At the end of 2019, the federal “SECURE Act” became law. The acronym stands for “Setting Every Community Up for Retirement Enhancement.” It created more flexibility for more workers to be able to contribute to tax-deferred, retirement accounts, such as IRAs, 401(k)s or 403(b)s, which is a good thing. The new law also changed the rules on “inherited” retirement assets, that working and retired Americans often leave to spouses, children and grandchildren. These assets can be substantial, and the changes could have unintended tax consequences for the new owners.
In addition to other changes, the SECURE Act limits the ability for most folks who inherit such accounts to “stretch” out the required payments from the account over the new owner’s life expectancy. Now, most folks who inherit such retirement accounts (“traditional,” not “Roth,” IRAs, and 401(k) and 403(b) plans) will need to withdraw all the assets in ten years or less, starting with accounts inherited from folks who die in 2020 and going forward. The exceptions are for: (1) surviving spouses, (2) minor children,[i] (3) disabled or chronically ill individuals, as defined in the Internal Revenue Code, and (4) individuals not more than ten years younger than the original account owner.
What does this mean for folks with such retirement plans who want to name people to inherit them? First, it is important for everyone with such a retirement account to review who their currently-listed beneficiaries are, both primary and contingent. This can be done by contacting the company holding the account, either online or by telephone. Second, if those individuals are not the desired beneficiaries, or if there are other reasons to revise the designation of beneficiaries, that should be done promptly.
If anyone has already listed a Trust as beneficiary of such a retirement account, that should be reviewed with an estate planning attorney. Trusts that would have functioned well with the ability to stretch out the distributions from the account, which would be taxable income, may now result in much more tax being owed due to the shorter distribution period. To make it worse, the income tax rates on income (such as retirement fund distributions) retained in a Trust or Estate are steeply graduated, and reach 37% when income in a year is over $12,750. If a Trust requires that all income must be distributed out to beneficiaries each year, this may result in excessive distributions, especially to young beneficiaries. On the other hand, if distributions are limited, and the income is retained in the Trust, it can result in much of the IRA or other retirement account going to the IRS. It is possible to craft an arrangement that will address these concerns and meet the goals of the account owner, in consultation with an estate planning attorney.
What if no beneficiary is listed on a retirement account? In that case, the default beneficiary is the person’s Estate when they die. This means the asset must pass through the Probate Court process, and be administered as part of the other assets of the deceased person. If a retirement account is titled in an Estate, the income from a 1/10, annual distribution to the Estate could well top $12,750, triggering income taxes owed by the Estate at the same high rates as for a Trust: 37%. Generally, it is better to name individuals, or a Trust designed to hold retirement assets, as beneficiaries.
What if a person dies without revising their Trust to handle retirement accounts that need to be distributed in ten years? There are some maneuvers that Trust & Estate attorneys can do to distribute retirement accounts, or portions of them, intact to beneficiaries of Trusts or Estates, if the accounts wind up in an Estate, or in a Trust that is not recognized by the IRS as a “qualified beneficiary.” As with many things involving the IRS, timing is key. If you face this situation in 2020 or later, speak with an attorney about your options.
Bottom line: do not delay in updating your beneficiary designations for your retirement accounts, and if a family member passes away, in 2020 or later, without updating theirs, do not delay in seeking legal advice on your options for handling the situation! Few people mean to name Uncle Sam as the beneficiary of their retirement accounts, but if they are not paying attention, Uncle Sam could get a 37% slice of the account.
[i] It should be noted that minor children cannot take ownership of retirement accounts directly. A guardianship, under supervision of the Probate Court, would need to be set up, leading to complexity and costs. At age 18, the minor would have outright ownership of the entire account – not always a wise thing! Naming a Trust for the benefit of the minor would address that issue, but creating the Trust and doing the beneficiary designation are both tricky and experienced counsel should assist.