By Patrice M. Ticknor and Harvey B. Wallace II
The Secure Act was passed by Congress in December 2019. A major goal of the Act was to raise revenue by accelerating tax on Individual Retirement Accounts (IRAs) by changing the pay-out rules for most non-spouse beneficiaries of inherited IRAs. Through the Secure Act, Congress tapped the estimated 30 million IRAs owned by taxpayers, many of whom were planning to transfer the wealth they contained at their deaths to their children in a tax-advantaged manner.
Prior to 2020, most non-spouse beneficiaries of an inherited IRA could “stretch out” IRA distributions over their lifetimes. In the common scenario, the account owner named his or her child as beneficiary and the “stretch out” feature enabled the much younger beneficiary to allow the IRA to grow tax-free over his or her longer life expectancy by taking only the relatively small required minimum distributions (RMDs) from the IRA annually. In the case of traditional IRAs, income-tax would be paid by the beneficiary on these annual small pay-outs over that long time period. This was very advantageous since the entire value of an IRA account is treated as ordinary income to the taxpayer.
Those non-spouse beneficiaries who inherit a traditional IRA in 2020 or later must now take a total pay-out of the account by the end of the tenth year after the account owner’s death. Although withdrawals are not required until the end of the tenth year, distributions from the IRA may be taken in installment fashion over the 10 (or 11) taxable years following the IRA account owner’s death. Whether withdrawn in installments over the 10 year period or in a lump sum at the end of the 10 year period, income tax must be paid on the entire amount withdrawn when withdrawn. As a result, the beneficiary will be making larger income tax payments over a shorter time period and the tax-free growth of the account will be limited to only 10 years.
Unlike traditional IRAs, distributions from Roth IRAs are not subject to income tax when paid out because the account owner paid the income tax on the amount contributed to the IRA when that amount was contributed (or converted from a traditional IRA to a Roth IRA). However, Roth IRAs now are also subject to the 10 year pay-out requirement. Like the traditional IRA, tax-free growth on a Roth IRA will be limited to a maximum of 10 years after the account owner’s death because any further income earned by the beneficiary on the paid-out proceeds will be subject to income tax in the tax year earned.
If an account owner’s IRA is not large and will be used-up during his or her lifetime, the loss of the “stretch” will not be a problem. However, if the “stretch” feature was a significant aspect of an account owner’s estate plan, he or she should revisit the plan to determine whether changes should be made to carryout his or her estate planning goals in the most income tax efficient manner possible.
This is particularly true if the account owner desires to name a trust as the IRA beneficiary. Trust income tax rates are “compressed” –that is, higher income tax rates apply at much lower income levels for trusts than for individuals. Therefore, Roth IRAs and Traditional IRAs should be left to different types of trusts to minimize income taxes.
Since conduit trusts require all distributions received from an inherited IRA to be distributed to trust beneficiaries, those IRA distributions would be taxed at the beneficiary’s lower tax rate and not at the trust’s higher tax rate over the 10 year pay-out period. In contrast, a Roth IRA could be left to a continuing trust since those funds are not subject to further income tax at the higher trust tax rates when paid out. However, any income earned on the proceeds of the account during the continuance of the trust would be subject to the higher trust income tax rates. Therefore, if the funds were not immediately needed, the pay-out of a tax exempt Roth IRA could be deferred until the end of the 10 year pay-out period.
The Secure Act also created a new class of “eligible designated beneficiaries” (“EDBs”) who are exempt from the 10 year pay-out requirement. EDBs include: spouses; minor children (until they reach the age of majority or age 26 if in school); individuals with disabilities; chronically ill individuals; individuals who are not more than 10 years younger than the IRA owner; and any designated beneficiary (including qualifying trusts) who inherited the IRA prior to 2020.
The above only summarizes the Act and the strategies that could be used to minimize its detrimental income tax consequences. Determining appropriate actions in light of the Act takes a thorough understanding of its provisions and a comprehensive analysis of the account owner’s estate planning goals and current documents, the amounts and types of IRAs involved, the ages and situations of the intended beneficiaries, and other relevant circumstances.