On December 19th, 2019, the SECURE Act was passed for the purpose of bolstering retirement savings and became effective as of January 1, 2020. Among other things, this one-hundred thirty-page document gave more buoyancy to certain types of savings accounts that focus on retirement, which is something that retirees and those moving toward retirement can appreciate.
Major changes, however, were enacted by this law that dictates how your retirement accounts can be inherited down the line.
Estate planning was just made a little bit less secure, not by means of loss, but by means of taxes. With a good estate lawyer, however, your assets can be inherited by your loved ones at the highest capacity through clever planning and the proper trust.
Types of IRA’s Affected by the SECURE Act
Before we begin, let’s get acquainted with some vocabulary. An IRA is an acronym for an “individual retirement account,” and it’s often your second largest asset, typically only following your home in its worth. It’s a big deal, and often contains a large lump sum of your money. And, if you don’t manage to spend it before you pass away, your IRA is a lump sum of what you’ll be passing down to your heirs. With a traditional IRA, you don’t pay taxes upfront. As you take distributions, later on, you pay taxes on what you withdraw.
A Roth IRA is different in that you pay taxes upfront, instead of later on. While both Roth IRAs and Traditional IRAs are heavily impacted by the SECURE Act and current estate plans may be frustrated by the passage of this Act, the impact on Traditional IRAs include substantial tax consequences that need to be accounted for and balanced with other objectives in an estate plan.
Retirement Account Rule Changes
Four major components have changed since the original drafting of laws that govern retirement accounts.
Firstly, the required distribution years, or the years in which one must make a required minimum distribution, has risen from 70 1/2 to 72 years old. This means, simply, that you don’t have to start withdrawing a specific amount of money from your retirement account until you’re 72.
Secondly, there is no longer an age cap on contributions to traditional IRAs. If you’re interested in continuing to invest in your IRA, you’re more than able to do so under the SECURE Act. Annuities have now been designated in some cases as investments in 401k plans, which gives people the opportunity to add guaranteed income streams to their retirement portfolio.
However, the largest change from the SECURE Act, and what some tax attorneys refer to as a bomb hidden within your documents, is the new post-mortem required minimum distribution rule change. The “Stretch,” or the ability to grow the IRA’s assets after the death of the account holder, has been severely limited. Specifically, with very few exceptions, all assets within the IRA account must be removed by December 31st of the ten-year anniversary of the death of the account holder.
This lack of stretch matters because it brings to the forefront of the other inevitability of life: taxes.
When the beneficiary takes distributions from the IRA account, they are seen as increasing their income. If one were to remove everything within the account at once, or a large portion of it, that is taxed as income and is added to the other income the person earned that year, which may throw the person into a much higher tax bracket.
Because of the push to distribute the funds faster (over 10 years rather than over the lifetime of a young beneficiary), this creates a pot of additional tax money for our government. The amount of money that can be passed down has been decreased due to the SECURE Act, which meddles with the account holder’s intentions of giving the largest inheritance possible to their heirs. And while the government is looking at a net increase of 15 billion dollars in tax revenue, your heir is looking at a tax rate of, in some cases, 37%.
How Do We Prepare for Changes from the SECURE Act?
Retirement plans are defined contribution plans. They can be overseen by a designated beneficiary, which is either an individual or a see-through trust, such as a conduit trust or an accumulation trust. Individuals applicable to become exceptions to this rule are spouses, young children, chronically ill heirs, or disabled heirs.
Spouses aren’t heavily affected by the SECURE Act, as they can continue to use the life expectancy rules when they inherit a retirement account from their spouse, which existed pre-2020.
Young children are in a basket of their own, as they can only continue to use the life expectancy concept until they hit the age of majority within their state. When the child reaches the age of majority, let’s say 18 as an example, they need to have removed all of the money from the retirement account before December 31st in the year they turn 28.
When left to its own devices, the retirement will grow tax-deferred at a higher rate when funds aren’t forced to be distributed out over a short period, which is desirable for heirs looking to grow their assets. After the passage of the SECURE Act, the race is on to mathematically plan your withdrawals in order to try to maximize the amount you’re able to hold onto the finances without increasing your income to the point where you’ve bumped into the next tax bracket. Because, let’s face it, inheriting two million dollars is great, but paying $884,000 in taxes on it would kind of put a damper on the whole thing.
In the past, conduit trusts were highly suggested as ways to plan an estate. Building trusts into your estate plan is a form of asset protection so that you don’t need to worry about your daughter’s shifty husband taking her inheritance and darting off into the night or your son investing your life’s savings into a packing peanut investment scam, for example. In the past, these trusts used to be structured like your IRA, with a required minimum distributor based on life expectancy.
The problem with these conduit trusts now is that this money must also be distributed within ten years. If the original intent was not for a lump sum of money to be distributed over a short period to your beneficiaries, then this frustrates the intent of the individual who created this trust in the first place. And while this change won’t affect your spouse under the SECURE Act, it will affect young beneficiaries, such as children, and other non-spouse beneficiaries.
While there are multiple strategies to deal with this removal of the stretch IRA, one common one is the use of an accumulation trust. The accumulation trust can hold money in the trust to be distributed later, thus preventing a young beneficiary from getting a large chunk of money outright to be spent frivolously, but gives the flexibility to make distributions of a chosen amount to offset the tax consequence.
While conduit trusts are simpler, an accumulation trust offers more flexibility. The accumulation trust also can pay taxes on itself, rather than the benefactor. Therefore, if the benefactor does not withdraw money, the trust, which is in a higher tax bracket than the benefactor, is where the money is withdrawn from for tax purposes.
To further avoid tax creep, one can “sprinkle” the accumulation trust, allowing multiple benefactors to take shares that don’t “bump” their income into unreasonable tax brackets.
If you’re “in the know” about trusts, you may be asking about Charitable Remainder Trusts. Charitable Remainder Trusts may be an alternate vehicle under the right circumstances to achieve estate planning objectives of more sensible distribution amounts over a longer period.
However, CRTs have charitable institutions as the remainder beneficiary and the rules governing how these types of trusts work make it unlikely to be a better solution to an accumulation trust unless you happen to have charitable intentions as part of your overall estate plan.
Life Insurance and Roth IRA Conversions
Life insurance can also be strategically used to bolster the outcomes post-taxes from your IRA. If the insurance policy is payable to the same trust, money lost to taxes via the required minimum withdrawals from the SECURE Act can be covered by the death benefit.
Additionally, some financial advisors are suggesting to clients that they begin doing Roth IRA conversions. This option permits a person to move funds previously invested in a Traditional IRA into a Roth IRA. It causes you to have taxable income now, but if you can strategically make these transfers in a way that keeps you in a reasonable tax bracket, you can essentially handle the tax consequences now, rather than having your children inherit the tax burden.
Since Roth IRA’s flowing through a trust have fewer tax concerns, this is a tenable solution if you previously were investing heavily in a Traditional IRA. This, in combination with an accumulation trust, maybe the optimal solution for many people with young children.
Disabled or chronically ill beneficiaries will be able to continue to spread retirement distributions over their lifetime under the SECURE Act, but many disabled beneficiaries that have estate plans themselves or have family that have provided for their needs which use Special Needs Trusts or Supplemental Needs Trusts, which are designed to prevent a person with government means-tested benefits from losing eligibility for such benefits (such as Medicaid, SSI, etc.), so planning in a manner to prevent ineligibility for government benefits while also providing the benefit of the tax-deferred growth that comes with stretching benefits may also require the use of accumulation trusts.
Get Ahead of the SECURE Act Changes
The gold standard for estate planning with retirement and children was at one time the conduit trust. It was a method of using trusts to protect kids from getting too much too soon, but essentially created a barrier around retirement accounts while maintaining the tax benefit of stretching benefits over the kids’ lifetimes. However, new strategies must be employed with the SECURE Act to account for the various factors, such as your estate planning objectives and tax consequences.