Estate Planning With Retirement Accounts
Planning with retirement savings plans should preserve the beneficial income tax treatment for your beneficiaries. Family considerations, however, may require that those retirement accounts flow to a trust. The IRS imposes rules as to how such a trust must be designed for the income tax benefits to be preserved. A fundamental job of an estate and trust planning lawyer is to assist clients in coordinating the design of their wills and trusts with their retirement plans and IRAs. Effective January 1, 2020, the job of the estate planning lawyer got more difficult because of the Setting Every Community Up for the Retirement Enhancement (SECURE) Act.
Since 2017, all 401(k)s have been treated the same as IRAs and, after leaving the company supporting the 401(k), the employee may roll over the plan to an IRA. Assuming a person was designated as a beneficiary of an IRA, after the death of the retiree the IRA continued over that beneficiary’s life expectancy. It was this “stretch” over most designated beneficiary’s life expectancy that dramatically changed by the SECURE Act.
Nor are these changes just for non-government 401(k) and IRA plans. Thrift Savings Plans (TSP) is the Federal government’s version of the 401(k) plan and can be rolled over to an IRA. Inherited IRA treatment was available to both 401(k) plans and TSPs. The SECURE Act changed the planning considerations for these plans also.
Although this article is written by Maryland estate planning lawyers who regularly handle IRAs, Thrift Saving Plans, and other retirement plan issues, these issues are governed by federal law and have broad, national application. Nevertheless, our firm is a Maryland law firm focusing on the law of fiduciaries and the law of estates and trusts. As such, we make no representations related to other jurisdictions.
Retirement Plan Basics
The policy behind the tax provisions governing defined contribution plans and IRAs was to encourage retirement savings. The main thrust of the federal tax provisions encouraged savings by allowing a tax deduction for the contributions into the plan. However, federal tax provisions also mandate an age when the participant must begin taking funds out so that the plan does not become simply a way to accumulate wealth. Instead the plan creates a (taxable) stream of income during retirement.
Theoretically, the minimum distribution amounts were to force the savings account to come back to the account owner over his or her life expectancy in retirement. The actuarial calculation, however, does not exactly match this actuarial amount because it must allow for individuals beating that calculation.
The general rule is that at age 72 the plan participant must begin withdrawing from the account based on actuarial calculations. Prior to the SECURE Act, the mandatory withdrawal started when the participant reached 70 ½. For those reaching the old threshold before the SECURE Act kicked in, they remain in pay status regardless of whether they are not yet 72.
COVID-19 Stimulus Bill
The coronavirus pandemic triggered a stock market plunge. The withdrawal rule works by applying the annual percentage withdrawal calculation to the value of IRAs based on the end of the year immediately preceding the required minimum distribution. The impact of applying these rules could trigger sales of securities reset by the market fall to low values to cover pre-coronavirus market levels that were much higher. The impact of this means that retirees will lock in losses instead of permitting the required minimum distribution amount to (hopefully) recover over time.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act, suspends the required minimum distribution for retirees and owners of inherited IRAs or 401(k)s for 2020. This “skip year” will benefit those who can look to other income sources instead of takes funds from their retirement savings. This aspect of the CARES Act presents an additional, potential planning opportunity. Some retirees convert to Roth IRAs after retirement when their ordinary income level is lower than while they are employed. By skipping a 2020 withdrawal from an IRA, their adjusted gross income will be lower thereby possibly opening lower bracket room for the conversion.
Spouse As Beneficiary
By naming a spouse as the beneficiary of the account, at the participant’s death the spouse was permitted to roll it over to their own IRA, effectively having it governed as if they established the retirement account initially. The surviving spouse also could receive the IRA as an inherited IRA taking payments over their actuarial life expectancy but not adjusted each year to hedge against out living the initially determined life expectancy.
A trust is often the most effective way to ensure that your retirement account is handled according to your wishes after death if your estate planning does not involve a spousal rollover. “In many cases, a spousal rollover to a surviving spouse is almost a reflexive choice and, in fact, works well from an estate planning perspective. If the spouse is from a second marriage with children from the first, however, you should consider using a trust as the designated beneficiary. If the marital trust is structured properly, the estate qualifies for the marital estate tax deduction under both the Maryland and federal rules. Unlike estate planning with other assets, the use of a trust at your death for retirement assets comes with important income tax considerations,” says Jack Beckett, a principal of the Maryland estates and trusts law firm of Franke, Sessions & Beckett, LLC.
How are Non-Spousal Distributions Treated?
If there is no designated beneficiary to receive the account proceeds at the death of the plan participant, then the account is paid to the estate and the post-death distributions must be withdrawn over a 5-year period (the 5-year rule). This accelerated withdrawal period also applies if there is a defective beneficiary designation on the account—for example, if a trust is designated as a beneficiary, but the trust terms violate certain IRS rules (this is discussed below). The 5-year rule does not mandated that funds be withdrawn each year, just that it be collapsed in the fifth year. Withdrawal from an IRA is treated as ordinary income so often any distribution is postponed until the last year to permit tax-free appreciation of the fund.
If a beneficiary was designated (typically on a form provided by the plan provider or custodian, which is governed by contract law), however, the rules are different and depend on who is inheriting the IRA. Before the SECURE Act, the rule was that a non-spouse beneficiary could elect to treat it as an inherited IRA and take it out over the non-spouse beneficiary’s actuarial life expectancy. Under the SECURE Act, most non-spouse beneficiaries must withdraw all the assets from the account by December 31 of the 10th year following the account owner’s death (the “10-year rule”). Aside from the treatment of spouses as designated beneficiaries, there are important exceptions to the 10-year rule – including for children and for disabled or chronically ill individuals. Otherwise, the plan assets will come out according to the 10-year rule. The SECURE Act imposes a new 10-year rule applicable to most non-spouse beneficiaries for account owners defined contribution accounts (IRAs, 401(k)s, and 403(b) plans).
The End of the Stretch IRA for Most Beneficiaries
Before the SECURE Act which became effective January 1, 2020, a designated beneficiary could take an inherited IRA over his or her actuarial life expectancy. This was a very significant benefit because it permits a larger amount of assets to remain in the IRA growing tax-free. A 35-year old, for example, is deemed to have a life expectancy of 48.5 years.
Under the SECURE Act, the general rule is that designated beneficiaries must drain the retirement account by December 1st of the year in which the 10th anniversary of the account participant’s death occurs. Although more guidance is needed from the IRS, it presumably would be applied in the same manner as the current 5-year rule is applied where there is no designated beneficiary. In other words, withdrawals from the plan by a designated beneficiary could be deferred and all taken out in the last year.
Important Exceptions to the 10-Year Rule
The general 10-year rule does not apply for “eligible designated beneficiaries” who are:
- The surviving spouse who receives an inherited IRA or retirement account or completes a rollover.
- Disabled individuals as defined by the Internal, Revenue Code.
- Chronically ill individuals as defined by the Internal Revenue Code.
- Children (but not grandchildren or other minors) of the account owner who have not reached the age of majority.
- Individual beneficiaries who are not more than 10 years younger than the account holder.
Beneficiaries Less Than 10 Years Younger
The exception for individual designated beneficiaries who are no more than 10 years younger than the account owner is useful if the beneficiary designated by the account participant is a sibling who is either older or not more than 10 years younger. Such a sibling could take the IRA distributions over his or her actuarial lifetime. This would appear to be a strict, “cliff” rule whereby if a sibling is 11 years younger, they would not be an eligible designated beneficiary and therefore would be forced into the 10-year rule.
Minor Children Exception
The exception for children who have not reached the age of majority is a complex rule. The general rule for majority is 18 but it can be extended up until the age 26 if the child is in a specified course of study defined under the regulations. [This may encourage children to enter graduate programs.] Once they reach majority, the 10-year payout rule kicks in. Because this only covers children of the participant, a grandchild is not an eligible designated beneficiary under the minor child exception.
Disabled and Chronically Ill Individuals
Disabled individuals and chronically ill individuals would also be entitled to use of the actuarial life expectancy tables. Under the Internal Revenue Code § 72(m)(7) “a disabled individual is someone unable to engage in any substantive gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death or be of long continued and indefinite duration.” A chronically ill individual is defined under IRC § 7702B(c)(2) as a person unable to perform at least 2 activities of daily living and such condition must be certified to be indefinite and reasonably expected to be lengthy.
Role of “Conduit” Trusts Under the SECURE Act
A “conduit” trust was a commonly used structure to preserve the IRA “stretch.” A conduit trust is one where the trustee must remove the required minimum distribution amount from the inherited IRA and distribute it to the beneficiary. Under pre-SECURE Act law, this technique worked well given the fact that the required minimum distribution was based on the actuarial life expectancy of the beneficiary.
Under the SECURE Act, generally a conduit trust forces the entire IRA to be paid out to the beneficiary within 10 years of the death of its owner. This may defeat the purpose of having the IRA designated to the conduit trust in the first instance. Conduit trusts are used as a hedge to protect the IRA principal from attachment by a beneficiary’s potential creditors. A high-risk beneficiary (such as a lawyer, doctor, or business entrepreneur) would be better served if those assets did not come out to the beneficiary. Under the Maryland Trust Act, the beneficiary can be his/her own trustee and, if properly designed, a spendthrift clause can provide the beneficiary with asset protection. Conduit trusts are also used with independent trustees for beneficiaries who the settlor does not believe should be handling substantial assets but where regular distributions based on the actuarial tables are acceptable. Here too, the conduit structure will trigger the distribution of the IRA corpus earlier, and in a lump sum, which may not be what the trust settlor had in mind.
Because of the requirement that the withdrawals be paid to the beneficiary, the beneficiary and not the trust is the deemed taxpayer. The income tax brackets of trusts are collapsed in relation to the individual brackets, so the income tax bite may be less at the individual level. At approximately $13,000 of income in one year, for example, a trust hits the highest income tax bracket. With a large inherited IRA, a lump sum distribution may cause the beneficiary to be at the highest bracket so any income tax savings may not be a compelling planning consideration. If the IRA is large enough, perhaps the conduit force only enough to run up the beneficiary’s lower bracket and have the trust retain the amount over that amount. If the beneficiary is already at the highest bracket independent of the inherited IRA, of course, then the bracket issue is not a consideration.
The Role of “Accumulation” Trusts Under the SECURE Act
An “accumulation” trust in another commonly used structure to be named the beneficiary of inherited IRAs. Accumulation trusts were often used as special needs trusts. Under prior law, the rate of withdrawal was dependent on the age of the oldest potential beneficiary. To assure that the “stretch” could extend over the life of the disabled beneficiary, ideally the remainder beneficiary would be a younger individual. Under the SECURE Act, because a disabled person is included as an “eligible designated beneficiary,” the identity of an individual remainder beneficiary is immaterial to the stretch payout during the life of the disabled or chronically ill individual. As with pre-SECURE Act law, however, the remainder beneficiary probably needs to be an individual and a charitable remainder will preclude any stretch.
Using Charitable Remainder Trusts to Mimic Long Payout
An innovative technique that might avoid the full impact of the income tax hit caused by the 10-year payout. This would involve having the inherited IRA paid to a charitable remainder trust which pays an annuity interest of at least 5% back to the death beneficiary for his or her lifetime with the remainder going to charity. This does not, of course, avoid the income tax but merely spreads it out over the lifetime which would have the benefit of permitting tax-free growth of those funds being held in the trust. This somewhat parallels keeping the assets within an IRA for the life of the remainder beneficiary. The downside is the same downside of charitable remainder trusts in general which is if the annuitant needs more than the income stream, he or she cannot look to that fund to provide it. Until the IRS provides guidance, such a technique carries a risk of IRS challenge.
Retirement Accounts and Revocable Trusts
If a plan recipient or the owner of an IRA is using a revocable trust to manage the possibility of their own disability, it is important that the IRA or retirement plan not be transferred into the revocable trust. That would trigger an income tax based on the value of the entire account. Accordingly, there should be a power of attorney giving authority to an agent to withdraw the minimum distribution amount and turn it over annually to the revocable trust. In certain circumstances, one might consider providing that the agent also have the ability to modify beneficiary designations within a pre-determined scope: for example, changing an outright beneficiary to a trust for the primary benefit of the outright beneficiary for his or her share. This would permit the agent under a power of attorney to direct one of the otherwise designated beneficiaries to a special needs trust if the occasion requires.
Contact a Maryland Trust Lawyer to Ensure That Your Retirement Accounts are Handled Properly
Given the popularity and number of IRAs, 401(k)s, and other qualified retirement savings plans, one would expect that planning with these types of accounts would be straight-forward. If trusts are needed to implement an estate plan involving qualified retirement plans, however, such planning becomes somewhat complex. Experienced estate and trust planning lawyers should be able to guide clients through the process of achieving the estate planning objectives without sacrificing the income tax advantages of inherited retirement plans.
The Maryland estate and trust attorneys at Franke, Sessions and Beckett LLC understand the complexity of various retirement plans and are prepared to guide you in planning to make sure that your retirement assets are coordinated with your wills and trusts. For over 35 years, the law firm of Franke, Sessions & Beckett, LLC has concentrated on the law of estates and trusts – including meeting the unique needs of clients with complex assets or family situations. All of our lawyers are involved in all three aspects of an estates and trusts practice: estate/trust planning; fiduciary litigation; and, estate/trust administration. Because “we do it all” within the niche of estates & trusts, we stay current and bring a wide understanding of the law of estates and trusts to our estate planning engagements. In order to schedule a consultation with an experienced Maryland estate and trust attorney, call 410-263-4876 to get in touch with our Annapolis office.