By SCOTT M. SIMMONS, J.D., LL.M., Senior Wealth Strategist & Family Office Fellow

Those who are victorious plan effectively and change decisively. They are like a great river that maintains its course but adjusts its flow.
-Sun Tzu

On December 20, 2019, President Trump signed the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) into law. This created a seismic shift in the income tax treatment of inherited retirement plans and the estate planning surrounding retirement accounts. Not since the Pension Protection Act of 2006 has there been such a fundamental change to the law regarding retirement accounts.

Looking Back at the Route Previously Taken
For decades, individuals developed their estate plans secure in the knowledge that the named beneficiaries of their retirement plans and IRAs would have the ability to stretch their annual payments over their Designated Beneficiary’s life expectancy,1 provided the beneficiary qualified as a Designated Beneficiary.2 This Inherited IRA allowed for the possibility of decades of continued tax-deferred growth of those retirement accounts, tax-free in the case of Roth accounts, and delayed the impact of the income tax owed.

Additionally, many individuals were not comfortable leaving significant sums outright to a beneficiary. Thus, they designed their estate plan to protect the trust assets from both the beneficiary’s spending habits and the future impact of lawsuits against their beneficiaries that could potentially deplete the funds left to them. To protect the retirement accounts, they often named their revocable trust as the beneficiary of the retirement account.3

In those cases, if the appropriate IRS rules were followed,4 the oldest trust beneficiary’s life expectancy was used to determine the appropriate annual minimum distribution from the retirement accounts. Often the trusts were designed as a conduit trust allowing the annual minimum distribution from the IRA to flow through to the trust and then be distributed outright to the beneficiary.

Individuals who utilized a trust as a beneficiary in this way felt that they had secured their beneficiary’s future in the following ways:

  • They had prevented the beneficiary from cashing out the retirement account. When a beneficiary cashes out the retirement account, they lose the tax deferral benefits and force all the income taxes to be paid at once in the year of distribution.
  • They had ensured an income stream to the beneficiary each year as the annual minimum distributions flowed from the retirement account to the trust and out to the beneficiary.
  • They had protected the Inherited IRA from the beneficiary’s creditors.

Unfortunately, the route previously taken is now filled with obstacles due to the passage of the SECURE Act.

Using 2020 Foresight to Secure the Future
The SECURE Act has fundamentally altered the previous secure path. No longer may a non-spouse beneficiary’s life expectancy be used unless they are in a narrow class of Eligible Designated Beneficiaries. The SECURE Act now requires that a retirement account be cashed out within 10 years of the account owner’s death, unless the beneficiary is one of the following Eligible Designated Beneficiaries who are grandfathered and remain subject to the old life expectancy rules:

  • The surviving spouse;
  • A minor child of the account owner, but only until the child reaches majority;5
  • A chronically ill individual;6
  • A disabled beneficiary;7 or
  • An individual who is not more than 10 years younger than the account owner.

In an odd twist, the new rules produce a result where a 75-year-old surviving spouse has the ability to stretch out Inherited IRA distributions longer than a 55-year-old child. Naming an adult child as the retirement account beneficiary results in not only the retirement account being fully distributed within 10 years, there is no longer a requirement of an annual minimum distribution during that 10-year period.

A similar result occurs when a revocable trust is named as the beneficiary. Naming a revocable trust, designed as a conduit trust, as the beneficiary, which was typical under the prior law, the income stream previously available over the beneficiary’s lifetime has been replaced with the full retirement account balance being distributed out of the trust and to the beneficiary no later than 10 years following the account owner’s death. Therefore, the previously well drafted conduit trust no longer protects the retirement account from the beneficiary’s creditors after 10 years.

For those who continue to favor asset protection for their beneficiaries, it may be important to modify the terms of their trust to provide for an accumulation trust rather than a conduit trust. An accumulation trust retains the distributions from an Inherited IRA in the trust rather than distribute them to the beneficiary. While this will subject any distribution during the 10-year period to the trust income tax brackets, the retirement account balance would remain in the trust, protected from the creditors of the beneficiary.

If an income stream is important for your beneficiaries and you have a philanthropic desire, consider whether naming a Charitable Remainder Unitrust as the beneficiary of your retirement account would be beneficial. This could provide a protracted income stream to your beneficiary, typically 5%, throughout his or her lifetime. When the beneficiary passes away, any balance remaining would be distributed to the charity you name in the Charitable Remainder Unitrust.

One other item to consider for any retirement account is the possible impact of the changes in income tax brackets that may occur in the future, either as a result of the rollback to the prior higher rates that will occur January 1, 2026 under the Tax Reform Act or future legislative increases to income tax rates. Because, in most cases, there is no longer a lifetime of continued tax deferral when a retirement account is inherited, it may be advantageous to convert all or some of a retirement account to a Roth IRA. Naming a trust as the beneficiary of the Roth IRA allows for at least 10 years of continued tax-free growth. In addition, during the account owner’s lifetime, no annual required minimum distributions are required from a Roth IRA.

The passage of the SECURE Act provides the opportunity to look back at the choice of retirement account beneficiaries and realign your plan in order to accomplish your current goals and objectives. There are a multitude of items to consider that will require the input of the family’s entire team of advisors. Your Oxford advisor will work with your team to coordinate the optimal solution for your family.

1Calculated typically using Table 1 (Single Life Expectancy) Publication 590-B
2I.R.C. § 401(a)(9)(E)
3This proved to be the best of both worlds when the U.S. Supreme Court, in 2014, ruled that an “Inherited IRA”, owned in the beneficiary’s name individually and not as part of a trust, was not a retirement account protected under the bankruptcy laws. Therefore, the individually-owned “Inherited IRA” was subject to the claims of the beneficiary’s creditors. This case reinforced to many that to protect an “Inherited IRA” against creditors, they could name a trust as the beneficiary of their retirement accounts. Clark v. Rameker, 134 S. Ct. 2242 (2014)
4Reg. § 1.401(a)(9)-4, A-5
5Once the account owner’s child reaches majority, the retirement account must be paid in full to the child within 10 years. “Majority” is determined by the beneficiary’s state of residence and is typically 18 or 21 but may be extended if the child has not completed a specified course of education and is under the age of 26. It is anticipated that the IRS will clarify the application of this exception by issuing regulations in the future.
6Defined in I.R.C. § 7702B(c)(2)
7Defined in I.R.C § 72(m)(7)

The information in this presentation is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. This presentation has been prepared from original sources and data believed to be reliable. However, no representations are made as to the accuracy or completeness thereof.