[Note to reader: We published our original News Alert on the Secure Act on January 15, 2020. However, we soon came to an important realization that pre-Secure Act Treasury Regulations still technically apply, even if their likely historical purpose is no longer relevant. Being wrong as to the application of these rules can result in an annual 50% penalty, so being wrong is a very big deal! As a result, our planning recommendations have changed rather significantly, at least until the IRS may one day provide us with favorable legal guidance. This July 2019 Newsletter is updated to account for our changes in planning recommendations. We apologize for any inconvenience.]
Our July 2019 Newsletter discussed the proposed 2019 Secure Act1 that had been recently passed by the U.S. House of Representatives and was likely to soon be passed by the U.S. Senate on its way to becoming law. Of course, Congressional dysfunction continued, and we believed the Secure Act would be on hold until at least 2020. Well, we were wrong. On December 16, 2019, the Secure Act was included in the budget legislation needed to keep the federal government running, and President Trump signed this new legislation on December 20, 2019.2 Effective as of January 1, 2020, our tax laws have changed in some very significant ways, especially as to the rules applying to the distribution of assets remaining in Individual Retirement Accounts (“IRAs”) and Qualified Retirement Plans (“QPs”) after the death of the owner/participant/employee (“participant”). Both IRAs and QPs will sometimes be hereinafter referred to as “retirement plans.”3
Our July 2019 Newsletter on the Secure Act is still an accurate summary and it is a must read for those that want to learn more. The one significant change to the Secure Act made after our July 2019 Newsletter will be discussed in this News Alert, which provides more favorable rules to benefit disabled and chronically ill beneficiaries. You can see our July 2019 Newsletter HERE.
The Secure Act is complex but critically important from an estate and tax planning perspective. We have already spent tens of hours studying this new Act and its meaning. While we are fairly confident we understand the meaning of the Act’s terms, it also likely that the Internal Revenue Service (“IRS”) will eventually issue regulations to clarify some of Act’s unclear, technical, and possibly unintended consequences. Because the changes to the tax laws controlling the timing of retirement plan distributions is so important, this News Alert is limited to covering this topic. We will cover the other important tax changes made by the Secure Act in a future Newsletter.
Table of Contents
III. The general RMD rule is that retirement plan funds remaining after the participant’s death must now be distributed within 10 years rather than over the beneficiary’s LE, but meaningful exceptions apply
The government provides significant tax incentives to encourage saving for retirement. Contributions to retirement plans (other than for Roth IRAs) are tax deductible, any earnings inside of a retirement plan are generally tax deferred, and income taxation only occurs when amounts are actually distributed from the retirement plan to the beneficiary. Initially, the retirement plan account owner and beneficiary are the same person, who we will refer to as the participant. While the government encourages saving for retirement, it eventually wants to tax these funds. As a result, the government begins to force distributions from the retirement plan under the Required Minimum Distribution (“RMD”) rules.4 These rules either require a minimum amount to be distributed each year or require the retirement plan account to be fully distributed by a certain number of years in the future. The penalty for failure to distribute the full RMD amount during the year is 50%!
The downside to these new rules is that less retirement assets will be left to benefit your desired loved ones because of likely higher tax rates paid sooner, and what is left will fairly quickly lose the control and asset protection benefits of the trusts under your estate plan. Action is likely needed to modify your estate plan and beneficiary designations to minimize the negative impact of the Secure Act on your retirement plan accounts. However, for those who neither need nor want the significant non-tax benefits of trusts under their estate plans and plan to pass all such retirement plan accounts directly, these new rules should essentially apply automatically as long as your beneficiary designations properly reflect your intent.
You may ask why the new shortened tax deferral period for assets remaining in retirement plans at the participant’s death is such a big deal? Yes, part of the reason is a compressed time for assets to be distributed, which will likely lead to taxation sooner and at higher marginal tax rates. But, as or more important is the loss of the non-tax benefits of trusts as to those assets.
Most of our clients appreciate the non-tax, asset protection and control benefits of trusts to help ensure that the inheritance they leave to their loved ones is actually able to benefit them in a desirable manner and is not subject to getting accessed by unwanted outsiders, including a spouse in a divorce, personal guarantees, judgement creditors, bankruptcy and predators.
Under the pre-Secure Act rules, the best way for most clients to achieve the combination of these significant non-tax benefits of trusts without suffering any negative income tax effect was to use so-called, “conduit trust” planning. Conduit trust planning qualified the trust to gain the same income tax deferral benefits under the RMD rules as an outright distribution to the individual beneficiary, specifically RMDs based on the beneficiary’s life expectancy. As discussed above, the RMD rules are critical since they require a minimum amount to be distributed from a retirement plan, with failure to comply subject to a 50% penalty! While the downside of conduit trust planning is that any amounts distributed from a retirement plan to a trust have to be immediately distributed from the trust to the specified trust beneficiary (“conduit beneficiary”), such as a child or other loved one, this downside was normally deemed to be insignificant since the RMD amount based on life expectancy would likely be relatively small.
After the Secure Act, the RMDs will generally require all of the retirement plan assets to be distributed within 10 years. So, the effect will be that the significant non-tax benefits of trusts will be lost in 10 years. The combined downside to these new rules is that less retirement assets will be left to benefit your desired loved ones because of higher tax rates paid sooner, and what is left will fairly quickly lose the control and asset protection benefits of the trusts under your estate plan.
III. The general RMD rule is that retirement plan funds remaining after the participant’s death must now be distributed within 10 years rather than over the beneficiary’s LE, but meaningful exceptions apply.
The Secure Act is structured as an overlay on top of the pre-Secure Act retirement plan distribution rules. For the most part, they are limited to changing the RMDs for designated beneficiaries (“DBs”). The Secure Act did not change how to qualify as a DB or as to the RMDs for non-DBs. As a result, to fully understand the post-Secure Act rules, you need to understand both the pre-Secure Act rules and the Secure Act changes.
Based on the pre-Secure Act RMD rules, the most common recommended retirement plan beneficiaries after the participants death were: (I) where wanted to benefit the surviving spouse, name the spouse directly except to the extent willing to give up significant income tax deferral benefits to gain access to the control features of a trust (to better control use of funds during surviving spouse’s life and/or control where any remaining funds passed at the surviving spouse’s death), and to extent the surviving spouse was named directly, rollover the deceased participant’s account into the spouse’s own IRA account except to the extent the spouse may need use of the funds before attaining age 59 1/2 to avoid the 10% premature distribution penalty; (ii) where wanted to benefit non-spouse individual beneficiaries, name individuals directly if the accounts at issue were not significant and/or no desire for the asset protection and control benefits of trusts; or name trust(s) for the desired individuals’ benefit to better ensure that these assets benefit them as desired while also protecting them from unwanted outsiders, including spouses in divorce, personal guarantees, judgement creditors, bankruptcy and predators. If a trust structure was desired, the trust would normally be structured as a conduit trust, but exceptions existed. By using these recommended beneficiaries, income tax deferral benefits would continue to be significant after the participant’s death, as they would be based on (I) the joint life expectancy of themselves and someone 10 years younger (“Jt LE”) (for spouses who did a rollover), (ii) on the life expectancy of the beneficiary (“LE”) (for spouses who did not do a rollover and for non-spouse individuals), (iii) on the life expectancy of the individual conduit beneficiary (when named conduit trust as the beneficiary), and (iv) on the life expectancy of the oldest individual beneficiary of a see-through accumulation trust5 where no non-individual could ever benefit. Because of this significant LE based income tax deferral benefit, these were often referred to as “stretch IRAs.”
The only situations where RMDs based on LE was not available was when the beneficiary was a non-DB. The RMD rules for a non-DB depend on the date of death of the participant. If the participant died before the age 70 1/2, the RMDs were based on the 5 year cliff rule, i.e., the retirement plan account needed to be fully distributed by the end of 5 years. If the participant died on or after 70 1/2, then the RMDs were based on the ghost LE, i.e., the participant’s remaining LE as if the participant was still living. Non-DBs included a beneficiary that was a non-individual (i.e., an estate or charity), or a trust that did not qualify as a see-through trust (“non-DB trust”). In most cases, the only reasons that retirement plan benefits would be paid to an estate was the result of poor planning or a mistake. When a charitable beneficiary was named, this was a non-issue since a charity would not normally pay any income tax on the retirement plan distributions. A non-DB trust would normally only be used when both (I) no distributions should be forced to a particular trust beneficiary (so could not use a conduit trust) and (ii) the client did not want to limit the potential future beneficiaries who could benefit after the primary beneficiary’s death (so could not use a see-through accumulation trust).
(A) RMD rules that apply to the participant.
The RMD rules are fairly friendly while the participant is living, as the RMDs are based on annual distributions over the joint life expectancy (“Jt LE”) of the participant and someone 10 years younger (unless the participant’s spouse is actually more than 10 years younger than the participant6). These RMDs generally had to begin in the calendar year the participant attained age 70 1/2, known as the Required Beginning Date (“RBD”).7 The IRS provides a chart so the RMD amount can be fairly easily determined. [Note: These RMD rules remain the same under the Secure Act, except for changing the Required Beginning Date (“RBD”)8 from age 70 1/2 to age 72.]
(B) RMD rules after the participant’s death.
The complexity starts when the participant dies leaving assets in the retirement plan. The RMD rules provide that the beneficiary’s life expectancy (“LE”) can be used to determine the annual RMD amounts as long as the beneficiary is considered to be a “designated beneficiary” (“DB”). A DB needs to be someone with a life expectancy, which includes either an individual or one of two types of qualified see-through trusts. The two types of qualified see-through trusts include the “conduit trust” and the “accumulation trust.”9 If a conduit trust is used, the trustee must immediately pay out all retirement plan distributions, and as a result, the Internal Revenue Service (“IRS”) treats the conduit beneficiary of the trust as the sole beneficiary of the retirement plan for purposes of the RMD rules. If a see-through accumulation trust is used (i.e., the retirement plan distributions to the trust are not required to be immediately paid out to an individual trust beneficiary), the RMD rules generally look to find and use the shortest LE of any potential beneficiary of the trust. If the accumulation trust has any possible beneficiary which has no LE, such a charity or an estate, then the trust does not qualify as a see-through accumulation trust. If the retirement plan beneficiary is neither an individual nor a qualified see-through (conduit or accumulation) trust, then it is considered a non-designated beneficiary (“non-DB”). If the beneficiary is a non-DB, the RMDs are based not on life expectancy but on either a 5 year cliff (all retirement plan assets must be distributed within 5 years) if the participant died before age 70 1/2 or the ghost life expectancy (the participant’s remaining life expectancy as if still living) if the participant died on or after age 70 1/2 (“ghost LE”). In all of the above cases, the death of a beneficiary (who is not also the participant) has no effect on how the RMDs continue to be determined thereafter.
(C) In practice before the Secure Act, choosing retirement plan beneficiaries would depend on who was intended to benefit and the significance of the amount likely to be remaining.
(1) If spouse was intended beneficiary.
The spouse would normally be named directly. In fact, with QPs, the law generally provides that the spouse is required to consent in writing if a non-spouse was named as the beneficiary. Normally, the only reason a trust for the spouse’s benefit was named rather than the spouse directly was if the asset protection and control benefits of a trust in that particular situation were deemed to outweigh the potentially significant loss in income tax deferral benefits. Spouses named directly as the beneficiary have tax deferral options that no other beneficiary has. Specifically, a spouse has the option to rollover the deceased participant’s retirement plan account to their own IRA account. If this rollover option was chosen, the spouse’s RMDs began at age 70 1/2 and would be based on Jt LE. If this rollover option was not taken, then the spouse would be like any other individual beneficiary10 with RMDs based on his or her single LE, but with the added benefit of the RMDs not starting until the deceased participant would have attained age 70 1/2.11 In most cases, spouses would elect the rollover option except to the extent that the retirement plan funds were needed for support or otherwise before the spouse attained age 59 1/2. If the rollover election was made and distributions were made before age 59 1/2, then the 10% premature distribution penalty would generally apply. If the beneficiary was a trust for the spouse’s benefit, the normal RMD rules for trusts would kick in with the best case scenario (using a specialized trust, known as a QTIP marital/conduit trust)12 being similar to the rules applying to the spouse as the individual beneficiary where the rollover option was not elected, i.e., spouse’s LE beginning when the deceased participant would have attained age 70 1/2.
It is important to note that, as discussed below, the Secure Act did not change the RMD rules that apply to a spouse as a direct beneficiary or as a spouse as beneficiary of a conduit trust, other than changing the RBD from age of 70 1/2 to age 72. For most other beneficiaries, the changes to the RMD rules by the Secure Act were significant.
(2) Where Non-Spouse Individual is Desired Beneficiary:
The RMD rules for a non-spouse individual were excellent and fairly easy to administer. Any individual non-spouse beneficiary would need to start their RMDs beginning in the year after the participant’s death, and the RMDs would be based on the individual’s LE. The IRS also provides a fairly simple chart to determine the RMDs for this purpose. However, by naming a non-spouse beneficiary directly, you give up the significant asset protection and control benefits of trusts. In particular, the U.S. Supreme Court determined in Clark v. Rameker13 that the special asset protection status for IRA accounts while the participant is living ends when the participant is no longer living. While not directly stated by the U.S. Supreme Court, a spouse that rolls the deceased participant’s IRA over to their own IRA should be the new participant and should thereby retain this special asset protection status. From a practical perspective, this meant that naming individual non-spouse beneficiaries was simple but it was not nearly as beneficial as naming a trust for their benefit if the significant asset protection and control benefits were desired.
For those that wanted to do the best they could for their non-spouse loved ones after their deaths, trusts were the clear answer unless the amounts at issue would not justify the additional costs and hassle of administering a trust in the future.
Where trusts were desired, the trusts were almost always structured as qualified see-through trusts, including either conduit trusts or accumulation trusts. Conduit trusts required that all retirement plan distributions must be immediately distributed to the conduit beneficiary, i.e., the designated individual trust beneficiary. In this case the conduit beneficiary would receive all retirement plan distributions while living and therefore the RMDs would be based on that individual’s life expectancy. See-through accumulation trusts were permitted to accumulate retirement plan distributions, but trust provisions were required to limit who could ever benefit from any such retirement plan distributions. Normally, the provisions would prevent anyone older than the oldest primary beneficiary of the trust, for example the oldest child, from benefitting from any retirement plan distributions. These provisions would also prohibit anyone without a life expectancy, for example a charity or an estate, from ever benefitting in any way from a retirement plan distribution. While some attorney’s preferred accumulation trusts over conduit trusts, the majority, including our firm, preferred the conduit trust structure. Accumulation trusts limit who could actually benefit from the retirement plan funds, and we did not want the tax tail wagging the dog. On the other hand, the conduit trust structure only required relatively small annual distributions to be paid out to the conduit beneficiary. In cases where we simply could not force any distributions out to a beneficiary, for example where had child with special needs, drug dependency issues or serious creditor issues, then we would go with an accumulation trust structure. In the infrequent situation when we could not force distributions to particular beneficiaries and we felt it was inappropriate to limit possible future beneficiaries, we would go with a non-DB trust.
The Secure Act did not create a whole new set of RMD rules. Rather it layered a new IRC Section 401(a)(9)(H) on top of the existing rules to modify the payout periods for DBs. The Secure Act essentially made two major changes to the RMD rules. First, it changed the general rule for when RMDs must begin for retirement plan participants and their spouses from the participant’s age 70 1/2 to age 72. Second, it changed the general RMD distribution period rule from LE for non-participants with distributions required annually to a new 10 year cliff rule where the entire retirement plan must be distributed in 10 years.14 However, important exceptions exist that permit RMDs based on LE for distributions to Eligible Designated Beneficiaries (“EDB”). Further, and in general, upon the death of an EDB, the RMD changes to a 10 year cliff rule for the successor / remainder beneficiaries. While there is some complexity in understanding these rules, the more complex and important aspect of these rules is how they should be dealt with in the planning process.
In general, the Secure Act applies to retirement plan distributions with respect to participants who die on or after January 1, 2020. The Secure Act also applies to the RMDs as to any retirement plan account assets remaining at the participant’s death even if the participant died before January 1, 2020. Specifically, when the participant dies, the RMDs for the successor beneficiaries switches to the general 10 year cliff rule.
(A) Plan participant: RMDs based on the same excellent Jt LE rule as before the Secure Act, except the RMDs begin upon attaining the new RBD, which is age 72 rather than the previous age 70 1/2.
(B) Spouse as direct beneficiary: Similar RMD rules as before the Secure Act. The spouse is given the option to rollover the participant’s retirement plan to the spouse’s own IRA, and the spouse will be able to use the same RMD rules available to a retirement plan participant, i.e., Jt LE beginning at age 72. If the spouse does not choose the rollover option, then the spouse becomes the beneficiary of their deceased spouse’s retirement plan (“inherited IRA”). Under the Secure Act rules, the spouse is given EDB status. With this status, the RMDs are based on the spouse’s LE beginning when the deceased participant would have attained age 72. However, upon the spouse’s subsequent death, the RMDs switch to the 10 year cliff rule for the remainder / successor beneficiaries.
(C) Non-spouse individual as direct beneficiary: The general RMD rule when name non-spouse individual beneficiaries of a retirement plan after the participant’s death is the 10 year cliff rule. However, the Secure Act creates a special Eligible Designated Beneficiary (“EDB”) status which qualifies for a modified LE rule. The RMD rules that apply to EDBs are as follows:
(D) Disabled and chronically ill beneficiaries. Disabled beneficiaries [as defined in IRC Section 72(m)(7)] and chronically ill beneficiaries [as defined in IRC Section 7702B(c)(2) with some modifications] have RMDs based on their LE during the beneficiary’s life and then switches to the 10 year cliff rule upon their death. A significant impediment to qualifying as disabled or chronically ill is the need to have this status as of the participant’s date of death. Consequently, unless the beneficiary is actively receiving disability or means tested government benefits before the participant’s death, it may be difficult to qualify. This is an area where the IRS may provide rules to liberalize this restrictive timing requirement.
(E) Beneficiary not more than 10 years younger than the participant. A beneficiary who is not more than 10 years younger than the participant has RMDs based on their LE, which then switches to the 10 cliff rule upon their death.
(F) Beneficiary is a child of the participant who has not yet attained age of majority. A child of the participant who has not yet attained the age of majority [as defined by IRC Section 401(a)(9)(F)] has RMDs based on child’s LE, but only until the child attains the age of majority, at which point the RMDs switch to the 10 year cliff rule. The child’s death will have no effect on the RMDs thereafter. Two important points should be considered. First, this EDB status only applies to the actual legal child(ren) of the participant. It does not apply to grandchildren, step-children or otherwise. Second, the definition of the age of majority is unclear. We believe it will be interpreted to be the state law age of majority (either age 18 or 21), but then possibly extended until the child completes a specified course of education, but no later than age 26. Is this specified course of education extension supposed to parallel the age rules under the Kiddie tax? This was be an excellent interpretation, but at this point, it is unclear what is intended.
(G) Non-DB as direct beneficiary. A DB has to have a LE. Estates and charities do not have LEs. As a result, if the beneficiary is the estate, either by being named or it is directed by the terms of the retirement plan, or if a charity is named, the RMD rules are determined based on not having a DB. These rules depend on the age of the participant when the participant died. If the participant was less than the RBD of age 72, then the RMDs are based on a 5 year cliff rule. If the participant was at least age 72 when the participant died, then the RMDs are based on the ghost rule, i.e., the remaining LE of the participant as if the participant was still living. These rules were unchanged by the Secure Act.
(H) Trust as beneficiary: Three (3) types of trusts are possible from an RMD perspective. The first two are the conduit trust and the accumulation trust, are see-through DB trusts, and the third trust is the non-DB trust. The conduit trust requires that all retirement plan distributions to the trust must immediately be paid out to the conduit beneficiary. The accumulation trust generally requires that all possible present and future beneficiaries have to be individuals (i.e., they have life expectancies), meaning that no estate or charity may be a possible beneficiary and they could never be added in the future as a beneficiary or benefit via a power of appointment or otherwise.15 Finally, the non-DB trust includes all other trusts.
(1) Conduit Trusts. For purposes of the RMD rules, the conduit beneficiary of a conduit trust is to be treated as the sole beneficiary. Therefore, an EDB that is the conduit beneficiary enables the conduit trust to benefit from the EDB’s special RMD status. Therefore, if the conduit beneficiary is the surviving spouse, a disabled or chronically ill individual, or an individual that is less than 10 years younger than the participant, then the RMDs are based on that person’s LE. In the case of the spouse as the conduit beneficiary, the RMDs do not need to begin until the participant would have attained age 72 if still living. If the conduit beneficiary is a child of the participant below the age of majority (age 18 or 21 depending on the state, with a possible extension up to age 26 depending on education status), then the RMDs will be based on the child’s LE until the child attains the age of majority, at which point the RMDs switch to the 10 year cliff rule.
(2) Accumulation Trusts. If the only beneficiary of the see-through accumulation trust is a disabled or chronically ill individual (as these terms are defined) and no one else is permitted to benefit during the disabled or chronically ill individual’s life, then the RMDs will be based on the LE of the disabled or chronically ill individual. Upon the death of the disabled or chronically ill individual, the RMDs switch to the 10 year cliff rule. This special rule for the disabled and chronically ill was the major change to the RMD rules in the Secure Act after it was passed by the U.S. House of Representatives on May 23, 2019. This exception may permit the use of special needs trusts to prevent the loss of government means-tested benefits.
For all other accumulation trusts, the RMDs are based on the 10 year cliff rules, and the death of any trust beneficiary will have no effect on the RMD rules thereafter.
(3) Non-DB Trusts. Any trust that does not qualify as either a conduit trust or a see-through accumulation trust is considered a non-DB trust. The RMD rules for a non-DB trust were not changed by the Secure Act16 and depend on the age of the participant when the participant died. As discussed above, if the participant was less than age 72 when the participant died, then the RMDs are based on the 5 year cliff rule. If the participant was at least age 72 when the participant died, then the RMDs are based on the ghost rule, i.e., the remaining LE of the participant as if the participant was still living.
An opportunity may exist to benefit from pre-Secure Act law if a retirement plan participant died within the last 9 months of 2019. This strategy uses a disclaimer, which treats the disclaiming party as deceased for property rights and tax purposes.
Here are the likely needed facts: (i) either a married couple with spouse as primary beneficiary and their child(ren) as successor/contingent beneficiaries of the deceased spouse’s retirement plan or parent dies with child as primary beneficiary and the child’s children as successor/contingent beneficiaries; (ii) no assets/benefits have been received by the stated beneficiary (spouse or child) from the retirement plan since the participant’s date of death; (iii) the spouse / child is willing to disclaim his or her beneficial interest in the retirement plan so it can instead pass to their children to achieve additional income tax deferral benefits (along with possible estate tax benefits if the disclaiming party has a significant risk of paying a future estate tax); and (iv) the disclaimer can be completed within 9 months of the participant’s date of death. With this strategy, the RMDs for the retirement plan will be controlled by more beneficial pre-Secure Act law. Specifically, the RMDs will be based on the LE (with likely lower income tax rates when outside the kiddie tax) of the child or grandchild who becomes the beneficiary as a result of the disclaimer.
The preferred option to benefit the spouse remains the same as it was before the Secure Act. The spouse is given the best possible options if the spouse is named as the direct beneficiary. The spouse is given a choice to either rollover the retirement plan to the spouse’s own IRA or to become a beneficiary of an inherited IRA. If the rollover option is taken, the spouse’s RMDs are based on Jt LE and begin at age 72. If the spouse does not elect the rollover option, then the spouse’s RMDs are based on the spouse’s LE and begin when the participant would have attained age 72. The reason not to rollover all of the retirement plan is to avoid the 10% early distribution penalty if the spouse may need to access part or all of the retirement plan funds prior to attaining age 59 1/2.
The child of the participant who has not yet reached the age of majority is treated as an EDB, who qualifies for RMDs based on LE until the child reaches the age of majority, and then the 10 year cliff rule kicks in thereafter. If you want to take advantage of this status, then you will either need to name the child directly or as the conduit beneficiary of a conduit trust.
The more important question is if either of these options is consistent with your estate planning intent. Specifically, in order to take advantage of this EDB status, the retirement plan distributions will need to be paid out to the child at fairly young ages (relatively small distributions annually before the age of majority (up until as early as age 18), with the remainder having to be distributed under the 10 year cliff rule, which could force full distributions by as early as age 28. Of course, if the child is named directly, the child would have the ability to fully access the retirement plan balance as early as age 18. Are you ok with a young child gaining direct access to all of the retirement plan funds? If the amount in the retirement plan is insignificant, you may not mind. However, you may feel that this result is unacceptable if the retirement plan amounts are fairly significant. You also need to be aware of the following:
(i) the special EDB status only applies to the participant’s children, and this does not include, for example, grandchildren, step-children, nieces or nephews;
(ii) the age of majority is key since the only extra income tax deferral spans from the child’s age on the participant’s date of death until the child attains the age of majority. The age of majority is age 18 in Georgia (this age ranges from 18 – 21 in most states), and while not totally clear, this age can be extended up to age 26 based on educational status. This EDB status could potentially provide significantly more benefit if the educational status paralleled the kiddie tax ages, but this is far from clear.
If the downside to naming the child directly or utilizing a conduit trust is not deemed worth the potentially insignificant additional income tax deferral, the better way to go may be to ignore the child’s EDB status and plan as if the child was not an EDB individual, which is discussed below. The favored options in this case will likely be to name the child(ren) as beneficiaries of either a see-through accumulation trust (10 year cliff) or a non-DB trust (5 year cliff if participant dies before 72 or participant’s remaining LE as if still living if participant dies on or after age 72).
For individuals that meet the definition of being disabled or chronically ill, the beneficiary should be an accumulation trust with this disabled or chronically ill person as the sole beneficiary during his or her life. This is a special EDB rule that provides for RMDs based on LE that should likely be used whenever it is available. In these situations, you should also consider structuring this accumulation trust as a supplemental needs trust so that these funds will not be counted when considering means tested government benefits.
The more difficult question is the structure of the trust if the individual is not currently qualified as disabled or chronically ill, but significant risk exists that the individual may qualify for such status at some point in the future. At least based on the current Secure Act rules, this EDB status must be met as of the date of the participant’s death. Therefore, the individual may need to already be considered disabled or qualified to receive means tested government benefits before the participant’s date of death. In other words, while this EDB status looks significant at first glance, the reality may be that it is difficult to qualify, depending on timing issues.
To make an informed beneficiary choice, you will need to consider the effect of the see-through accumulation trust if the individual is either qualified (LE) or does not qualify (10 year cliff) at the participant’s death as disabled or chronically ill. These options then need to be compared to the effect of a non-DB trust (5 year cliff if participant dies before 72 or participant’s remaining LE as if still living if participant dies on or after age 72). In this regard, the major cons to the see-through accumulation trust are the restrictions on who can benefit from the trust. Specifically, (I) to qualify for this special EDB status, no one else can be a beneficiary during the disabled or chronically ill individual’s lifetime, and this includes not being able to benefit the individual’s own child;17 and (ii) the trust must prohibit non-individuals from ever benefitting, as well as non-identifiable individuals, such as an un-named spouse (since spouses can theoretically change over time). If the limitations on possible beneficiaries is not a significant issue, then naming a see-through accumulation trust may be the right answer. However, if the limitation on possible beneficiaries is somewhat concerning, then the answer may be to condition qualification as a see-through accumulation trust (along with its beneficiary limitations) on the individual properly qualifying as a disabled or chronically ill EDB. However, if the limitation on possible beneficiaries is very concerning, then it may be better to forgo maximum income tax deferral, go with a non-DB trust where a trust is needed or desired.
A desired beneficiary that is an individual who is less than 10 years younger than the participant is an EDB who is to receive RMDs based on his or her LE. These individuals could commonly include siblings, unmarried life partners, friends, and cousins. To take advantage of this special status, the beneficiary should be either the individual directly or the individual as the conduit beneficiary of a conduit trust.
If the retirement plan amounts are not significant and/or the asset protection and control benefits of a trust are not needed at all, then naming the individual directly as the beneficiary is recommended.
If the asset protection and control benefits are desired, the highly recommended option is to name the individual as the conduit beneficiary of a conduit trust, at least if the retirement plan account amount is significant enough to make it worth protecting.
However, if in your particular situation, you simply cannot force any distributions to the individual because of, for example, serious disability, drug dependency or creditor issues, then you will need to forego the EDB status and name an accumulation trust for the individual’s benefit. In this case, the RMDs will be based on the general 10 year cliff rule (unless the individual qualifies as disabled or chronically ill as discussed above), but no amounts will need to be forced out to the individual. While more complex, flexibility could also be added to the trust to enable future possible modification to a non-DB trust status if the participant died between ages 72 and age 79, when the participant’s remaining LE would be somewhat longer than 10 years if the participant was still living. In this situation, you would get the participant’s remaining LE as if still living (with required annual distributions) rather than the 10 year cliff where all must be distributed by the end of the 10th year.
Finally, if you should not force any distributions to this particular beneficiary but you have a significant concern with the possible beneficiary limitations of an accumulation trust, then the right answer may be to just go with the better trust terms and the RMD rules of a non-DB trust (5 year cliff if participant dies before 72 or participant’s remaining LE as if still living if participant dies on or after age 72).
If the retirement plan amounts are not significant and/or the asset protection and control benefits of a trust are not needed at all, then naming the individual directly as the beneficiary is recommended. Normally, this means that if the rest of the assets under the participant’s estate plan are to pass outright to the beneficiaries, then the retirement plan assets can likely pass that way as well. In this case, unless the beneficiary meets one of EDB categories discussed above, the RMDs will be based on the 10 year cliff rule.
If the asset protection and control benefits of a trust are desired, the recommended option is to name the individual as the beneficiary of an accumulation trust. The RMDs will be the same as if the individual was the direct beneficiary of the retirement plan beneficiary, i.e., 10 year cliff rule. The biggest negative to an accumulation trust is that it puts some limit on possible trust beneficiaries, including prohibiting non-individuals (charities or an estate) and individuals who are not identifiable as of the participant’s date of death (such as spouses who are not specifically identified, otherwise the non-specifically named spouse could change after the participant’s date of death).
If the asset protection and control benefits of a trust are desired, but you also want the option to benefit charity or non-identifiable beneficiaries (such as descendants’ spouses) with the retirement plan assets at some point in the future after the death of the primary individual beneficiary(ies), then the recommended option is to name the primary individual as the conduit beneficiary of a conduit trust. The RMDs will still be based on the 10 year cliff rule, but all amounts passing from the retirement plan to the trust must be immediately paid out to the conduit beneficiary. Hence, the non-tax benefits of the trust structure as to the retirement plan assets will be fairly short lived. The other option in this case is to use a non-DB trust.
If either an accumulation trust or a conduit trust is used, a creative, flexibility strategy could be used in the trust to possibly increase the RMD distribution period. Specifically, the trust could enable the future possible modification to non-DB trust status if the participant died between ages 72 and age 79, when the participant’s remaining LE would be somewhat longer than 10 years if the participant was still living. In this situation, you would get the participant’s remaining LE (with required annual distributions) rather than the 10 year cliff where all must be distributed by the end of the 10th year.
If either a see-through accumulation trust or a non-DB trust is used, the issue arises as to the high trust income tax rates on any accumulated retirement plan distributions. The answer is that flexibility can be built into these trusts to permit ongoing income tax planning. Specifically, the trustee will have the ability to choose who is to pay tax on these retirement plan distributions. The general rule is that amounts distributed to a trust beneficiary will carry out the taxable income with it, so the trust beneficiary will pay the tax at his or her tax rate. If the retirement distributions are accumulated, the general rule is that the trust will pay the tax on this income at the trust’s generally higher income tax rates. However, with particular provisions built into the trust agreement, the trustee will have the practical flexibility to accumulate the retirement plan distribution, but pay tax at one or more selected beneficiary’s tax rates (subject to the kiddie tax for young beneficiaries). In other words, tax planning can often mitigate the potentially higher income tax rates on taxable income accumulated by the trust.
In light of the general RMD rules, a higher risk exists that less net value will get to most non-spouse retirement plan beneficiaries because of likely faster taxation (via less income tax deferral) at likely higher marginal income tax rates (by bunching more taxable income in fewer years). The question is if other alternatives should be considered in dealing with this issue other than trying to maximize the available RMDs after the Secure Act? In this regard, the following additional options could be considered:
Two options exist to use retirement plan funds in a tax advantaged manner to benefit charity at the participant’s death. First, one or more charities can be directly named as beneficiaries of the retirement plans. Charity will be able to benefit from 100% of the amount passing to them from the retirement plan since charities generally do not pay income tax on distributions from retirement plans. Second, a Charitable Remainder Trust (“CRT”) can be named as the beneficiary where want to initially benefit individual beneficiary(ies) for a term or years up to 20 years or for life or lives and have any remainder pass to charity. This strategy enables you to effectively create your own longer income tax deferral period for the benefit of your individual beneficiary(ies), if you are willing to provide at least a 10% remainder interest for charity.
Regardless of the option chosen, if the retirement beneficiaries include both a charitable beneficiary, which is a non-DB, and one or more individual DBs, then a critical timing issue exists. The rule is that in order for any retirement plan beneficiary to get the benefit of DB status, all of the beneficiaries must be DBs. However, the IRS provides a period of time to remove the non-DBs as beneficiaries so that they will not count. In the case of charitable beneficiaries, the key is to fully distribute from the retirement plan the full amount owed to the charity by the Beneficiary Finalization Date (“BFD”), which is September 30th of the year following the participant’s death.
One additional charitable strategy exists for the charitably inclined to save on some indirect taxes. This is called a “Qualified Charitable Distribution” or “QCD.” If instead of distributing the RMDs to yourself during your life, you can instead do a trustee to trustee transfer to have your RMD for the year (actually up to $100,000 per year) pass to one or more public charities. While the direct income tax effect is neutral (no taxable income recognized on the retirement plan distribution and no charitable income tax deduction on the contribution to charity). However, the indirect benefits may be significant depending on your situation. Because the RMD income was not recognized, your adjusted gross income was effectively reduced, which increases the ability to deduct certain itemized income tax deductions, may reduce the taxation on social security income and may reduce your Medicare premiums. It should be noted that the QCD cannot be done until 70 1/2, which before the Secure Act was the RBD. However, it seems as if a technical glitch in the Secure Act exists since the RBD in the Secure Act was changed to 72, but this change does not seem to have been made to the QCD. As a result, the QCD may be possible up to $100,000 per year beginning in the year you turn 70 1/2, even before your RMDs begin.
Roth IRAs do not require any RMDs during the participant’s life. The same RMD rules apply to Roth IRAs after the participant’s death, but the retirement plan distributions are not taxable to the beneficiary. This was already a known benefit before the Secure Act, and financial advisors have been advising their clients to convert Regular IRAs to Roth IRAs while using their lower marginal income tax rates over a period of years. The amount converted during the year is treated as taxable ordinary income for that tax year. The Secure Act now provides an even greater incentive to carry out such conversions. The converted assets will avoid the higher effective income taxes under the Secure Act, as well as provide other indirect financial benefits. RMDs create taxable income, which in turn increases your adjusted gross income, which in turn can minimize itemized income tax deductions, increase taxation of social security benefits and increase Medicare premiums. By minimizing RMDs during your life, you will be avoiding these issues.
An excellent conversion will have the following attributes: (I) the conversion income amount should end up being taxed in your lower marginal tax brackets as compared to the marginal tax rates you expect to pay in retirement and/or your beneficiaries will pay after your death if no conversion had been done (keeping in mind that income tax rates may be going up after upcoming Presidential and Congressional elections); (ii) you do not expect to need to spend the Roth IRA assets during your life unless your financial position changes significantly to the negative; and (iii) you have other non-retirement plan funds available to pay the conversion related income taxes. In fact, the ability to use non-retirement plan funds to pay the conversion related income taxes is a significant tax benefit. You will basically be taking assets pregnant with a future tax and turning them into non-taxable without reducing the total amount in the Roth IRA. The practical effect is as if you contributed the tax amount to the Roth IRA (which is otherwise not legal unless it is within the small annual contribution limit) and had the Roth IRA pay the tax.
As discussed above, the income taxation on retirement plan accounts will likely be more significant to your beneficiaries after your death. If you are planning to benefit one or more beneficiaries with higher tax rates and one or more with low or no tax rates, you may wish to rethink which beneficiaries are to receive the retirement benefits and which are to receive your other assets. For example, if you plan to benefit charity at your death, it would likely be best to satisfy this desired bequest with retirement plan assets.
(A) Relocation strategy. Distribute funds from retirement plan account and use these funds to fund life insurance (possibly in a Family Gifting Trust or Irrevocable Life Insurance Trust to avoid the life insurance proceeds being subject to estate tax at death). The effect is to use assets you otherwise did not need to support your lifestyle to convert what would have been high taxable income (RMDs after death) into tax free life insurance proceeds.
(B) Tax funding strategy. Use life insurance or other funding mechanism to assist beneficiaries in offsetting the expected income tax cost on the retirement plan assets.
1 The Secure Act stands for the “Setting Every Community Up for Retirement Enhancement” Act, and it was passed by the House of Representatives with a 417 – 3 vote on May 23, 2019.
2 The Secure Act related provisions are located in Section 401, in Title V – Revenue Provisions of “Division O” of the “Further Consolidated Appropriations Act, 2020.”
3 It should be noted that QPs are not required to provide the maximum allowable beneficiary options, and you first look to what beneficiary options are permitted under the QP document terms before looking at the RMD rules. However, beneficiaries have the option after the participant’s death to rollover their inherited QP account to an inherited IRA account. IRA custodians normally permit maximum number of beneficiary options permitted under the RMD rules.
4 These rules are technically referred to as the Minimum Required Distribution rules, but are more commonly referred to as the Required Minimum Distribution rules.
5 The see-through accumulation trust rules are some of the most complex in this area of the law, as they were written by those that did not really understand trusts used in estate planning. As a result, most attorney avoided these rules unless they were needed in a specific client matter.
6 If the participant’s spouse was more than 10 years younger than the participant, the RMDs would be based on the joint life expectancy of the participant and his or her actual younger spouse.
7 Under the law before and after the Secure Act where RMDs are based on LE or Jt LE, the first RMD can be made either in the calendar year that the participant attains age 70 1/2 (pre-Secure Act) or age 72 (post-Secure Act) or as late as April 1st of the following year, but if the first RMD is delayed into the next year, then two RMDs will effectively be required in that next year.
8 The RBD is the date when RMDs must begin with some exceptions. First, the first RMD can be distributed by April 1st of the following year, but this does not change the need to make the normal RMD for that same year. Second, a participant in a QP who is still working and is not at least a 5% owner, after application of ownership attribution rules, may postpone RMDs until retirement. Lastly, the RMD rules do not apply to Roth IRAs during the participant’s life.
9 It should be noted that these see-through trust types are not legal names, but rather commonly used descriptive names.
10 In this case, the retirement plan account would be considered an inherited IRA or retirement plan account.
11 See IRC Section 401(a)(9)(B)(iv) as to the ability to postpone the RMDs until the participant would have attained age 70 1/2 (pre-Secure Act) or age 72 (post-Secure Act). In the case of the spouse, the LE is also recalculated annually.
12 The QTIP Marital/conduit trust requires the trust to distribute to the spouse each year the greater of the trust’s income or the RMD amount.
13 134 S.CT. 2242 (2014).
14 Actually by the end of the calendar year of the 10 year anniversary after the participant’s death. So, the 10 year cliff deadline is 10 x 12 month years and the remaining months until December 31st. Effectively, this 10 year cliff will cover 11 taxable calendar years.
15 Before the Secure Act, the RMDs would generally be based on the beneficiary with the shortest LE, and as a result, the trust provisions used to also prohibit anyone with a shorter LE than a stated trust beneficiary in addition to prohibiting any possible beneficiary with no LE. Because of the changes under the Secure Act, we should no longer care about the length of any possible beneficiary’s LE as long as they have a LE.
16 The only change in the RMD rules as to non-DBs was the RBD change from age 70 1/2 to age 72.
17 Some ability to benefit a child may exist when the child is a minor, as the trustee would be benefitting the individual by helping satisfy the individual’s legal obligation of support.