What is the SECURE Act?

As you may be aware, a new law which significantly changes the way in which inherited retirement assets will be distributed to beneficiaries went into effect on January 1, 2020.  This is the SECURE Act.  While the SECURE Act includes some beneficial provisions such as increasing the age at which a participant must begin taking required minimum distributions from age 70.5 to age 72 and eliminating age restrictions for contributions to IRAs for individuals who continue to work, the significant downside to the Act is that it will require most beneficiaries of inherited IRAs or 401ks to withdraw all of the funds in the account within 10 years from the owner’s death.  This is a big change from the prior rules which permitted distributions over the life-expectancy of the beneficiary.  Read on for 5 Things to Know about the SECURE Act (and how it could impact your estate plan.)

1. Your beneficiaries will realize less value from the inherited IRA under the SECURE Act. If you were counting on your beneficiaries receiving a certain amount from your estate which includes large IRAs or employer retirement plans, count again. Under the pre-2020 rules, an individual beneficiary could “stretch out” the withdrawal period over which he was required to take distributions over his life expectancy as of the death of the IRA owner.  Since the IRS assumes everyone is going to live until age 80 or so, this could mean a very long withdrawal period if your IRA was left to a child or grandchild.

For example, under the pre-2020 rules, a $1 million-dollar IRA inherited by a 50-year old beneficiary could be distributed to the beneficiary over approximately 30 years.  This means that in the first year the beneficiary would be required to withdraw about $33,000 from the $1 million IRA and include that amount in his taxable income.  The remaining $966,666 that was not withdrawn would continue to grow tax free.  Assuming a modest 5% growth, the balance at the end of the year would be $1,015,000. The following year the beneficiary would have to withdraw 1/29^th of the balance in the IRA, or about $35,000 from that IRA. Again, the amount that was not withdrawn, about $980,000 would continue to grow tax free during that year and at 5% would be $1,029,000 at the end of the second year, and so on.

Under the SECURE Act rules for inherited IRAs, most beneficiaries will be required to withdraw the entire balance of the IRA within 10 years of the owner’s death.  Applying the new rules to the above example means that if the beneficiary withdraws 1/10^th of the IRA the first year, she would withdraw $100,000 and pay income tax on that amount. The remaining $900,000 would continue to grow tax free during the year.  Assuming a 5% increase, this leaves a balance of $945,000 at the end of that year. If the beneficiary took out 1/10th the second year, that would be a withdrawal of $94,500 leaving a balance of $850,000, and so on.

2. There are no changes in the distribution rules for a surviving spouse. While the rules regarding inherited IRAs for most beneficiaries have changed, they have not changed as to a surviving spouse. If you leave your traditional IRA or 401k to your spouse, your spouse will have the option to roll it over into his or her IRA and defer required minimum distributions until age 72. If your spouse is already age 72 or upon reaching age 72, the surviving spouse will be able to take withdrawals over his or her then life expectancy. It is only when the surviving spouse dies and the IRA passes on to the remaining beneficiaries, such as your children, that the 10-year rules come in to play and should be considered in your inheritance planning.

3. If your IRA is payable to your Trust it gets more complicated. If you require more complex trust planning or you have structured your estate plan to leave your assets to a Trust for the benefit of your children following your death to provide asset protection for their inheritance or to control the distribution of the funds to them, then this change in the law is even more complicated. The reason for this is that distributions from the IRA are income taxable to the beneficiary.  If the beneficiary is a Trust, then the Trust will be responsible for reporting as income the distributions from the IRA and paying the income tax unless the distribution from the IRA is distributed out of the Trust to the beneficiary in the same tax year, in which case the beneficiary will report the income on her income tax return and pay the tax.   The problem is that the income tax rates on Trusts are much higher than on individuals.   An individual taxpayer reaches the highest federal taxable rate of 37% when she has taxable income of approximately $510,000. A Trust reaches that highest taxable rate when it has income of about $13,000.   Since no one wants to pay more tax than is necessary, logic dictates that the distribution from the IRA be distributed out of the Trust to the individual beneficiary.  However, once the funds are distributed to the beneficiary, the money is subject to the easy reach of the beneficiary’s creditors such as a divorcing spouse, a bankruptcy, a lawsuit or other creditors.  In addition, funds distributed out to the Trust to the beneficiary may be spent as the beneficiary pleases which may not be in accordance with your estate plan goals.

4. IRAs passing to minor children may be paid out over the child’s life expectancy, but this comes with a price. Under the SECURE Act, if your IRA passes to your minor child, then the distribution can be stretched out over the minor’s life expectancy during the child’s minority.  (Note that the special stretch out rules for minors apply ONLY to the minor children of the IRA owner; they do not apply to step-children, grandchildren, or nieces and nephews).  Once the child reaches the age of majority, the 10-year rule applies.  There are many challenges associated with this new rule.  For example, a minor should never be designated as the direct beneficiary of an IRA.   Aside from the fact that most people don’t feel comfortable having assets pass into the hands of a young beneficiary, if a minor is named as the beneficiary of an IRA, then a court proceeding called a Conservatorship will be required. This is expensive and time consuming and best avoided.  The best practice is to leave an IRA to a minor beneficiary via a Trust.  In order for a Trust to be eligible for the life expectancy payout for a minor under the new rules, the Trust must direct that the required minimum distributions be distributed out of the Trust to the minor beneficiary immediately.  This may not be such a big deal while the beneficiary is a minor and the minimum distributions are calculated based on his then life expectancy.  Further, the minor would have a guardian who will receive and apply the funds for his benefit.  However, once the beneficiary reaches the age of majority (which, by the way, under the SECURE Act could be any time between the ages of 18 and 26), requiring that the IRA distributions be distributed out of the Trust and into the hands of the beneficiary could be a significant problem.

For example, if a $1 million IRA is left to a Trust for the benefit of a minor child who is 10 years old at the death of the parent, then the required minimum distribution the first year would be about $14,300.  This amount would have to be distributed out of the IRA to the Trust and then out of the Trust to the beneficiary, or his guardian.  Because of the small amount that must be distributed during the beneficiary’s minority, the balance in the IRA is likely to be $1.3 million or more when the beneficiary reaches the age of majority.  At that point, the balance in the IRA must be distributed to the beneficiary within 10 years.  The Trustee will have the difficult task of deciding on the timing of the withdrawals from the IRA.  Is it better to give an 18-year old $130,000 each year for 10 years, or should the Trustee defer taking withdrawals from the IRA until the beneficiary is older, and hopefully wiser, even if doing so will mean a larger tax liability?  These are hard decisions and will need to made on a case by case basis.  Given the requirement that IRA distributions be distributed out of the Trust to the beneficiary in order to obtain the stretch-out during the child’s minority, parents with large retirement assets may choose to forgo the stretch-out in favor of granting the Trustee discretion to retain withdrawals from retirement accounts in the Trust.

5. If you have a Roth IRA, this change is actually beneficial. Under the old rules, inherited IRAs, including Roth IRAs, had to be paid out either within 5 years of the owner’s passing, or over the life expectancy of the beneficiary.  The life expectancy option was almost always the best choice as it minimized the taxes and maximized tax-free growth.  However, the life-expectancy withdrawal method required that every year beginning with the year after the death of the IRA owner, the required minimum distribution calculated on the beneficiary’s then life expectancy be distributed out of the IRA to the beneficiary.  Under the new 10-year rule, the entire amount of the IRA must be distributed by the end of the 10^th year following the death of the owner; however, a beneficiary is not required to take the distributions in equal installments.  Since distributions from a Roth IRA are not income taxable to the beneficiary, a person who inherits a Roth IRA under the SECURE Act can refrain from taking any distributions for 10 years and allow the value of the Roth IRA to grow tax-free for that 10-year period.  After 10 years, the beneficiary will be required to withdraw the entire balance from the Roth but the amount withdrawn is not taxable income to the beneficiary since distributions from a Roth are income tax free.

The bottom line is that everyone who has significant retirement assets should review their estate plan with an experienced estate planning attorney who is familiar with the provisions of the SECURE Act, to understand the impact the Act will have on the distribution of these assets to their beneficiaries.  We are happy to review this with you and encourage you to be in touch to schedule a time to meet with one of our attorneys to evaluate how the enactment of the SECURE Act will affect your family and your estate plan.

Attorney Suzanne R. Sayward is a partner with the Dedham firm of Samuel, Sayward & Baler LLC which focuses on advising its clients in the areas of estate planning, estate settlement and elder law matters. She is certified as an Elder Law Attorney by the National Elder Law Foundation, a private organization whose standards for certification are not regulated by the Commonwealth of Massachusetts.  This article is not intended to provide legal advice or create or imply an attorney-client relationship. No information contained herein is a substitute for a personal consultation with an attorney. For more information visit www.ssbllc.com or call 781/461-1020.

Febraury, 2020

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