The SECURE Act and Inherited IRAs: What You Need to Know

The federal Setting Every Community Up for Retirement Enhancement (SECURE) Act was signed into law on December 20, 2019. This bipartisan legislation was designed to make it easier for Americans to save for retirement. However, some of the changes created by the law may have unintended consequences for those whose retirement and estate planning was done under prior law.

One of the most significant changes under the SECURE Act has to do with inherited Individual Retirement Accounts (IRAs). Prior to 2020, if an individual inherited an IRA as a designated beneficiary, he or she could usually take required minimum distributions (RMDs) annually from the inherited account based on the beneficiary’s life expectancy.

The New 10-Year Rule for Inherited IRAs

The new law changes that rule, known as the “stretch” rule for the beneficiary’s ability to “stretch” payments over his or her lifetime. The stretch rule has been replaced by the new 10-year rule. The 10-year rule makes it mandatory (with some exceptions that we’ll get to in a moment) for designated beneficiaries to withdraw all funds from the inherited IRA by the end of the tenth year following the year in which the account owner died.

That said, there is some flexibility built into the new rule. There are no requirements that funds be distributed on any regular basis within that ten-year period, only that they must all be distributed by the end of the tenth year.

This could have significant advantages for some beneficiaries. Let’s say you’re 58 years old and planning to retire at 63. You inherit an IRA containing $300,000 from a parent. You don’t need the money right now while you’re working, and would prefer to take distributions in five years when your income goes down, and before you start collecting Social Security retirement benefits. You can take distributions after you retire, meaning you will pay less tax on them, so long as you take them within the 10-year period.

Exceptions to the 10-Year Rule

The 10-year rule does not apply to all inherited IRAs. There are exceptions for certain categories of beneficiaries known as “eligible designated beneficiaries.” They include:

• Spouse of the deceased IRA owner;
• Individuals who are not more than 10 years younger than the deceased IRA owner;
• Certain minor children who are children of the original IRA owner, but only until they reach the age of majority (under state law);
• Beneficiaries who are disabled, as that is defined by IRC Section 72(m)(7);
• Most beneficiaries who are chronically ill, as that is defined by IRC Section 7702B(c)(2).

For these groups of eligible designated beneficiaries, the rules have not changed. They can continue to receive distributions over their own life expectancies.

A word about beneficiaries who are minor children. Once beneficiaries who are minor children of the original IRA owner reach the age of majority, the 10-year rule does apply to them. Let’s say your 16 year old daughter is the beneficiary of your IRA when you pass away and the age of majority is 18 in your state. Until she turns 18, the 10-year rule does not apply. Once she turns 18, however, the clock starts ticking, and she must withdraw all funds from the IRA before the end of the year in which she turns 28.

Also if a minor child is a beneficiary of an IRA from someone other than a parent (like an aunt, uncle, or grandparent) the 10-year rule applies immediately.

How the SECURE Act Affects Trusts Named as Beneficiaries of an IRA

Understandably, many people with minor children would prefer not to name them directly as beneficiaries of an IRA. Instead, they create a trust to serve as beneficiary of their retirement account. The changes brought about by the SECURE Act mean that it is more important than ever for the creators of such trusts to review them to ensure that they will continue to do what they were intended to. In many cases, trusts may have to be re-drafted in order to achieve the desired outcome.

Most trusts designed to serve as beneficiary of an IRA were drafted in accordance with “see-through” rules. Those rules allowed the trust to stretch distributions over the life expectancy of the oldest beneficiary of the trust. In general, there are two types of trust that fall into this category: accumulation trusts and conduit trusts.

Accumulation trusts frequently require most or all distributions from an IRA to remain in trust, rather than being distributed to trust beneficiaries. Unfortunately, under current tax law, trusts are bumped the highest federal tax bracket (37%) with a relatively small amount of income: just $12,950 of taxable income. That means that IRA funds in the trust are likely to be subject to high trust tax rates. What’s more, they are still subject to the 10-year rule.

Conduit trusts, on the other hand, are often drafted in such a way that only the required minimum distribution from an IRA is distributed annually to a trust. The trust then acts as a conduit, passing that RMD through to the trust’s beneficiaries. But with the new SECURE Act rules, as you will recall, there is no RMD until the tenth year, during which all IRA assets must be withdrawn. Depending on how the trust instrument is drafted, beneficiaries of the trust may not get access to IRA distributions for almost ten years, and then must take them all at once, which could result in a significant tax burden.

All of this analysis assumes that the IRS would even treat trusts as see-through to look beyond the trust to an eligible designated beneficiary. The SECURE Act states that if the trust beneficiary is a chronically ill or disabled person, the trust itself can be treated as an eligible designated beneficiary. The Act is silent about trusts for the benefit of other eligible designated beneficiaries.

One thing is certain: If you have an IRA, and especially if you have created a trust to serve as beneficiary, you should take the time to review your situation with an experienced trust and estate planning professional. We invite you to contact our law office to schedule a consultation.