In December 2019, the SECURE Act was passed into law. The SECURE Act became effective on January 1, 2020. The SECURE Act changes how long retirement accounts can be collected for nonspousal beneficiaries.
Before the SECURE Act passed, an individual named on a traditional individual retirement account (IRA) or on a ROTH IRA could collect the account over their life expectancy. The SECURE Act now generally provides that the individual would need to collect the IRA or ROTH IRA within 10 years of the account holder’s death. This is significantly shortening the period in which to continue the income tax deferral.
It is still best to name your spouse as the primary beneficiary on your retirement plans as the surviving spouse can roll the IRA or ROTH IRA into his or her name and collect the proceeds over his or her lifetime.
However, some people do not want to name their spouse as the primary beneficiary of the retirement plans for a variety of reasons. If they want the surviving spouse to have the use of the retirement plan during their life but assure that it goes to someone else at the time of death, the account holder is still going to want to name a trust that benefits the surviving spouse as the beneficiary but ultimately is distributed to the secondary beneficiaries.
Naming the trust will create a few issues. To begin with, the trust will need to collect the IRA within the 10 year time period. Trusts hit the highest income tax bracket at about $12,950.00. So unless the all of the IRA is distributed to the beneficiary within the 10 year time period, the trust will being paying tax on the distributions currently at 37% for everything in excess of $12,950.00.
For example, David names a trust for his wife Martha as the income beneficiary on his IRA and the children from David’s first marriage are the remainder beneficiaries of the trust. The IRA has $1,000,000.00 in it. David dies on October 1, 2020. The trust for Martha will need to collect all of the IRA prior to December 31, 2030. If the trust waits until December 1, 2030 to collect the IRA, then it would be paying approximately $365,000 in income taxes assuming that the tax brackets did not change and there was no growth on the IRA.
To avoid the trust paying the income taxes at the highest bracket, the account holder may want to convert the IRA into a ROTH IRA over a period of years while the account holder is living. This potentially reduces the income tax due and any estate taxes if the account holder has assets worth more than the amount exempt from estate taxes. The Washington state exemption amount is currently $2,193,000 in 2020 and the federal exemption amount is $11,580,000.00 in 2020.
For example, David has an IRA with $1,000,000.00 in it. David names a trust for his wife Martha as the primary beneficiary on the IRA. If the IRA was paid out to the trust and there would be approximately $365,000.00 in income taxes to be paid.
In comparison, David and Martha convert David’s IRA to a ROTH IRA while David is alive over a period of years. Assuming David and Martha have annual income of $100,000.00 and file a joint return in 2020 they could convert $225,000.00 to a Roth IRA at a cost of approximately $53,000.00 in income tax. David and Martha could continue the conversion program until the IRA had all been transferred to the ROTH IRA with the amounts being transferred each year being adjusted so that they remained in the lower income tax brackets.
The next best beneficiary on an IRA is a charity. The benefit of naming a charity is that the charity does not have to pay any income tax on the money withdrawn from a traditional IRA in comparison to any other beneficiary which would have to pay the income tax on the money withdraw from a traditional IRA.
Remember that no one has to pay income tax on withdrawals from a ROTH IRA so ROTH IRAs should be used for gifts to individuals and trusts.
If the account holder has no surviving spouse and is not charitably inclined, then the account holder might want to name individuals as the beneficiary of the IRA. The individual can then choose how much to remove from the IRA each year to create the best tax consequences but all of the IRA needs to be withdrawn within the 10 years following the account holder’s death.
For example, David has an IRA with $1,000,000.00 in it. David dies on October 1, 2020. David named his child, Chris, as the beneficiary on the account. Chris is not married and has income of approximately $100,000.00 per year. If Chris withdraws all of the IRA in one year she would pay approximately $316,000.00 in tax for the withdrawal of the IRA.
In comparison, David has an IRA with $1,000,000.00 in it. David dies on October 1, 2020. David named his child, Chris, as the beneficiary on the account. Chris is not married and has income of approximately $100,000.00 per year. Chris might want to use up the 24% bracket for distributions in 2020 – 2028 (approximately $506,000.00) and then utilize the 32% bracket for the final distributions in 2029 and 2030 she would end up paying a total of approximately $269,000.00 in tax for the withdrawals. The IRA is also allowed to continue to grow tax deferred during that 10 year period of time. By utilizing the lower income tax brackets, Chris saves approximately $47,000.00 in income taxes.
A minor child can still qualify as an eligible designated beneficiary so that they can collect the IRA over the life expectancy of the child until the child attains “majority” when the distributions switch to the 10 year rule. This means majority might be extended to the age of 26 if the child is enrolled in an educational course or if the child becomes disabled while the disability lasts.
For example, David is the account holder. David names his 10 year old child, Emily as the beneficiary on his IRA. David dies. Emily would be able to collect the IRA over her life expectancy until she reached the age of majority. Emily decides that she does not wait to pursue her education when she turns 18. Emily would then have 10 years to collect the IRA. Emily would need to withdraw everything from the IRA when she was 28.
In comparison, David is the account holder. David names his 10 year old child, Emily as the beneficiary on his IRA. David dies. Emily would be able to collect the IRA over her life expectancy until she reached the age of majority. Emily has decided to become a doctor. She continues her schooling and is still in school when she is 26 years old. The age of majority in this case would 26 not 18 and Emily would have until she was 36 to withdraw everything from the IRA.
An important point is that it must be a minor child of the account holder not another minor such as a grandchild, niece or nephew or friend.
For example, David is the account holder. David names his 10 year child, Emily as his beneficiary on his IRA. Emily would be able to collect the IRA over her life expectancy potentially until she was 26 if she was still pursuing her education at 26. When Emily turned 26 then she would need to collect the IRA within a 10 year period of time. So Emily potentially would not have to have everything withdrawn from the IRA until she was 36 years old. If Emily was not in school after the age of 18, then everything would need to withdraw from the IRA by the time she was 28 years old.
In comparison, David is the account holder. David names his 10 year old grandchild, Pat as his beneficiary on his IRA. Pat would be required to withdraw everything out of the IRA within 10 years of the account holder’s death. Therefore, everything would need to be withdrawn by the time Pat was 20 years old.
Many parents do not want their minor children to have control of the IRA distributions when the child turns 18, so they choose to name a trust for the benefit of the minor child as the beneficiary of the IRA. For a trust to qualify as an eligible designated beneficiary, the trust must be a conduit trust that mandates that the required minimum distribution amount during the period when a child is a minor is distributed to or for the benefit of the minor annually.
However, if a child is not a minor child, then the trust should not mandate that the required minimum distribution amounts be distributed to the beneficiary. This will create a situation of larger distributions than originally intended being distributed to the beneficiary.
If you name a trust as a beneficiary of an IRA then you want to make sure that it is still appropriate for your situation. Most of the trusts that I have drafted over the last 20 years were created so that the trust could collect the IRA over a beneficiary’s life expectancy and qualify as a designated beneficiary. With the new SECURE Act, many of these trusts are not going to give the result that the testator originally intended. Therefore, if you have an IRA you should double check the beneficiary on the IRA. If the IRA names a trust as the beneficiary, you might want to reconsider whether it would now be appropriate to name individuals as the beneficiaries of the IRA. Secondly, if it is not appropriate to name individuals as the beneficiaries of the IRA, does it make sense to start converting the IRA to a ROTH IRA so that the trust does not have to pay income tax on the distribution of the IRA and the distribution does not have to be distributed to the beneficiary for the beneficiary to pay the income tax on the IRA withdrawal. Considering the recent market decline, this year might be a good year to start converting a retirement plan to a ROTH IRA.
Finally, for those individuals who do not want their beneficiaries to pay the income tax on the IRA within ten years and want the beneficiaries to receive the IRA over their life expectancy and have a charitable inclination, they may want to consider a charitable trust as the beneficiary for their IRA. If an account holder names a charitable trust as the beneficiary of the IRA, the charitable trust would collect the IRA without paying any income taxes. The charitable trust would pay a sum annually to the beneficiary. The amount that was paid could be either a fixed percentage each year or a fixed amount each year. On the death of the beneficiary, the remainder of the trust would need to be distributed to a charity.
The SECURE Act has changed how we want to deal with IRAs to create the best tax consequences for the account holder and for the beneficiaries. Naming a trust and mandating that required minimum distributions are paid to the beneficiary or on the beneficiaries behalf is no longer the best solution.