According to the SECURE Act, most non-spouse beneficiaries—with a few exceptions for beneficiaries who are not more than ten years younger than the account owner, the account owner’s children who have not reached the “age of majority,” disabled individuals, and chronically ill individuals—are now required to withdraw the balance of the inherited retirement account within ten years. Without prompt and proper planning taking the new law into account, this change could significantly increase the tax bill for non-spouse beneficiaries. Previously, beneficiaries of inherited retirement accounts could take distributions over their life expectancy. Under the SECURE Act, the shorter ten-year time frame for taking distributions will likely result in the income tax due being accelerated and possibly causing the beneficiaries to be bumped into a higher income tax bracket, thus receiving less of the funds contained in the retirement account than originally anticipated.
Keeping an eye on tax consequences and asset protection needs, there are several strategies that are available to address this new paradigm.
Revocable Living Trust (RLT) or Stand-Alone Retirement Trust (SRT)
Now that most beneficiaries are required to withdraw the entire balance of a retirement account within ten years of the owner’s death, an RLT or SRT might be the best estate planning tool for these unique assets. We should, however, reconsider the use of “conduit” trust provisions because they require any required minimum distributions (RMDs) to be distributed directly to the beneficiary through the trust. Under the SECURE Act, the balance of the account would have to be distributed directly to the beneficiary at the end of year ten, which is an outcome our client might want to avoid. Now, an “accumulation” trust provision may be more beneficial. This provision allows the trustee to receive the RMDs from the retirement account as often as required by law but allows the trustee to exercise discretion as to when and how much of the funds are distributed to or used for the benefit of the beneficiary. Although the trust will pay income tax on any of the distributions from a retirement account that are not distributed to the beneficiary, for many beneficiaries, it is equally or more important to protect the money from the beneficiary’s creditors, divorces, or lawsuits.
If you named your RLT or SRT as beneficiary of a retirement account, you should have your estate plan reviewed now. If the trust contains “conduit” provisions, an amendment to the trust may be appropriate. I can help with this.
Charitable Remainder Trust (CRT)
For charitably inclined clients, a charitable remainder trust may be the right solution to plan for the disposition of their retirement accounts. Such a trust would allow the client, as the grantor, to name beneficiaries to receive an income stream from the retirement account for a period of time, with the remainder going to a charity named in the trust agreement.
When the trust is created, the net present value of the remainder interest must be at least ten percent of the value of the initial contribution. It can be payable for a term of years, a single life, joint lives, or multiple lives. Upon the plan participant’s or account owner’s passing, the estate will receive a charitable deduction for distributing the retirement account to the trust, and the distribution from the retirement account to the CRT is not taxed. However, distributions from the CRT to the beneficiaries will be subject to income tax. Another benefit to this strategy is that the distributions to the beneficiaries will be smaller and therefore subject to less income tax liability.
It is important to note that this strategy is best for individuals who are already charitably inclined. This strategy may not result in the beneficiaries getting more than they would have utilizing other estate planning strategies, but if you already wish to provide for a charity, this may achieve your goals in a more tax favorable way.
Irrevocable Life Insurance Trust (ILIT)
Due to the new ten-year mandatory withdrawal rule, there will be an acceleration of the beneficiaries’ income tax on inherited retirement accounts, potentially moving them into a higher income tax bracket. The new rule may also result in the amount of cash available to beneficiaries being less than the client originally anticipated. In order to help offset this shortfall, you may want to consider using funds from your retirement accounts during your life to purchase additional life insurance and transfer ownership of the policy to an ILIT. The ILIT will help protect the insurance funds from the beneficiary’s creditors and, if desired, can be designed so that the proceeds from the life insurance policy are not includible in your estate.
Multi-Generational Spray Trust
Any number divided by a large number results in a smaller number. The same philosophy is true with distributions involving retirement accounts. While the distributions must be made within ten years, by distributing the retirement account to multiple beneficiaries at the same time over the ten-year period, the RMDs received by each beneficiary will be smaller, and the resulting tax liability per beneficiary will be reduced.
For asset protection purposes, it is always advisable that the distributions be made to a trust for the benefit of a beneficiary instead of directly to the beneficiary.
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[1] If a beneficiary is not considered a designated beneficiary, distributions must be taken by the fifth year following the account owner’s death. Common examples of beneficiaries that are not designated beneficiaries are charities and estates. See Treas. Reg. § 1.401(a)(9)-3, Q&A (4)(a)(2) and 1.401(a)(9)-5, Q&A (5)(b).