The Secure Act or THE SETTING EVERY COMMUNITY UP FOR RETIREMENT ENHANCEMENT ACT OF 2019  was passed in late-December and is effective as of January 1, 2020.

In our last newsletter we talked about retirement distributions. We will now look at how the Secure Act will affect beneficiaries and what we can do to work around the distribution timing.

The bad news is that It accelerates the timing of when most beneficiaries must take distributions from their IRA or retirement plans after they die. This is the painful part of the Secure Act. It doesn’t necessarily increase the tax they’ll pay, but it means they’ll have to pay it sooner in most circumstances.

Under the Secure Act, most people designated as beneficiaries of IRAs and retirement plans of people dying in 2020 and beyond must take all distributions from the plan by the end of the 10th year after the death of the plan Participant. Prior to the Secure Act, the beneficiary would have been required to take distributions over their own life expectancy, which could have been many decades, depending on the age of the beneficiary at the Participant’s death. So, this substantially accelerates distributions for the typical beneficiary. Some beneficiaries are considered “eligible” beneficiaries and don’t face the 10-year rule, but the old rules continue to apply.

Eligible beneficiaries are:

• The spouse of the plan Participant. Just like under the old rules, the spouse can take it as an inherited IRA using their own life expectancy or can choose to roll it over into their own IRA.

 

• A child of the Participant under the age of majority (typically 18). There are two caveats here. First, it must be a child of the Participant, not just any minor child. Second, once the child reaches the age of majority, the 10-year rule applies at that time.

 

• A person who is medically disabled or chronically ill.

 

• A person who is less than 10 years younger than the Participant.

So let’s say that the beneficiary doesn’t meet the list of exceptions to the rule and they want to stretch the payout’s beyond the 10 years in order to save paying more taxes.  There are a few answers to this problem, but neither or ideal.

• The first is a simple strategy, to “Roth” the retirement assets while they are alive. When you convert their IRA to a Roth IRA, they pay income tax on the assets upon conversion. After that, they never have to take distributions during their  lifetime. When you or your beneficiaries take distributions, they’ll be free of income tax, including any growth on the assets. This is because you’ve already paid the income tax due to the Roth conversion. The Roth strategy avoids being taxed upon withdrawal because the withdrawal of the assets doesn’t impact the beneficiary’s taxable income because a Roth IRA is tax-free upon distribution.

 

• After the Secure Act, your beneficiaries will still be subject to the 10-year rule (unless they fall under the list of exceptions). But, they could wait until the end of the 10-year period and take the entire balance out at that time. This would allow the assets to grow free from income tax for the longest possible period. Without a Roth conversion, the beneficiaries would likely need to take them over several years to minimize the impact of taking the retirement assets into income and driving the beneficiary into a higher marginal income tax bracket.

 

• The more complex strategy is having a Charitable Remainder Trust (“CRT”) as the beneficiary of the IRA or retirement plan. A CRT itself is a tax-exempt entity but distributions to the non-charitable beneficiary carry out the income tax characteristics of income earned by the CRT. The IRA would payout to the CRT within 5 years of the Participant’s death, bringing taxable income to the CRT. But, as a tax-exempt entity, the CRT itself would pay no income tax on the distributions from the IRA.

However, the CRT has a non-charitable beneficiary, like the Participant’s adult son or daughter, and a charitable remainder beneficiary. In other words, the CRT could payout during the term of the CRT, perhaps over 20 years, to the non-charitable beneficiary. For example, it could payout 5% of the CRT’s assets each year for 20 years. As that distribution is paid out to the non-charitable beneficiary, they’d pay the income tax carried out by the distributions from the CRT. Whatever is left after the term of the CRT (20 years in our example), would go to the charitable remainder beneficiary. The tax-exempt nature of a CRT allows for a much longer deferral of the income taxation than the 10-year rule of the Secure Act itself would allow. This additional deferral is due to the nature of the CRT itself.

But, a CRT has certain strict rules and tests. At least 10% of the actuarial value of the CRT must go to charity. At least 5% must go each year to the non-charitable beneficiary. There is overhead with a CRT as it requires annual tax returns and other compliance. A CRT may be a great solution for those with a large IRA or retirement plan who want to defer income taxation for their beneficiary as much as possible and who are charitably inclined.