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SECURE Act Poised to Eliminate Benefits of the “Stretch” IRA

By Philip Nodhturft, III | Categories: Articles, Business & Tax Law, Trusts & Estates | Share July 2019

On May 23, 2019, the House of Representatives, in a show of overwhelming bi-partisan support, voted 417-3 to pass the “Setting Every Community Up for Retirement Enhancement” Act (the “SECURE Act”). Although the legislation is hailed by proponents as a means for enabling more workers to participate in retirement plans, it would also substantially change the manner in which many of our clients’ family members would be able to receive their inherited portions of such plans. The SECURE Act is currently stalled in the Senate. However, given the bi-partisan support for this legislation, once the SECURE Act is brought to the Senate floor for a vote, it appears likely to pass. Assuming it does, there will be significant tax consequences to many of our clients and their families, most of which will not be beneficial.

One minor victory that clients may experience from the passage of the SECURE Act is that the minimum age at which “required minimum distributions” (“RMDs”) must begin would be slightly increased from age 70.5 to age 72. For non-Roth IRAs and other retirement accounts, such as 401(k) and 403(b) plans, (all such retirement accounts are hereafter referred to as “IRAs”), once the IRA owner reaches age 70.5, he or she must withdraw a certain percentage of the account balance. Generally speaking, the amount that must be withdrawn is calculated based on the IRA owner’s remaining life expectancy, as determined by reference to the IRS actuarial tables. That amount is then treated as taxable ordinary income to the IRA owner, thereby causing income tax to be paid on the amount of the RMD.

For those clients who do not rely on RMDs to meet their standard of living or income needs, the requirement to receive RMDs each year can be annoying, if not financially burdensome. Accordingly, clients often look for ways to minimize the effects of the annual RMD. One such option, known as a “Qualified Charitable Distribution,” is being highlighted in a separate article that will be published in the near future.

If enacted, the SECURE Act will provide some minimal additional relief for those clients who are approaching, but have not yet reached, their RMD beginning date, as these clients will be able to defer the recognition of additional taxable income (from their RMDs) for an extra year and a half. However, other than the minor increase in the beginning age for taking RMDs, the SECURE Act will likely cause a negative impact on the way younger family members and generations can inherit an IRA. Before examining what changes would be implemented as a result of the SECURE Act’s passage, it is important to understand what the current law provides.

Under existing law, when the initial owner of an IRA dies, the remaining IRA balance passes to those recipients who have been named on the IRA’s beneficiary designation form. It is very common for married clients to name their spouse as the primary beneficiary and to name their children or other family members as the contingent or secondary beneficiaries. A spouse who is named as the primary beneficiary is able to engage in a “spousal rollover,” which essentially allows that spouse to treat the deceased spouse’s IRA as his or her own (including for purposes of using the surviving spouse’s own age for purposes of receiving and calculating RMDs). However, only spouses can elect this “rollover” treatment. That means that for unmarried clients, the individuals who have been designated as the beneficiaries of the IRA in question are forced to treat the deceased account owner’s IRA as an “inherited” IRA.

From an income tax perspective, a beneficiary of an inherited IRA must begin receiving RMDs by the end of the year following the year of the account owner’s death. This rule applies regardless of the beneficiary’s age (including if the beneficiary is a minor). The benefit of the current law is that the inheriting beneficiary may use his or her own remaining life expectancy for purposes of calculating the amount of the RMD each year. This method of calculating RMDs based on the inheriting beneficiary’s own remaining life expectancy is known as the “stretch” period. Utilizing the stretch period allows the beneficiary to receive only the smallest amount possible from the inherited IRA each year, which in turn has the positive effects of minimizing taxable income while also preserving as large a principal balance as possible so that future growth and continued appreciation in value would be likely.

With a few exceptions which are detailed below, the SECURE Act would eliminate these benefits. In general, if the SECURE Act is enacted into law, non-spouse beneficiaries of IRAs (including Roth IRAs) will be required to receive their entire inherited portion within 10 years from the date of death of the original IRA owner. This compressed payout period represents a drastic change from the potentially much longer time horizon that is available under the “stretch” (remaining life expectancy) period.

Although it is unclear under the pending legislation whether the 10-year payout period would require equal installment payments in each of those 10 years, or whether a beneficiary could pick and choose when during that 10-year period to receive distributions (including possibly taking $0 in years 1-9 and then receiving the entire IRA in year 10), the compressed distribution period would be a certainty, unless one of the narrow exceptions applies.

            1.         The decedent’s surviving spouse. A surviving spouse can elect to treat the IRA as an “inherited” IRA and still take advantage of the “stretch” period. Alternatively, a surviving spouse can still elect a spousal rollover of the deceased spouse’s IRA to treat it as his or her own (the SECURE Act does not eliminate “rollover” treatment for surviving spouses). The decision on which of these options to use depends on the surviving spouse’s individual circumstances, including age and potential need for more immediate income/liquidity. Thus, a surviving spouse should consult his or her tax professionals and financial advisors before making a final decision.

            2.         A child of the decedent, but only if the child is still a minor as of the account owner’s death. Once the child reaches the age of majority, the 10-year payout period must be applied for the remaining account balance.

            3.         A “disabled” beneficiary within the meaning of Internal Revenue Code § 72(m)(7), which requires that the beneficiary be unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.

            4.         A “chronically ill” beneficiary within the meaning of Internal Revenue Code § 7702B(c)(2), which requires a certification from a licensed health care practitioner that the beneficiary is unable to perform daily living activities without substantial assistance of another or that the beneficiary requires substantial supervision to protect against health and safety threats due to the beneficiary’s severe cognitive impairment.

            5.         A beneficiary who is not more than 10 years younger than the deceased account owner.

For many IRA owners, the goal is to leave the IRA balance to younger generations in a tax-efficient manner. The narrow exceptions detailed above will make this more difficult. Even for married clients, a surviving spouse will eventually need to plan for whatever IRA balance remains upon that spouse’s subsequent death. In addition, many of our clients have beneficiary designations that are currently in place that would allow their designated beneficiaries (e.g., children or grandchildren) to receive their inherited share in trust. It is common to prepare customized beneficiary designations that direct the beneficiary’s inherited share of an IRA to be routed through that beneficiary’s separate trust, so that the Trustee of that beneficiary’s trust is the party that actually owns and controls the inherited IRA.

Under this strategy, the beneficiary designation and the client’s Trust Agreement work in tandem to ensure that the stretch IRA treatment (using the “remaining life expectancy” method for purposes of calculating the beneficiary’s RMD amount each year) is preserved. This result is accomplished by including language in the Trust Agreement that requires the Trustee to distribute only the RMD amount each year to the beneficiary, while authorizing the Trustee to keep the remaining IRA balance intact.

In addition to minimizing the income tax impact for the beneficiary each year, this language also helps ensure that the beneficiary will be protected from receiving larger distribution amounts and potentially squandering such amounts. For example, allowing a Trustee to remain in control above the remaining IRA balance (other than the RMD amount each year) offers peace of mind to those clients who are concerned that their beneficiaries are either too young, immature, or financially irresponsible to handle the receipt of large distributions. Other beneficiaries who may be battling substance abuse, gambling, or other similar issues can also be protected from themselves. Further, many states do not recognize inherited IRAs as an exempt asset that is protected from claims of the inheriting beneficiary’s creditors. For beneficiaries who reside in such states, routing the inherited IRA through the beneficiary’s trust can add a layer of asset protection that may not otherwise exist.

If the SECURE Act is enacted into law, these trust provisions will no longer apply in the same way as they do now. Additional planning, including incorporating updated language into the Trust Agreements, would be required to offset—to the extent possible—the effect of the forced 10-year payout period. Clients should keep in mind that these effects go beyond just income tax consequences and can involve the beneficiary protection aspects mentioned above. For example, even if the IRA is a “Roth” account (meaning the distributions received are not subject to income tax because the IRA owner already paid such tax when the contributions were initially made), the compressed payout period of 10 years would still apply and, therefore, would still force a potentially large sum of money into the hands of a beneficiary who may not otherwise be financially savvy or mature enough to handle such funds, or who may have active creditors seeking to satisfy a judgment against a non-exempt asset.            

As with many things in life, the devil is in the details. The SECURE Act is no different, and we expect additional guidance (in the form of Treasury Regulations) will be necessary to flesh out the basic framework provided for in the bill. Nevertheless, these changes appear to be coming sooner than later. Assuming the Senate votes on the bill this year, the effective date would apply to IRA or other retirement account owners who die on or after January 1, 2020. Therefore, clients should contact us now to explore what updates may be possible to mitigate the effects of the SECURE Act.


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