A year into the SECURE Act, estate planners and other retirement advisors are still waiting for clarification from the IRS regarding key changes made to the payout rules for retirement plans by the new legislation. Many of these questions pertain to novel rules governing a new class of designated beneficiaries, called eligible designated beneficiaries (“EDBs”), and to the implications of client decisions to name a trust as the beneficiary of a retirement plan or account. Until the IRS issues Proposed Regulations or notices interpreting the SECURE Act, planners are updating trust agreements to account for the new statute and provide trustees without the requisite tools to obtain the best possible results.
Generally speaking, trustees will need greater focus on tax planning. The SECURE Act deprives most non-spouse beneficiaries of the ability to receive a gradual, lifetime payout (“a stretch IRA”) and mandates withdrawal within ten years of the account owner’s death. Many IRA owners planned their estates around the stretch payout, appreciating the idea that the account would be paid out over a beneficiary’s life expectancy all the while maintaining the tax-deferred wrapper around the balance of the account. Now, some IRA owners are reconsidering the advantages of naming a trust as beneficiary.
There are several situations where naming a trust as beneficiary is crucial. These situations include second marriages, beneficiaries with special needs, families with minor children, asset protection concerns and employees needing to use a retirement account to fund a credit shelter trust. The SECURE rules have complicated the trust planning regardless of whether the trust names a class of individuals as beneficiaries or provides for successive interests for beneficiaries.
QTIP trusts are instructive of the new regimen. Under the new rules, five favored beneficiary classes remain eligible for the stretch payout. These beneficiaries, identified as EDBs, include surviving spouses, minor children of the retirement plan participant, disabled beneficiaries, chronically ill beneficiaries and individuals, such as siblings or unmarried partners, who were born within ten years of the plan participant. QTIP trusts named as beneficiaries of retirement accounts are not affected by the SECURE Act so long as the provisions of the QTIP comply with Revenue Ruling 2006-26 and carry out the requisite income to the surviving spouse. However, once the surviving spouse dies, the successor beneficiaries of the plan, whether that is a trust or an individual outright, will then be subject to the ten-year payout rule. If spouses die within a few years of each other, there will be precious little opportunity for tax deferral.
IRA trust planning has always involved two options, and nothing in the SECURE Act alters these two options. Conduit trusts are aptly named as they function to carry out to the trust beneficiaries the distributions that the trustee must withdraw from the retirement account payable to the conduit trust each year. For non-EDBs, the conduit trust will no longer work to minimize taxes or spread distributions over the beneficiary’s lifetime. IRA owners may well decide that they would rather allow the trustee to retain some or all of the distributions in trust. Their planning would then migrate to the second type of trust, a so-called accumulation trust, where the trustee has the discretion to accumulate distributions from the retirement account within the trust. While this option does offer protection for the assets, the benefit comes at a significantly higher tax cost due to the compressed brackets for trusts.
Accumulation trusts do not automatically qualify as a designated beneficiary. Rather, each trust must be tested to ensure that an individual (and not a charity or an estate) will receive the account balance on a date certain. Along these same lines, IRA account owners intending to benefit their grandchildren will need to review their estate planning documents, especially if their intent was to use a conduit trust and distribute the plan assets in modest annual increments over each grandchild’s life expectancy. Grandchildren, even if minors, are not EDBs, and there is no “move up” rule that would permit grandchildren to obtain a “stretch” payout during minority if their parents were deceased. An accumulation trust will protect the assets but will need to build in flexibility to enable the trustee to manage the tax liability.
At this point, it is unclear how the IRS will treat trusts with multiple beneficiaries, some who are EDBs and some who are not. Hopefully, the IRS will permit the trust to be divided into separate shares for purposes of allowing any minor beneficiaries to qualify as EDBs or permit the payout period to be based on the youngest beneficiary’s status. The payout period is also unclear where the account owner’s remaining payout period is longer than ten-years. The pre-SECURE rules provided that the payout period, once commenced, was the longer of the life expectancy of the account owner and the life expectancy of the designated beneficiary. This should be the rule post-SECURE as well and the IRS is expected to confirm such by regulation in 2021.
As part of estate planning discussions for those skeptical of using a trust, it will be important to review the treatment of inherited IRAs in bankruptcy and divorce. In a unanimous decision, the Supreme Court said that inherited IRAs are not retirement funds because a beneficiary cannot add to his or her account and can withdraw his or her account in full without penalty. But the application of the decision to state exemption statutes is not as straightforward as a unanimous decision portends. In In Re Pacheco, 537 B.R. 935 (Bkrtcy. D.Ariz 2015), for example, the Arizona court said that the plain language of the Arizona exemption statute evidenced a deliberate policy to protect inherited IRAs and that Arizona was free to create and implement its own bankruptcy exemptions. The Rhode Island Supreme Court reached a similar result last year. The key point to impress on clients is that this issue is now dependent upon the state law of the debtor’s primary residence.
In conclusion, the SECURE Act offers a new and urgent reason to review client’s IRA planning. Ideally, the IRS will act swiftly to offer guidance on the issues left unresolved by Congress.