How to Secure the Inheritance of Your Retirement Plans Under the SECURE Act
On January 1, 2020, the Setting Every Community Up for Retirement Enhancement (SECURE) Act went into effect. The new law threw estate planning for qualified retirement accounts on its ear as it changed the rules for the inheritance of IRAs and 401(k)s following the original account holder's death. Under the prior law, if your children inherited your retirement accounts, they would begin taking Required Minimum Distributions (RMDs) annually. But, the amount of the distribution would be calculated based on your child's life expectancy. This was often referred to by planners as a "stretch IRA" since the receipt of the retirement account could be stretched out over the life of your child.
Unfortunately, Congress giveth and Congress taketh away. Under the SECURE Act, Congress all but eliminated the option to stretch out retirement account distributions over the life expectancy of the beneficiary.
So, what are the new rules? And how does this affect who you name to be your beneficiaries? Here's what you need to know:
If the retirement account is inherited by anyone other than your spouse, then the account must be fully distributed by December 31st of the 10th anniversary of the original IRA or 401(k) account holder’s death. This is referred to as the 10-year payout rule.
Although there is no mandated “withdrawal schedule” included in the SECURE Act, the proposed IRS Regulations issued in February 2022 (but not yet formally approved) do state that the beneficiary must take RMDs annually during the 10-year payout period. The remaining balance (that portion not taken in the form of RMDs) must be distributed by the end of the 10th year following the account holder’s death.
Spouse beneficiaries do not follow the 10-year payout rule. The SECURE Act did not change the rules for spouses. Spouses retain the favorable rollover provisions that existed under the prior law.
There is also an exception to the 10-year payout rule for a chronically ill or disabled beneficiary or a beneficiary who is less than 10 years younger than you (such as a sibling). These beneficiaries are eligible for the "stretch," meaning they can continue to receive IRA distributions over their remaining life expectancy.
For more information about the different rules that apply to spouse beneficiaries and non-spouse beneficiaries, review the section from the IRS regarding the death of an account owner after 2020 here: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-beneficiary
There is a slight modification to the 10-year payout rules for your minor children—the payout window does not start until your child’s 18th birthday. However, your child will still be forced to empty out the entire IRA or 401(k) by his or her 28th birthday under the terms of the SECURE Act.
This modification only applies to your minor children. It would not apply to stepchildren, nieces or nephews, grandchildren, godchildren, or any other beneficiary who is under the age of 18 at the time of the account holder's death. For minors who are not your children, the 10-year payout period starts immediately upon the death of the account owner.
Of course, once your child reaches age 18, nothing stops him or her from withdrawing the entirety of the account in one lump sum whenever he or she chooses (say, their 21st birthday... Vegas, anyone?). They can take it all as one lump sum or take out bits here and there like your IRA is their personal piggy bank. The only requirement—aside from taking annual RMDs—is that the retirement account be zeroed out by the time your child turns age 28.
It is worth noting that distributions from a traditional IRA or 401(k) are taxed to the recipient. Therefore, if your beneficiary takes $100,000 a year from your million-dollar IRA, he or she will pay substantial federal and state income taxes on the amount he or she receives each year. In planning for the inheritance of your retirement accounts, you may want to consider if your beneficiary is financially sophisticated enough to realize the tax implications of these withdrawals.
Would making my trust the beneficiary of my IRA or 401(k) solve these issues?
Perhaps. Naming the trust as the beneficiary of retirement accounts does not alter the requirement that the IRA or 401(k) be emptied out in 10 years. Still, if the retirement monies are distributed to the trust, then the trust can control how the funds are to be used and when the funds will actually get into the hands of the trust heirs. There are pros and cons to designating your trust as beneficiary.
1. CON: Your spouse loses the ability to rollover the retirement account into his/her name (a direct rollover by the spouse avoids the 10-year payout rule under the SECURE Act). The solution would be to name your spouse as the primary beneficiary so that the favorable rollover terms would apply. You could name your trust as the secondary beneficiary in the event your spouse does not outlive you.
2. PRO: If you name the trust as the primary beneficiary in place of your spouse, it allows your retirement account to be protected should your spouse remarry following your death (assuming your trust has some remarriage protections in place and does not distribute trust assets outright to your spouse immediately upon your death).
3. CON: Allowing IRA distributions to accumulate inside of a trust means the trust pays the associated income taxes. The tax rate for trusts is often higher than an individual’s rate.
4. PRO: Allowing the IRA distributions to accumulate inside of the trust allows those funds to be protected from a beneficiary who may be too immature, too unsophisticated, or too unwise to be in control of that much money.
Ultimately, there is no one-size-fits-all approach. Each person must consider all of the pros and cons and make the best decision possible for his or her family and loved ones. For people curious about ways to lessen the impact retirement accounts may have on their kids' inheritance, consult a financial advisor about whether (1) converting traditional retirement accounts to Roth retirement accounts makes sense, and (2) reducing your rate of contributions to your traditional retirement accounts is wise considering these types of accounts are no longer useful as wealth transfer vehicles. In addition, if you are concerned about the amount of money available to your beneficiaries and the impact income taxes may have on the actual amount of inheritance your beneficiaries receive, you may want to explore ways to infuse your estate with additional cash upon your
death (for example, by adding or increasing life insurance coverage).
NOTE: Although Roth IRAs and Roth 401(k)s also require a maximum 10-year payout period, the distributions are not taxable. Since income taxes are not a factor with Roth accounts, the decision over whether to fund your trust with these accounts becomes less complicated. Your two primary considerations are (1) the age and maturity level of your children and (2) the level of concern you have over assets being diverted from your children should your spouse remarry after your death. If your trust contains remarriage restrictions and/or if your children’s inheritance is via a trust (as opposed to being distributed to your child outright at your death), then you should consider naming your trust as either the primary or secondary beneficiary of your trust.
Making sure your retirement beneficiaries are properly designated is not an easy task given the complexity of the law and the changing rules. If you want to better understand how the SECURE Act impacts your plans, schedule an advisory phone call with Attorney Amy Privette. For a more thorough analysis of all of your beneficiary arrangements, call the office or send us an email to set up a Beneficiary Alignment.
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