26 Feb Important information about the new SECURE Act
Dear Clients and Friends,
On January 1, 2020, the new SECURE Act (Setting Every Community Up for Retirement Enhancement Act) became effective and makes significant changes to how we plan for our families to inherit retirement accounts. The Act increased the age at which you must take distributions from 70 ½ to 72, and also repealed the age restriction for contributions to retirement plans allowing you to continue making contributions to your plan if you work past the age of 70. This letter will focus on the major changes made to the distribution rules for beneficiaries of the plan after the original owner has died.
The new law makes substantial changes to the prior law which allowed a “stretch pay-out” over the designated beneficiary’s lifetime, so it is important to review your beneficiary designations as well as your estate plan, particularly if you have named a trust to receive any retirement benefits at your death. The modifications to the distribution rules for inherited retirement benefits can cause unintended results, and in some cases, the results may be disastrous to the overall family plan.
While the definition of a designated beneficiary did not change, the time period over which the designated beneficiary must withdraw the retirement benefit has changed from life expectancy to a 10-year payout. There are however, five categories of designated beneficiaries who are excepted from the 10-year rule and can use life expectancy to determine the annual distributions, and they are referred to as “eligible designated beneficiaries”: (1) the surviving spouse, (2) minor children of the participant, (3) disabled individuals, (4) chronically ill individuals, and (5) individuals who are not more than 10 years younger than the participant. Importantly, on the death of the eligible designated beneficiary or the attainment of majority of the minor child, the 10-year payout rule applies.
Since your surviving spouse is an eligible designated beneficiary, the rules for the spouse inheriting retirement plans outright have not changed. Your spouse can still roll over the inherited plan to his or her own plan electing to treat the inherited plan as his or her own plan. In this case, the rules permitting distributions to the spouse for the spouse’s life expectancy remain the same. However, if a trust for your spouse’s benefit is the beneficiary, the trust needs to be reviewed. In some cases, the trust will permit payment over the spouse’s life expectancy but with other trusts the new rule requiring complete distribution within 10 years may apply.
The requirement to pay out all benefits from the retirement plan within 10 years of the owner’s death is the major change to how our beneficiaries inherit retirement plans. If your Will or Living Trust names a trust as beneficiary of your retirement plan, in most cases the benefits must be distributed out of the plan to the trust by December 31 of the year that contains the 10th anniversary of the owner’s death. The life expectancy payout is no longer applicable, and, in fact, there are no required annual minimum distributions. Consequently, distributions can be made at any time during the 10-year period, so long as the plan is completely distributed by the end of the period.
Since the plan distributions cannot be paid over the beneficiary’s life expectancy, there are several issues of concern. First, the tax-deferred status of your plan is significantly reduced. For example, your 50-year-old son cannot use his life expectancy of 34.2 years to receive distributions. Instead he now must receive all the funds within 10 years of your death. Second, for beneficiaries who need a trust structure for inherited retirement assets because of concerns about the beneficiary’s financial responsibility (for instance, creditor or spendthrift issues), the retirement trust is no longer the best solution. Most trusts for retirement benefits require all distributions to pass through the trust directly to the beneficiary (known as a “conduit” trust). Since there are no required minimum distributions under the Act, the conduit trust will distribute all the benefits to the beneficiary within 10 years of the owner’s death defeating the goal of limiting the beneficiary’s access to the funds. Third, if the retirement trust directs the plan distributions to remain in trust to accumulate and be distributed over a number of years, the benefits will be taxed at higher income tax rates. While an “accumulation” trust maintains control over the beneficiary’s unfettered access to the funds, the trust will likely pay more income taxes on the distributions since under current law a trust attains the highest income tax bracket of 37% when its taxable income reaches only $12,950. By contrast, an individual attains the highest income tax bracket of 37% when income reaches $518,400 (or $622,050 for a married couple).
Under the new distribution rules of the SECURE Act, you must either reduce the income taxes to be payable when the retirement benefits are paid or accept the potentially higher income taxes and consider ways to alleviate the burden. So, what are some planning options for you to consider?
- If you name an eligible designated beneficiary, such as your spouse, your minor child or a disabled/chronically ill individual, the life expectancy payout can be used for that beneficiary’s lifetime or the period of minority for the child. But, remember, the 10-year payout applies once the eligible designated beneficiary dies or the child attains the age of majority.
- You can designate a charitable remainder trust (“CRT”) as the beneficiary and name an individual as the lifetime beneficiary along with your favorite charity to receive the remainder on the lifetime beneficiary’s death. In this case, the CRT pays no income tax when the benefits are distributed out of the plan to the CRT, and the trust beneficiary pays taxes only when the distributions are made to him or her over his or her life expectancy. However, the amount of the distributions to the individual beneficiary must be configured so that at least 10% of the trust principal will ultimately pass to the charity at the end of the beneficiary’s life. A variable strategy is to just name a charity as the beneficiary of the retirement plan since a charity pays no income tax.
- If you as the owner of the plan expect to be in a lower income tax bracket than your beneficiary (and this may be the case if a trust is the beneficiary), consider earlier distributions from your traditional IRA or doing a series of conversions to a ROTH IRA, which is designed to manage your income tax bracket.
If you have family circumstances that require a trust to be designated as the beneficiary, and such trust will accumulate funds for later distribution to the children and/or grandchildren, the trust is most certainly going to pay more income taxes due to the compressed tax brackets applicable to trusts. In this case, you may consider purchasing life insurance to help offset the income tax burden.
Estate, Gift and Generation-Skipping Transfer (GST) Tax Rates and Exemptions in 2020
In 2020, the exemption from estate, gift and GST tax increases to $11.58 million. This means a married couple can now transfer up to $23.16 million of assets gift, estate and GST tax free to their heirs. The estate, gift and GST tax rates are 40%. The exemption amounts are indexed to the Consumer Price Index (CPI) and as a result will continue to increase annually. These enhanced exemptions are scheduled to expire after December 31, 2025, and without further legislative action they will revert to $5 million indexed for inflation. As a result, if you have assets you would like to use to make gifts to take advantage of these enhanced exemption amounts, now would be the time to do so to avoid the risk that the exemptions substantially decrease after December 31, 2025.
Annual Exclusion Gifts and Education and Medical Care Gifts
For 2020, the annual gift tax exclusion will remain $15,000. The annual gift tax exclusion is the amount that you as a giver can gift to any number of individuals each calendar year without using your lifetime gift tax exemption or incurring a gift tax. An annual exclusion gift plan can be a beneficial way to reduce the overall value of your estate without using any gift tax exemption. In addition, an individual can make unlimited gifts for the education or medical care of an individual. These gifts must be made directly to the education provider or medical care provider to qualify for this exclusion. The education and medical care gifts are also a beneficial way to reduce the overall size of your estate at no gift tax exemption cost while directly benefiting heirs.
Estate Planning in 2020 and Beyond
Prior to 2011, with lower estate tax exemption amounts and no estate tax exemption portability, it was imperative for a first-to-die spouse’s estate plan to utilize a two-trust plan which first funded a by-pass or credit shelter trust up to the amount of the estate tax exemption. Any remaining balance would then pass either outright to the surviving spouse or into a marital deduction trust. Today, due to the substantially increased estate tax exemption and the availability of estate tax exemption portability on a first spouse to die, a current review of your estate plan may be advisable to determine whether the two-trust plan still is consistent with your wishes. Many old estate plans that were drafted as tax-efficient plans when the estate tax exemption was only $1 million or less may now be overly complicated and unnecessary.
Despite the enhanced estate, gift and GST exemptions, estate planning will still be important for many non-estate tax reasons. As circumstances may change with your children and grandchildren, you should consider whether the current dispositive provisions of your will and/or trusts are still aligned with the lives of your children and grandchildren. For instance, if your estate plan includes age withdrawal rights and/or mandatory distribution standards in favor of your children and one of them has creditor, bankruptcy, marital or substance abuse issues, we recommend you revise your estate plan to retain such child’s share in further trust for the child’s lifetime and make distributions payable in the discretion of an independent trustee. This will insulate the child’s share from the potential claims of his or her creditors. These non-tax issues will still be relevant to estate planning even though potential estate taxes may no longer be relevant. We recommend you periodically review your estate plan to ensure it remains up to date with your current family circumstances and addresses all your concerns.
We encourage you to contact our office to arrange for a mutually convenient time so that we can review and discuss your current estate plan and the implications of the SECURE Act and the 2020 estate, gift and generation-skipping transfer taxes on your estate plan and, of course, any other issues of concern to you.
Very truly yours,
HAILE SHAW & PFAFFENBERGER, P.A.
Ellen L. Regnery, Esq.
Matthew N. Turko, Esq.
 A designated beneficiary is an individual or a “see through” trust. A non-designated beneficiary is the participant’s estate, charity and certain trusts that do not qualify as a “see-through” trust.