SECURE Act - What You Need To Know

January 23, 2020

The SECURE Act was passed into law at the end of 2019 and went into effect on January 1, 2020. The SECURE Act makes sweeping changes to the rules for distributions from retirement plans.  First, the age that an owner of a retirement plan must start withdrawing the funds from the account (and paying the resulting income taxes) has risen to age 72.  Second, and more importantly from an estate planning perspective, the SECURE Act makes dramatic changes to the way children and other beneficiaries are taxed when they inherit retirement accounts.  
 

Prior to the SECURE Act, a child inheriting a retirement account could withdraw the funds from the account over his/her life expectancy, thus “stretching out” the income tax consequences on the funds.  This technique was often referred to as the “Stretch IRA” or “life expectancy payout.”  The SECURE Act eliminates the Stretch IRA for most beneficiaries.  Now, the funds must be paid out of the retirement account no later than 10 years after the death of the account owner in a  “10 year payout.”  
 

Example: Marilyn Jones has a $500,000 IRA.  She named her daughter Karen (40 years old) and her grandson Michael (20 years old) as the equal beneficiaries of her IRA.  If Marilyn had passed away in 2019 prior to the SECURE Act, Karen could have withdrawn the funds and paid the resulting income taxes over 43 years.  Michael would have been entitled to a 60 year withdrawal period.  If Marilyn passes away in 2020 or later, the rules of the SECURE Act require that both Karen and Michael must withdraw the IRA funds within 10 years. 
 

With a few limited exceptions discussed below, the new 10-year payout rule also applies when you name a trust as a beneficiary of a retirement account.  Many parents create trusts as part of their estate plan to hold funds for a child until that child reaches a certain age that the parents feel the child will be ready to manage money.  Parents often name these trusts as the beneficiary of their retirement account so that the retirement funds are protected by the trust.   Some trusts are designed so that the trustee can keep the funds and manage them inside the trust with the other trust assets.  

 

 

However, trusts pay higher income tax rates than individuals. To avoid higher income taxes, some trusts require any retirement funds withdrawn from the retirement account to be paid out to the beneficiary(so called “conduit trusts”) so that the resulting income taxes are charged to the beneficiary at his/her individual rates and are not exposed to the high income tax rates that trusts pay.  In either case, the new 10-year payout rule now creates unintended consequences for these trust situations.
 

 Example: John Smith wanted his son, Peter, to inherit his $1,000,000 IRA but was concerned that Peter would withdraw the funds and spend them unwisely.  So, Mr. Smith created a trust for the benefit of Peter and named the trust as the beneficiary of his IRA.   In order to avoid the negative consequences of the trust paying the income taxes, Mr. Smith designed the trust as a “conduit trust” so that any funds withdrawn from the retirement plan would be distributed out and taxed to Peter (who would pay lower overall taxes than the trust). When Mr. Smith created this plan, the rules allowed the trust to withdraw only a little bit of the IRA funds each year and distribute them out to Peter.  Mr. Smith felt that Peter would be able to manage those smaller amounts.  Now, under the SECURE Act, the trust is required to withdraw all of the funds from the retirement account and distribute them out to Peter within 10 years after Mr. Smith’s death, leaving Peter with much larger distribution amounts than Mr. Smith ever intended.   


Example: Mary Jenkins named a trust for the benefit of her daughter, Amy, as the beneficiary of her retirement account.  Ms. Jenkins had stronger concerns about Amy’s ability to manage finances and chose not to include any conduit language for Amy’s trust so that retirement funds would remain protected by the trust.   Ms. Jenkins understood that the trust would have to pay the income taxes on the retirement funds as the funds were withdrawn from the retirement account (and not distributed to Amy).  She knew that trusts pay high rates of tax on income but was satisfied with the arrangement because the trust could withdraw the funds slowly and in small increments over Amy’s remaining life expectancy of 40 years thus reducing the amount of income taxes paid by the trust.   Now, the SECURE Act requires the funds to be withdrawn in 10 years and the resulting income tax bill will be much higher than Ms Jenkins expected.
 

There are three important exceptions to the 10 year payout rule.  First, surviving spouses are still entitled to roll over retirement accounts into their own IRA accounts and withdraw the funds over their life expectancy, with the required withdrawals beginning at age 72.
 

Secondly, trusts established for the benefit of a person experiencing a disability (special needs trusts) can continue to use the life expectancy of the disabled beneficiary to withdraw the retirement funds.  This exception is welcome news to the special needs community and to parents who do not have much choice other than to direct retirement funds to a special needs trust in order to protect their child’s eligibility for certain government benefits. 
 

Finally, certain trusts for minor children can use the life expectancy rule to withdraw the funds out of the retirement account until the child reaches age 18.  However, at age 18, the 10-year payout rule kicks in and the funds must be withdrawn from the retirement account by the time the child reaches age 28.
 

What now?  

As outlined in the examples with Mr. Smith and Ms. Jenkins above, the SECURE Act’s new rules can create unintended consequences for estate plans that name a trust as the beneficiary of a retirement account.  For that reason, if you have named a trust as the beneficiary of your retirement plan, we recommend that you engage the services of your Fitzwater Law attorney to review how the SECURE Act affects your estate plan. 
 

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