Changes You Need To Know About The SECURE Act and The Beneficiaries of Your Retirement Accounts

This New Year has brought some very important tax changes that could impact you.

Very rarely do we have changes in our laws that happen quickly and affect huge segments of our population. But that’s exactly what occurred at the end of 2019 with the new SECURE Act, which was signed into law on December 20, 2019 and which went into effect on January 1, 2020.

This new law could profoundly affect the beneficiaries of your retirement plans, such as your 401(k)’s, 403(b)’s, and IRA’s and could result in consequences that you never intended.

Under the old law, if the beneficiary of a retirement plan were an individual or a trust that qualified as a designated beneficiary, the beneficiary’s life expectancy could be used to calculate how much the beneficiary had to withdraw from the inherited retirement plan each year. You may have heard this arrangement referred to as a “stretch IRA.” The amount a beneficiary must withdraw each year is referred to as the requirement minimum distribution or RMD.

Why was it important that the beneficiary’s life expectancy be used to calculate the amount of the annual RMD?  The fact that the retirement account could grow on a tax deferred basis and the fact that the beneficiary was taxed only on the amounts taken out during a given year resulted in the account gaining value and the beneficiary receiving more in the long run. 

The New Law

Under the Secure Act, the general rule is that most non-spouse beneficiaries must withdraw inherited retirement account balances within 10 years of the account owner’s death. Non-spouse beneficiaries may no longer calculate their RMD’s based on their life expectancy.

This means that a non-spouse beneficiary, such as a child of the account owner, must withdraw the whole amount of the inherited retirement account over 10 years. The beneficiary can do this equally over the 10 years or all at once provided that the whole amount is withdrawn within 10 years of the account owner’s death.

While the rule for spousal beneficiaries has not changed, what happens at the death of the surviving spouse is governed by the new law.

Under the old law, if a spouse is named as beneficiary, he or she could roll the retirement account over to his or her own name and designate new beneficiaries, such as the couple’s children.  After the surviving spouse’s death, the children could use their life expectancies to determine the amounts they had to withdraw from their inherited retirement account, allowing the accounts to grow tax deferred and be taxed at presumably a lower rate because taking smaller amounts out of the inherited retirement account would not result in pushing the beneficiary into a higher tax bracket.  

Under the new law, the spouse is still able to take distributions over his or her life expectancy; but after the surviving spouse’s death, the next level of beneficiaries (in many cases, the couple’s children) must withdraw the amount in the retirement plan within 10 years of the surviving spouse’s death.

There are exceptions to this general rule, just as there are with almost every rule.

A spouse may still use his or her life expectancy to calculate RMD’s.

If a minor child is a beneficiary of an inherited retirement plan account (such as an IRA, 401(k) or other similar tax deferred account), the life expectancy of a minor child of the account owner may be used to calculate his or her RMD’s, but only until the child reaches the age of majority. Age of majority is not defined in the SECURE Act, and many states define “age of majority” differently. Without any further guidance, we probably have to look to state law to determine the age of majority. In Texas, that age is 18.

If the beneficiary of an inherited retirement account is a disabled individual or chronically ill individual, as determined under Social Security rules, he or she may use the life expectancy method to calculate RMD’s.

Another exception is made for an individual beneficiary of an inherited retirement benefit account who is not more than 10 years younger than the account owner. So if the beneficiary is a sibling of the account owner or the account owner’s unmarried “significant other,” this exception would apply so that the life expectancy method could be used.

It seems the biggest group of people most affected by the new law are retirement account holders who name their children, grandchildren, or other young family members as beneficiaries and, of course, the children, grandchildren, and other young family members who are the named beneficiaries.

Unintended Consequences

The immediate problem is that the new Act has drastically changed how some estate plans work causing unintended consequences, especially in the area of creditor protection.

People, who before January 1, 2020 created an estate plan that they thought protected their children’s inherited retirement benefit account’s from creditors and divorcing spouses, now may have estate plans that cause their children’s inherited retirement benefit accounts to be vulnerable to those creditors and divorcing spouses. 

Let me give you an example:

Before January 1, 2020, if a person wanted to protect his or her child’s inherited IRA from the child’s creditors and from being divided in a divorce, the person would name a trust for the child as beneficiary. Typically that trust would include what we refer to as “conduit” provisions; meaning that the inherited retirement benefit account would stay intact for the child’s lifetime, the RMD’s would be paid to the trust, then the Trustee, according to the terms of the trust, would distribute the RMD’s to the child. The RMD’s going to the child would not be creditor protected, but they would be relatively small because they would be based on the child’s life expectancy. Many estate planning practitioners, including the estate planning attorneys at our firm, used these conduit provisions in the trust because they were considered a safe harbor for favorable tax treatment for the trust.

But all that changed as of January 1, 2020.

Now, as a result of the SECURE Act, the Trustee must withdraw the whole amount of the retirement benefit account over ten years and distribute it to the beneficiary. This leaves the beneficiary without the protection of a trust so that, after ten years, the whole amount of the inherited retirement benefit account is available to creditors and possibly subject to division in a divorce.

Steps You Need To Take

So what steps should you take in light of the SECURE Act?

If you have a retirement benefit account that names a trust as a primary or contingent beneficiary, it is imperative that you consult us so that we can review your estate planning documents to determine if any changes need to be made to your estate planning documents, especially if your goals include creditor and divorce protection for your beneficiaries.

One solution we are suggesting to our clients is that they amend their estate planning documents to remove the conduit provisions from the trusts for their beneficiaries. The amendment provides that the Trustee can decide what amounts to distribute to a beneficiary, instead of mandating that the amount the trust is required to withdraw from the retirement benefit account be distributed immediately to the beneficiary.

The down-side of keeping the retirement benefit account distributions in the trust is that the trust is usually taxed at a higher rate than the beneficiary. But giving the trustee the flexibility to decide which is more important, tax savings or creditor protection, allows the Trustee to act in the best interests of the beneficiary.

In any event, you need find out if the new law has caused your estate plan to change in a way that you did not expect. You need to make sure that your plan does what you want it to do, and that the new law did not create unintended consequences for your beneficiaries.

Please contact us if you would like us to review your documents to determine if an amendment is necessary to achieve your estate planning goals. This would also be a good time to review the beneficiary designations for your IRA’s, 401(k)’s and other similar retirement accounts to make sure that they are coordinated with your estate plan.

And, if your estate plan is three years old or older, we suggest that you download and review our Estate Plan Update Issue Spotter or contact us to schedule a review to see if any other changes need to be made to carry out your wishes.  There have been other tax law changes and new state legislation that may even help to simplify your estate plan.

You can schedule an appointment or request more information by calling us at (713) 955-7304 or by clicking HERE to fill out our contact form, and someone from our office will contact you.