beneficiaries, many trusts with specifically drafted provisions tied to the life expectancy payout requirements, and which otherwise would have qualified as see-through trusts prior to the SECURE Act, may now no longer qualify as “see-through trusts.” If a trust fails to qualify as one of the two types of see-through trusts, the trust is not a “designated beneficiary” and the account must be withdrawn by the trustee within 5 years, regardless of whether the trust’s beneficiary meets one or more of the exceptions discussed above. If the trust fails to be a “see through trust,” the plan administrator can no longer “see through” the trust to its underlying beneficiaries when looking for the designated beneficiary; therefore the 5-year payout period applies.
Even if the beneficiary trust qualifies as one of the two types of see-through trusts, an additional and unforeseen problem may be lurking in the payout provisions of the trust instrument itself. Many beneficiary trusts expressly limit annual distributions only to RMDs, presuming that the inheritors could, under the law, receive income indefinitely and reap the tax benefits of smaller, extended distributions. In these instances, the SECURE Act’s new 5-year or 10-year limit on distributions sets trust beneficiaries up for a rude awakening on the 5th or 10th anniversary of the account owner’s passing. At that point, the trust will need to distribute all remaining funds in the IRA and any other such accounts. This can lead to a substantial tax hit in the final year because the inflexible trust document itself did not permit earlier, larger withdrawals during the intervening years.
For these reasons, anyone who has named a trust as a primary or contingent beneficiary of a retirement account should revisit their trust and their beneficiary designations to make sure the trust still qualifies as a “see-through” trust and has the flexibility to address the new finite payout period. Also, consider whether the trust beneficiary is still the best payout option for your beneficiaries, or whether your beneficiaries have reached an age or stage in life where the protective trust wrapper is no longer needed.
Why Plan? Estates are not Designated Beneficiaries
As mentioned above, under the SECURE Act (and even under prior law), any account without a “designated beneficiary” must withdraw account assets within five years of the owner’s death. Plan documents oftentimes name an account owner’s estate as the default beneficiary if the account owner does not specifically name a beneficiary. Others intentionally name their estates as account beneficiaries. Estates are not “designated beneficiaries.” In both cases, the account owner inadvertently has opted for the most accelerated and punitive required payout period for their heirs under law – 5 years. This short payout period is a primary reason why it has been and continues to be important to specifically name individuals or see-through trusts as account beneficiaries, and to not rely on the plan documents to transfer your retirement assets to your heirs.
Financial Planning – No More Contribution Age Limit for Traditional IRAs
A combination of longer lifespans and economic necessity have changed the reality of retirement for increasing numbers of Americans, with more and more people continuing to work well into their 70s. The SECURE Act acknowledges this new reality. Previously, individuals could not make contributions to a traditional IRA after age 70 1/2, even if they were still earning an income. The SECURE Act eliminates that age limit and allows those who keep working to keep saving for retirement, whenever that may be. This change impacts employees’ retirement savings decisions; financial plan calculations regarding the length of time individuals can make contributions must be updated.
Retirement Planning – Start-Date of RMDs Raised to 72
For the same reasons that the SECURE Act eliminated the age cutoff for contributions, it also raised the age at which IRA owners must start taking their required minimum distributions. Now, individuals do not need to start withdrawing from their accounts until they turn 72, up from 70 1/2. However, if you celebrated your 70 1/2 birthday before 2020, you will still need to start your RMDs in 2020. This change impacts employees’ financial planning decisions; financial plan calculations regarding when individuals must make account withdrawals must be updated.
New Credits and Benefits for Parents
Additional provisions of the SECURE Act are of particular note for new parents. Plan providers now have the option to amend plans to permit new parents to take a penalty-free "qualified birth or adoption distribution" within one year of a birth or adoption, of up to $5,000, from each parent’s individual IRA, 401(k) or other defined contribution plan, for qualifying child-care costs. The SECURE Act eliminates the 10 percent penalty that those younger than 59 1/2 would usually pay on an early distribution, and the distribution, which is still subject to tax, can be repaid to the parent’s retirement account. The withdrawal amount is not treated a loan and the parent is not required to adhere to a strict repayment schedule. Additional clarification and guidance is needed before plan sponsors will be able to administer this benefit and the repayment option to answer practical questions such as whether the repayment is made with pre-tax or after-tax dollars.
Employers and Small Businesses
We note two changes of particular interest to small business owners. First, small businesses that establish retirement plans for employees may be eligible to receive a tax credit of up to $5,000, and can avail themselves of a further $500 tax credit for three additional years if they automatically enroll new hires in the plan. Second, unrelated small employers may join with other companies to establish 401(k) plans, which reduce the overall administrative expenses to each single employer and creates greater leverage to negotiate better pricing and fee structures.
Many other the changes brought by the SECURE Act directly impact employer sponsored plans and plan administrators, and may ultimately require an amendment to the governing documents.
SECURE Act questions and concerns
Previously effective retirement, wealth protection, and estate planning strategies may no longer work as expected after the passage of the SECURE Act. If you have concerns about whether your existing plans and beneficiary designations need to be modified or questions about how these changes in the law may affect you and family, please contact the Wealth & Succession Planning attorneys at Burke, Warren. MacKay & Serritella. This article was prepared by Mary Kruit McWilliams, practice chair. Contact Mary at (312) 840-7081 or firstname.lastname@example.org.
This information is intended for information purposes only and is subject to change at any time. This information is not written or intended as specific tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel.