The SECURE Act was signed into law on December 20, 2019. It significantly modified many requirements for employer-provided retirement plans, individual retirement accounts (IRAs) and other tax favored savings accounts.
Key Provisions Affecting Individuals
Repeal of Maximum Age for Traditional IRA Contributions
Before 2020, traditional IRA contributions were not permitted once an individual reached age 70½. Starting in 2020, however, an individual of any age may make contributions to a traditional IRA as long as that individual has compensation (earned income from wages or self-employment). This is a great benefit for individuals to continue to make contributions to their IRA even though they may be in pay status.
Required Minimum Distribution Age Raised
Before 2020, retirement plan participants and IRA owners were required to begin taking required minimum distribution amounts from their plan by April 1st of the year following the year they reach 70½. For anyone who is not 70½ as of December 31, 2019, the new age that triggers a required minimum distribution is 72. This permits the beginning of the depletion of retirement funds to be deferred.
Elimination of the Stretch IRA
The SECURE Act imposes a new 10-year rule applicable to most non-spouse beneficiaries for account owners defined contribution accounts (IRAs, Roth IRAs, 401(k)s, and 403(b) plans).
Under current law, a designated beneficiary may take an inherited IRA over his or her actuarial life expectancy. This is 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.
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 accountholder.
The exception for individual designated beneficiaries who are no more than 10 years younger than the account owner would be 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.
The exception for children who have not reached the age of majority is actually a fairly complex rule. The general rule for majority is 18 but it can be extended up until the age 26 as long as the child is in a specified course of study under the regulations. [This may encourage children to enter into 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 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.
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 would force 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. Clients with significant IRAs or other retirement plans that are left in trust to their beneficiaries should revisit their planning and make changes if warranted.
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. Also, if the beneficiary is at the highest bracket independent of the inherited IRA, the bracket issue is not a consideration.
An “accumulation” trust is 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 should 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 actuarial payout. As with pre-SECURE Act law, however, the remainder beneficiary must be an individual and a charitable remainder will preclude any stretch.
An accumulation trust may become the preferred option for third party asset protection trusts. One needs to be aware of the extent of the possible income tax tradeoff. Another possibility is to have an independent trustee or trust protector be able to decide between a conduit or accumulation structure at the point the trust becomes irrevocable – usually the death of the settlor.
Some have suggested a 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 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 mimics keeping the assets within an IRA. 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.
The impact of the SECURE Act on sophisticated estate planning cannot be minimized. The 10- year rule has changed settled law which has governed the treatment of inherited IRAs for a generation.
Penalty Free Retirement Withdrawals for Expenses Related to the Birth or Adoption of a Child
Under prior law, a distribution from an IRA before the age of 59½ is subject to a 10% early withdrawal penalty as well as income tax on the withdrawn amount. One exception was in the case of financial hardship which was a very narrow exception and difficult to apply. The SECURE Act permits distributions of up to $5,000 that are used to pay for expenses related to the birth or adoption of a child without a penalty. The $5,000 withdrawal amount applies on an individual basis so for a married couple each spouse may receive a penalty free distribution up to $5,000.
The SECURE Act also allows the early distribution to be recontributed to the same plan or IRA and treated as a rollover without any time limit.
529 College Savings Plan Changes
Unlike prior law, the 529 plan may now be used on a limited basis to repay student loans.
Key Provisions Related to Retirement Plan Management
The SECURE Act may enable more working Americans to save for retirement and to have access to a way of converting those savings to regular lifetime payments. These changes were designed to encourage small businesses to provide retirement savings benefits for their employees. These attributes of the SECURE Act are only briefly touched upon because the focus of this memorandum are those changes that will immediately impact individuals.
The SECURE Act Small Business Incentives
The SECURE Act has various provisions to encourage employers to become plan sponsors. These include increasing the business tax credit for planned startup costs. This would increase the current cap of $500 to up to $5,000 in certain circumstances. Additionally, there would be a further $500 tax credit for 3 years for plans that have an automatic enrollment for new hires.
Another change would be to allow unrelated small employees to band together to open 401(k) multiple employer plans which will reduce costs and administrative duties on each employer who would otherwise find it uneconomical to do it alone. This change would allow unrelated employers on the same insurance platform to file standard reporting forms to the IRA and create other savings for running such a plan.
Another selling point of the SECURE Act was to ease the fiduciary obligation of the employer when permitting annuities to be held in the plan. Traditionally, plan sponsors needed to make appropriate decisions about investing the assets which meant a fiduciary duty of due diligence with acquiring and monitoring investments in annuities. Annuities are something that beneficiaries may prefer because they give some assurance regarding the amount of payments coming from their retirement funds. The SECURE Act has various requirements that will protect employers from liability if they select an annuity provider that meets certain criteria.
The SECURE Act has upended settled law as to the treatment of inherited IRAs which, at the least, will require a re-examination of existing estate plans that depended on the stretch.