Monday October 26, 2020
SECURE Act Creates Potential IRA Beneficiary Problems
The SECURE Act was passed by Congress and signed by the President in late December. It reduces future taxes for IRA owners by increasing the age for required minimum distributions from 70½ to 72. However, to pay for the cost of this tax reduction, the taxes paid by future IRA beneficiaries (typically children) will increase.
After the owner's death, IRAs, 401(k)s and other retirement accounts are generally transferred to designated beneficiaries. Custodians of IRAs and other retirement accounts offer a form, either printed or online, to select primary and secondary beneficiaries.
Most married IRA owners select their spouse as the primary beneficiary and children as the secondary beneficiary. When the first spouse passes away, the surviving spouse usually rolls over the IRA into his or her own IRA account. Under the SECURE Act, this is permitted and the surviving spouse must start required minimum distributions (RMDs) after reaching age 72.
When a surviving spouse passes away, children are typically the IRA designated beneficiaries. For individuals without children, the designated beneficiaries are often nephews and nieces. If the IRA owner designates children, nephews, nieces or other family as beneficiaries and also allocates part of the account to a charitable beneficiary, the portion for the nonprofit is normally distributed in a lump sum. However, distributions to children, nephews, nieces and other family members must now be made within 10 years.
For IRA owners who passed away in 2019, a child was able to "stretch" the IRA payout over his or her life expectancy. Assume mother Mary owned a traditional IRA and passed away in 2019. She designated daughter Susan (age 50) as her IRA beneficiary. While the IRA payouts are taxable income, Susan could reduce taxes by taking RMDs over her life expectancy. For a child age 50, the potential distribution period was approximately 34 years. By "stretching" the traditional IRA payout over 34 years, Susan reduced her income tax and benefitted from tax-free growth within the IRA.
If Mary passes away in 2020, the SECURE Act makes Susan take all distributions within ten years. She can wait and take the full payout in the tenth year, but that will greatly increase the tax rate paid on the IRA. Most children will choose to take partial payouts each year for the ten years. With a ten-year payout, the income taxes paid by Susan will be substantially higher than the prior "stretch" plan.
Some surviving spouses have three, four or more children. If one of the children is a "creative spender," a parent may choose to set up a trust. Without the protection of a trust, this creative spender may take the full IRA payout, send a huge tax payment to the IRS and quickly exhaust the balance in creative and unexpected ways. To protect these children, many parents have created "conduit" trusts to restrict the payout to only the RMDs due to the child.
Unfortunately, the SECURE Act eliminates RMDs for most children (there are exceptions for a disabled or chronically ill child). Under the SECURE Act there is no RMD and thus, with a conduit trust, no payout to the child until the tenth year. At that time, the full payout is made and the child will face a huge income tax bill.
Jamie Hopkins is a financial expert with Carson Wealth, headquartered in Omaha, Nebraska. He explains the conduit IRA trust problem and notes, "That is a complete disaster from a planning perspective," Hopkins said. "We just subjected most of that IRA money to the highest tax margin possible and locked up access to it."
Many concerned IRA owners want to update their estate plans to attempt to replace the "stretch" IRA distribution schedule. Could a plan combine the tax-saving benefits of a stretch IRA with a term-of-years or life payout to children or other heirs? Could this plan also have the tax-free growth benefit of a stretch IRA?
While it sounds too good to be true, an IRA to a testamentary unitrust plan includes all of these benefits. An IRA owner may create a testamentary unitrust to create a replacement stretch distribution. When the IRA owner passes away, the unitrust is funded with the traditional IRA. Because the unitrust is tax-exempt, there is a bypass of the income tax on the traditional IRA and any future growth within the trust.
In the unitrust, the full IRA proceeds are invested and earn taxable income for the unitrust recipients. After all payments are completed, the remaining unitrust principal is transferred to qualified charities. The children or other heirs benefit from substantial income (with no reduction in trust corpus earning power due to taxes). After all payments are completed, there is a generous gift to the donor's favorite charities.
Published December 27, 2019
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