By: Juliya Ismailov
For anyone who has substantial tax-deferred retirement assets in the US, it is important to understand that the US rules with respect to retirement assets dramatically changed in the last two years under the Setting Every Community Up for Retirement Enhancement (SECURE) Act enacted on December 20, 2019.[1]
Previously income distributed from an inherited retirement account (which could include an IRA or a 401(k) plan; in this article, all such pre-tax retirement accounts referred to collectively as an “IRA”) could be “stretched out” over the lifetime of the beneficiary based on his/her life expectancy. The most significant change under the new law is that, except for a select group of beneficiaries, all IRA proceeds must be distributed within 10 years, generating in the process substantial taxable income, often at the highest tax bracket.
US retirement account rules require that, once the account holder reaches a designated age (raised from 70½ to 72 years under the SECURE Act), he or she must start taking required minimum distributions (“RMDs”) that, until then, would have been accumulating tax-free (unless it is a Roth IRA, which accumulates and invests after-tax dollars). The amount of the RMD is calculated based on the account holder’s life expectancy and is subject to income tax. Upon the account holder’s death, the beneficiary inheriting the retirement account is subject to the RMD rules once the decedent had or would have turned 72 years old.
Before the changes under the SECURE Act, the planning goal was to have the longest life expectancy applied to the RMD calculation. This was accomplished with a trust naming young beneficiaries (often as contingent beneficiaries) whose long life expectancy would cause the IRA distributions to be “stretched out.” For illustration purposes, the life expectancy of a toddler named as a contingent trust beneficiary (who may or may not ever inherit the assets) would be about 80 years, and that would be the period over which an inherited IRA would be paid out through mandatory distributions.
Generally, a good practice in estate planning is to steer clients toward setting up lifetime trusts to hold assets inherited by children—for both creditor protection and estate tax reasons. These testamentary trusts (i.e., created upon the death of another) always needed to accommodate receipt of an inherited IRA. When the IRA was inherited by a trust, the trust had to be properly structured as a “see-through” trust.
The two types of “see-through” trusts are conduit trusts and accumulation trusts. The “conduit trust” requires that a current beneficiary receive RMDs outright based on his or her life expectancy, with the rest continuing to accumulate tax-free. By contrast, the “accumulation trust” itself collects the RMDs based on the life expectancy of the oldest of a group of individuals named as beneficiaries. Both of these types of “see-through” trusts invoke a “stretch IRA” technique pursuant to the Tax Code to preserve income deferral of the inherited retirement account.
Now, under the 2019 legislation, unless the beneficiary is a member of a specific class (a spouse, a minor child, younger by 10 years or less than the account holder, or suffering illness or disability), all of the IRA has to be paid out and taxed within 10 years. For those who do fall into this special excluded group, trust planning for these beneficiaries can continue as before to include the “conduit trust” and the “accumulation trust” techniques.
But for those who do not fall into the limited group of individuals not affected by the change in the law, trust planners have been racking their brains on how to stretch the IRA income—particularly for non-minor children. The best solution identified so far is to create a charitable remainder trust for charitably inclined clients. The trust pays an annuity to lifetime beneficiaries (such as non-minor children), with the remainder payable to a charity. With this technique, it is possible to stretch income taxes on the IRA distributions over the beneficiary’s lifetime, and then pay out the remainder of the trust assets, with the federal government’s blessing, not into its coffers but to a favorite charity or a family foundation.
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[1] The proposed Securing a Strong Retirement Act of 2020 (SECURE 2.0) that has lagged in Congress does not affect the provisions discussed in this article.