How Estate Plans Are Impacted by the SECURE Act

Significant legislation concerning the treatment of retirement accounts called the SECURE Act became law on January 1, 2020. Among other effects, this eliminates the lifetime stretch for inherited IRAs.  

In this article, I will discuss the issues and adjustments many clients will need to make in their trust planning, the tax implications, and the financial strategies to cope with this change.

Trusts: Still Useful But in Need of Updating

If you leave your IRA or 401(k) to your spouse, they can still “roll over” the account to their own IRA at your death under the same old rules. Without a spouse, you typically will leave your IRA either directly to individuals or to a trust.

If you have a trust that is the beneficiary of an IRA or 401(k), then your trust document most likely contains provisions that make it a “conduit trust.” This is necessary to allow the trust to qualify as a beneficiary on the account. As we wrote about in June 2019, the conduit trust protects the undistributed account balance, while only the required minimum distributions (RMDs) that come out of the account each year are subject to taxation. Distributions may also be subject to outstanding claims against the beneficiary in divorce, debt collection, and during other troubles (our so-called “Killer Ds”) that could reduce your beneficiaries’ inheritance.

Under the SECURE Act, a retirement account will have to be emptied completely within 10 years, with few exceptions. If the account is payable to a conduit style trust, then within 10 years all of the retirement money will bypass the trust and be placed directly into the hands of the individual beneficiaries who may not be in a good position to receive it, and where it is no longer protected from the Killer Ds.

Therefore, you may want to change the “conduit” language in trusts to “accumulation.” I am reminded how, recently, an electrician installed conduit tubing under the floor of our conference room for the purpose of running wires from a new TV screen to a video camera for conference calls. The conduit allowed the cables to be pulled through the tube without getting stuck, fast and easy.

But now, conduit trusts may be a little too fast and easy.  Accumulation trusts, on the other hand, can regulate funds to leave the trust for the beneficiary when the trustee decides. The child may even be the trustee, similar to the inheritance trust system we have created for all non-retirement assets. In many cases it will now be advisable to have a similar, separate trust created to achieve asset protection over retirement funds.

This accumulation style trust, referred to as a retirement plan trust, is a standalone trust agreement whereby retirement accounts are administered by a trustee for the lifetime of a beneficiary. It protects the beneficiary against hypothetical risks to the enjoyment and use of the IRA and/or 401(k) distributions.

Dealing with Potential Increased Income Taxes on IRAs under the SECURE Act

When a trust is the beneficiary of a retirement account — and if not drafted properly — the trust itself (and not the individual beneficiary of the trust) might have to pay the income tax due on the withdrawals. With the acceleration of payouts from inherited IRAs under the SECURE Act to a maximum of 10 years, trusts need to be reviewed to be sure there is not a tax trap.

The difference in tax between trust and individual rates can be huge. A trust pays tax at the highest tax rate (37%) once it has only about $13,000 of income, and an individual would have to earn more than $500,000 ($600,000 if married) to be in that 37% realm.

The tax language in many irrevocable trusts and inheritance trusts should be updated to address this nuance by permitting trust income to be taxed to its beneficiaries at their personal tax rates. This could potentially save thousands of dollars in taxes. At the very least, trust protector powers in trust documents should be amended to permit a trust change of this sort, if and when desired.

Younger beneficiaries (more than 10 years younger than you) will no longer be permitted to “stretch” out the length of time (over life expectancy). This means they will be faced with higher income taxes to pay upon account withdrawals, and those withdrawals must be taken within an accelerated period of 10 years.

Imagine a $500,000 retirement account left to a child at age 40. The old law allowed the child to deplete the account over 43.6 years (according to life expectancy tables), meaning a withdrawal of roughly $11,000 per year would be added to their other personal income earned that year. Under the SECURE Act, this child would have to withdraw the entire $500,000 by year 10 (not year 43.6), or about $50,000 per year, and would have to pay tax on that higher amount.

While nothing can be done to stop the “10 year dump” of the IRA, the tax can be managed. You have to consider the timing of the withdrawals, as well as the possible impact of creditors and predators of the beneficiary who may be ready to pounce on the distributions.

On one hand, timing the withdrawals into even installments over 10 years can help the beneficiary stay in lower tax brackets. On the other hand, it is conceivable that waiting until the 10th year could be a better strategy. Trustee management will be key for larger IRAs in order to avoid tax mistakes. This could be a case for an independent trustee or at least a certain level of confidence in the trust management.

Financial Strategies

While amending trusts may serve to achieve estate planning objectives, the issue of higher taxes related to a payout over 10 years under the SECURE Act remains to be addressed. Gone are days when you could stretch and defer tax for the lifetime of the beneficiary.

What can be done to improve the tax hit of the IRA dump? Simply trying to manage the payout during the 10 years offers limited opportunities. Several useful strategies have been suggested, some of which include:

• Converting Traditional IRA accounts to Roth IRA accounts to provide beneficiaries with tax free distributions.   
• Purchasing additional life insurance to help replace the funds the beneficiary will spend on taxes.
• Leaving a portion of retirement accounts to a child/non-spouse even if there is a surviving spouse, in effect giving the child two 10-year payouts instead of one.
• Leaving the IRA to a minor child or grandchildren (in trust) to allow for additional deferral.
• Designating charitable beneficiaries, including charitable trusts. Charitable Remainder Trusts can be structured to mimic the lifetime payout (“stretch”) under the old law by providing a beneficiary with a percentage of the trust assets for their lifetime with the remainder going to charity at their death.

Determining whether any of these ideas are right for you requires a brainstorming session with us and your financial planning professional.

Take a look at our SECURE Act Planning Grid as a starting point to determine your next steps. If you want to talk about your specific situation, schedule an appointment with our paralegal to discuss.

Originally published in Feb 4, 2020. Updated May 21, 2021.