Editorial note: This article will appear in the Summer 2020 edition of The Accountant.
At the end of 2019, the Setting Every Community Up for Retirement Enhancement Act of 2019 (the “SECURE Act”) was enacted. According to a recent Forbes article, this is the most significant piece of retirement legislation in over a decade. The SECURE Act significantly impacts various features of retirement accounts (401(k), IRA, etc.), including when the beneficiaries inheriting those accounts are required to withdraw the assets after you pass away. Given that retirement accounts can make up a significant portion of your total assets, this change may drastically impact your estate plan and cause it to operate much differently than intended. This article highlights one of the more significant impacts the SECURE Act can have on your estate plan, specifically when your children will have access to assets in inherited retirement accounts.
What does this mean?
Prior to the SECURE Act, a child (let’s assume a daughter) inheriting retirement accounts was required to withdraw those assets during her lifetime. However, she could “stretch-out” those withdrawals over her lifetime. The stretch-out feature allowed the retirement accounts to grow tax-deferred for as long as possible. This tax-deferred growth provided a significant income tax benefit to children and, as such, a major component of planning with these assets was ensuring that the stretch-out option was preserved.
The SECURE Act eliminated the stretch-out option for most children and now requires all assets in a retirement account be distributed within 10 years. The elimination of this stretch-out benefit can cause significant problems if an estate plan is not updated to address this issue appropriately.
How could this affect my existing plan?
There are two ways to leave retirement accounts to a child: outright or in trust. Leaving assets to your daughter outright means she can do whatever she wishes with those assets upon your death (withdraw all the assets or leave the assets in the retirement account for as long as possible). Leaving retirement accounts in a trust for your daughter, on the other hand, ensures the assets are still available for her benefit, but protects her from having direct access/control over those assets until she is older and better situated to manage the assets.
If you elect to leave your retirement accounts to your daughter outright, the SECURE Act likely does not cause major problems in your estate plan. The difference to your daughter after the SECURE Act is that she will now be required to withdraw all of the assets within 10 years of your death, rather than having the option to stretch-out those withdrawals over her lifetime. If retirement account assets are left in a trust for your daughter, however, the SECURE Act may significantly disrupt your plan. There are two types of trusts that can be used to receive retirement accounts: i) an accumulation trust; and ii) a conduit trust. An accumulation trust allows distributions from a retirement account to remain in the trust. A conduit trust on the other hand, requires distributions from a retirement account to pass immediately out of the trust and directly to the beneficiary. The accumulation trust does not qualify for the stretch-out benefit while the conduit trust does. Prior to the SECURE Act, a conduit trust was the most common planning approach for leaving assets in trust for a child because it gave the ability to restrict access/control of the assets until later in life while preserving the stretch-out benefits over a child’s lifetime.
For example, let’s say you pass away and leave $1M of IRA benefits in a trust for your 18-year-old daughter. Because you do not want to give your daughter total control over that $1M until later in her life, but you want to preserve the income tax benefits of the stretch-out, you likely left the IRA in a conduit trust for her benefit. The problem with this plan following implementation of the SECURE Act is that it will result in all of the retirement assets ending up in your daughter’s hands within 10 years of your death. The result would be your daughter receiving the $1M (plus whatever it has grown to in the meantime) at age 28. The distribution of all the assets at age 28 can result in more total tax than if distributions were taken each year over the 10 year period now allowed under the SECURE Act. This is a significant change that would undermine your carefully crafted estate plan by pushing money into your daughter’s hands much earlier than you intended.
What's the solution?
The good news is there is a solution to this problem. You can adjust the terms of your estate plan to change that conduit trust into an accumulation trust. In our example above, this will allow the retirement account to be held in trust for as long as you intend and, now that the stretch-out is no longer an option, the accumulation trust does not result in a loss of the income tax benefits associated with the stretch-out. However, depending on a number of factors, there may be more tax due as a result of leaving the assets in trust and not distributing all of the withdrawals from the retirement account to your daughter. On balance, we think most people would prefer to protect their children from having access to too much money too soon, even if the result is paying a little more in taxes. Moreover, the accumulation trust approach gives the trustee flexibility to manage the tax consequences and make the best decisions for your children over the 10 year period.
Financial Planning Strategies:
For those who are charitably inclined, naming a charitable remainder trust as the retirement account beneficiary may be an appropriate consideration. The retirement account owner would be the grantor of this trust and could name beneficiaries to receive an income stream for a defined period with the remaining balance going to charity. There is flexibility in determining the term of the income stream (certain number of years, single life, joint life, etc.) with the caveat that the net present value of the remainder interest must be at least 10% of the value of the initial contribution. Upon death of the retirement account owner, the distribution to the trust wouldn’t trigger any immediate income tax while the estate would receive a charitable deduction. Unsure of what charity to name as the final beneficiary? Coupling a charitable remainder trust with a donor advised fund alleviates the pressure of needing to name the receiving charity when first creating the trust. To the extent that there is a desire to leave some assets to charity at death while maximizing after-tax wealth transfer to beneficiaries, this could be an appropriate planning vehicle. Thoughtful collaboration between the attorney, CPA, and financial advisor would be most appropriate when exploring this strategy.
Qualified Charitable Donations from IRA accounts could be a nice option for those who are charitably inclined but would prefer to see gifts made to charity during their lifetime. Note that this provision is available to IRA accounts but not to employer sponsored 401(k) accounts. Once over the age of 70.5, any individual can give up to $100k directly from an IRA to a 501c3 charity (private foundations and donor advised funds won’t qualify). Fulfilling charitable intent through this mechanism, instead of giving cash or appreciated securities, could prove to be more favorable in both the short-term and long-term. In the short term, the amount given to charity lowers taxable income as this amount counts toward required minimum distribution amounts. In the long term, this approach reduces the pre-tax IRA base that will eventually be taxed as ordinary income to the beneficiary while preserving non-retirement account assets that aren’t accompanied by an income tax upon receipt by the beneficiary and would receive a step-up in basis.
A series of micro Roth conversions during the retirement account owner’s life is another consideration. Rather than saddling the inheriting beneficiary(s) with potentially high tax rates that could accompany withdrawals over the 10-year period, the Roth conversion strategy slowly shifts funds from pre-tax retirement funds over to tax-free Roth assets. Inherited Roth IRA assets also face the same 10-year withdrawal timeline, but withdrawals are free of income tax. Ideally, these micro conversions would occur at a low-income tax rate and ultimately reduce the total amount doled out to taxes from these retirement accounts during the remaining lifetime of the retirement account owner and subsequent 10-year withdrawal window. There are a number of other considerations when evaluating the pros and cons of this strategy, including the impact on: Medicare premiums and surtax, taxation of social security income, federal income tax bracket differences between married filing jointly and single individuals, and tax bracket management for surviving spouse who will file as single.
We can help
Given the impact the SECURE Act may have on your estate plan, we recommend reviewing your existing estate planning documents (Wills and Revocable Trusts) and retirement account beneficiary designations, to ensure your plan continues to operate as intended in this post-SECURE Act environment.
Steven Zipper & Stefan Wolf are estate planning attorneys at Gevurtz Menashe. They are both members of the Oregon and Washington State Bar(s) and focus their practice exclusively on estate planning, including wills and revocable trusts, estate and gift taxes, probate, asset protection planning, guardianships, and beneficiary and trustee representation. They can be reached at Gevurtz Menashe at 503-227-1515 or online.
Rob Greenman, CFP® is a Partner and Lead Advisor with Vista Capital Partners. He works with clients to grow their wealth by utilizing thoughtful financial planning, optimal investment portfolio construction, and discipline.