SECURE Act: Time to Rethink Retirement Plan Beneficiary Designations

The Setting Every Community Up for Retirement Enhancement (SECURE) Act, enacted as part of the most recent appropriation bill and signed into law on Dec. 20, 2019, is a bipartisan effort to address fundamental issues in our retirement savings system. Provisions of the act make significant changes to the way in which the Internal Revenue Code (IRC) treats qualified plans and Individual Retirement Accounts (IRAs)—perhaps the most significant of which involve the treatment of plan balances payable to beneficiaries after the owner’s death. The act, which took effect Jan. 1, 2020, will have an immediate impact on financial, retirement and estate planning. 

Key takeaways: 

• Extends the age to begin mandatory minimum distribution from IRAs and qualified retirement accounts from the current age of 70½ years to 72 years. 
• Eliminates the maximum age limit for contributing to traditional IRAs. 
• Requires all but a limited class of beneficiaries to take the distribution of their benefits under qualified plans and IRAs within 10 years of the account owner’s death, limiting the beneficiaries’ ability to have tax-deferred growth and impacting the timing of the taxable distributions.
• Anyone with a qualified retirement plan or IRA should review the designation of beneficiaries, especially if a trust is used, and consider some additional approaches.

The SECURE Act

The SECURE Act changes IRC Section 401(a)(9), governing the tax treatment of qualified retirement plans and IRAs. 

The basic rule is that contributions to these plans are excluded from income when made, grow inside the plan without current income tax and are then taxable to the recipient when withdrawn. Note that there are no changes to Roth IRAs or plans, which are treated in the opposite manner: no tax deduction or exclusion on contribution, but no taxable income on withdrawal. Like all qualified plans, Roth IRAs and plans grow tax free prior to withdrawal.

For many years, a basic strategy for non-Roth plans and IRAs has been to contribute as much as possible for as long as possible; to withdraw as little as possible, starting as late as possible; and after the owner’s death, to permit beneficiaries to stretch out withdrawals from the plan as long as possible.

The SECURE Act loosens the rules on contributions and withdrawals by the plan owner to make the first two parts of this classic strategy easier, but the new law makes up the resulting lost tax revenue by tightening up the rules that used to allow many beneficiaries (and certain trusts) to stretch out the withdrawal of benefits—thus deferring the payment of income taxes—over their lives.

IRA Contribution and Required Minimum Distribution Age Limits Extended

In an effort to address longer life expectancies and many people’s need or desire to work longer, the act eliminates the maximum age for contributions to traditional IRAs and increases the age at which most people must begin taking taxable distributions from their qualified retirement accounts or IRAs—known as required minimum distributions (RMDs). 

Prior to enactment of the SECURE Act, the IRC ruled out the tax benefits of additional contributions to IRAs once individuals reached 70½ years of age. Now, however, the IRC, as amended, no longer contains this age limit—or any age limit—on contributions to IRAs, enabling those who choose to do so to continue to add to their retirement savings on a tax-advantaged basis.

The act also amends IRC Section 401(a)(9) to increase the age at which individuals must begin receiving taxable RMDs from qualified retirement plans from the current age of 70½ years to 72 years (specifically, April 1 of the year following the year in which the account owner reaches the RMD age). Individuals who reached 70½ on or before Dec. 31, 2019, are stuck with that RMD age, even if they are not yet 72. 

The replacement of age 70½ with age 72 throughout this section of the Code also results in surviving spouses who claim retirement benefits being able to wait until age 72 before beginning to receive RMDs.

New 10-Year Limit for Beneficiaries to Receive Distributions Eliminates Most “Stretch IRAs”

In order for the SECURE Act to score as revenue-neutral over 10 years under budget reconciliation rules, the loss in tax revenue from the amendments described above is to be offset by revenue gains from the following amendments. The act amends the rules for RMDs of the balances of defined contribution plans and IRAs after the death of the account owner and applies to beneficiaries of accounts whose owners die after the effective date; if the owner of the account died prior to Dec. 31, 2019, the beneficiaries are exempted from the new rules. 

Prior to the enactment of the new provisions, “designated beneficiaries” (either living beneficiaries for whom life expectancies could be calculated or certain qualified trusts for named individuals or a defined class) could elect to leave the funds in the inherited account and take distributions based on their individual life expectancies, an estate planning tool commonly called a “stretch IRA.” Of course, stretching out the payment distributions gives the IRA assets more time to grow tax deferred—potentially a significant benefit. The younger the beneficiary, the longer the life expectancy and the lower the required payment, so more money stays in the account to grow (and the lower the tax bill on withdrawals each year—except, as noted above, for Roth plans and Roth IRAs). 

Nondesignated beneficiaries (for example, charitable organizations or nonqualified trusts), under both the old and new rules, must receive all of the benefits within five years of the account holder’s death, except where the owner’s death occurs after the RMD age limit (previously 70½, now 72), in which case the benefits could be paid out to the nondesignated beneficiary on the same payout schedule (or faster) as such benefits were being paid to the owner. 

The SECURE Act eliminates the “stretch” by creating a new, limited category of designated beneficiary—an “eligible designated beneficiary” (EDB)—and providing that only those designated beneficiaries who are EDBs can continue to elect to receive their inherited benefits over their own life expectancy. All other designated beneficiaries must be paid their benefits in full no later than 10 years after the death of the account owner. (The choice of 10 years is no doubt intended to lead to the revenue-neutral scoring noted above.)

The newly created favored class of EDBs includes surviving spouses, disabled individuals (as defined in IRC Section 72(m)(7)) or chronically ill individuals (as defined in IRC Section 7702B(c)(2)), individuals who are not more than 10 years younger than the account owner, and children—but not grandchildren—of the account owner who have not reached the age of majority. 

For most of these EDBs (as well as for nondesignated beneficiaries), the SECURE Act has no real impact, with one major exception. In the case of minor children of the account owner, even though they are EDBs, the potential for any stretch is shorter than for all other EDBs—the new 10-year limitation period will apply to children once they reach the age of majority in the same way it applies under the new rules to any other designated beneficiary who is not an EDB. The act does provide for a “postponement” of majority for a certain period of time while the beneficiary qualifies as a student, including in college.

The changes will have significant impact on the use of trusts in estate planning for qualified plans and IRAs. As the tax law stood prior to the SECURE Act, only certain trusts could be considered designated beneficiaries for the purposes of distributing qualified plan or IRA benefits. Plan owners who wanted their intended beneficiaries to have the tax benefit of long deferrals of withdrawals while also limiting the actual amounts passing to beneficiaries each year, with control of all investments retained by a responsible trustee, could designate as plan beneficiaries so-called see-through trusts—generally, either a “conduit trust” (requiring the immediate distribution to the trust beneficiary of any IRA distributions the trust receives) or an “accumulation trust” (allowing for the accumulation in the trust of any IRA distributions, which then would be taxed at the trust’s generally high tax bracket but paid out to the beneficiary only as and when the trustee determined). Different requirements for the distribution of income of the trust would need to be met if the trust is intended to qualify for the federal estate tax marital deduction when left to a surviving spouse.

There are some open questions of how the changes to the tax law will impact these trusts and others, since it is no longer enough that the beneficiary of the plan (including a trust) be a designated beneficiary (including a see-through trust) to qualify for stretch treatment for the life of the individual beneficiary (including the trust’s beneficiary). The SECURE Act does provide EDB treatment for see-through trusts for the benefit of disabled or chronically ill beneficiaries if the trusts are structured so that the benefits are payable only to those individuals for whom they are created. It remains unclear under the text of the act, however, whether EDB treatment is available for a see-through trust for the sole benefit of a minor child (who is, of course, also an EDB), for example, and what the impact of the SECURE Act might be in coordination with other existing laws.

If a conduit trust is now in place for a designated beneficiary who is not an EDB, the plan owner may have contemplated that plan proceeds would be distributed to the beneficiary over his or her entire life expectancy. Under the new law, however, even with no change in the trust, the entire plan account will wind up paid out to the beneficiary within 10 years after the owner’s death, simply because the plan withdrawals are now going to be much more accelerated than the owner anticipated under the old law. Obviously, the trust should be revisited, since it is likely to frustrate the owner’s intent.

Impact on Planning for Beneficiary Designations

Conduit and Accumulation Trusts. In general, it appears that conduit trusts will no longer be particularly attractive under the new law because they would have to require that everything received from the retirement plan be distributed to the beneficiary or beneficiaries (other than EDBs) within 10 years. As a result of the requirement that the conduit trust must withdraw the plan balance (and distribute it to the trust beneficiary) within 10 years rather than over the beneficiary’s life expectancy, the beneficiary would need to pay income tax during that time frame and, of course, the funds no longer would be held by the trustee but instead would be in the hands of the beneficiary, available to creditors and requiring prudent investment.

A conduit trust for a surviving spouse still should work well. Likewise, if the beneficiaries all are in the EDB categories of disabled or chronically ill, a conduit trust will work for tax purposes, but at the expense of requiring funds to be distributed to individuals who may not be capable of managing them.

Accumulation trusts may remain a more practical alternative for EDBs other than surviving spouses, although the trust itself would be required to pay income tax at relatively high marginal rates upon receipt of the amount required to be withdrawn from the IRA or plan account. Nevertheless, the withdrawn funds, net of tax, could be retained inside the trust for as long as the trustee decides, thereby permitting the use of a discretionary long-term trust for one or more beneficiaries.

There is a potential planning opportunity if some but not all of the beneficiaries of an accumulation trust are in the category of EDBs described earlier in this alert. In such a case, perhaps the client can create two trusts instead of one—one trust just for the EDBs and a separate trust for all other beneficiaries. If that is done, it appears that the first of these trusts would be able to stretch out distributions of the benefits over the life expectancy of the oldest EDB. The cost of this option, however, would be that the retirement plan benefits received by the trust could not be distributed to any other beneficiaries, so it may be possible to use a separate conduit trust for each EDB if the amounts at stake justify that level of administrative complexity (including separate tax returns for each trust). We might need to wait for regulations under the new rules to confirm whether this would work as desired.

Note also that an accumulation trust for minor children will permit distributions to be spread out over the period when they are still minors (and probably through college education), but once the oldest of the children ceases to be treated as a minor, a 10-year payout would be required.

Reality Check. The maximum payout period for a conduit trust for persons who are not EDBs is 10 years, while if it is not a conduit trust, there is a five-year period. It may well be that these extra five years are not worth jumping through hoops to have the trust qualify as a conduit trust if the intended beneficiaries are not EDBs.

Finally, there is some flexibility to make changes in the type of trust that will be receiving benefits after the death of the plan participant; for example, toggling between a conduit trust and an accumulation trust within a specific time frame after the death of the plan owner. It will, therefore, be important to include flexibility in the trust documents, allowing a trust protector or a trustee to make appropriate changes. 

The bottom line here is that virtually every trust now designated to receive retirement plan benefits should be reviewed as soon as possible, given that the new law impacts anyone who dies on or after Jan. 1, 2020.

Charitable Contributions May Be More Powerful. Perhaps the most powerful planning response to the new law is one that actually has been advisable all along. To the extent that part of the overall estate plan is philanthropic, it makes a great deal of sense for the retirement plans to designate as beneficiaries one or more charities (potentially including a private foundation or a donor advised fund as well as public charities) while other, nonretirement assets are used for family members or other noncharitable beneficiaries. 

Any noncharitable disposition of the retirement plan (other than to a surviving spouse and excluding Roth plans and Roth IRAs) not only generates the income tax results discussed here but is also subject to estate tax. Therefore, designating a charitable recipient for regular retirement plan benefits essentially generates a deduction doubly effective because it can offset both taxes. By contrast, if, instead, other resources are used for a charitable legacy while plan assets are left to individuals, taxes would be higher no matter how the plan designation is structured.

As a variation, if the client wishes to benefit individuals during their lives but would want whatever is left of the retirement assets then to pass to charity, the client can create a charitable remainder trust (CRT) and designate it as the beneficiary of the retirement plans. A CRT will not be subject to income tax on receipt of the plan proceeds, although subsequent distributions to the individual beneficiaries of such a trust may carry out some of that income in future years. There are, of course, many details required to make sure that such a plan will achieve the intended result.

Roth Conversion. Yet another potential approach would be to convert IRAs to Roth IRAs. Continued growth inside the Roth IRA remains tax deferred, and unlike a regular IRA or other retirement plan, the ultimate distributions to beneficiaries are not subject to income tax. It is true that the conversion itself generates income tax, but if it is done at a time when the marginal income tax rate of the participant is lower than the expected income tax rate of the trust or other recipient in a future year after the participant’s death and after taking into account the continued tax-free growth inside the Roth IRA and plan during the rest of the participant’s life, this can be a powerful technique in the right circumstances.

Along similar lines, clients going forward may be able to elect to forgo the current income tax benefit of contributing to a qualified plan or IRA while entirely avoiding income tax (to anyone, including themselves) on withdrawal simply by using Roth plans or Roth IRAs from then on. Note that the ability to contribute to a Roth IRA phases out for taxpayers earning more than $206,000 (married filing jointly) or $139,000 (single), but there is no corresponding income limit on electing to contribute to a Roth 401(k) plan instead of a traditional non-Roth plan, assuming that the employer offers both versions.

Use of Life Insurance. Another completely different approach would be to withdraw funds during the participant’s life to the extent permitted without penalty (although subject to income tax) and then invest the proceeds in a life insurance policy, which eventually will pay death benefits without any income tax. If the policy is held in an appropriate insurance trust, there would be no estate tax either, but attention must be paid in order to avoid gift tax in creating such a trust.

Similarly, clients instead can simply use funds that would otherwise be contributed to a retirement plan to pay life insurance premiums. In a sense, this is similar to deciding that future retirement plan contributions will be to a nondeductible Roth plan, but in this case, there might be estate tax savings along with the future income tax savings.