The Setting Every Community Up for Retirement Enhancement (SECURE) Act accelerated income taxation on inherited retirement accounts dramatically. This was huge news for the estate and financial planning worlds in early 2020—until it wasn't. This past year was full of strange and dramatic turns, many of which have overshadowed this seismic shift in retirement account taxation under the SECURE Act. It is with some pleasure that I turn back to a topic that is pre-COVID that now feels almost normal, despite being such a dramatic change.    

Under the old law (prior to January 1, 2020), individuals inheriting a retirement account on the owner's death were able to "stretch" the income tax on the account over their lifetime. For example, Nick dies and leaves a $1,000,000 retirement account to his daughter, Lilah, who for purposes of this example will be 21 years of age. (She's really 2, but when she's constantly telling me "no," she seems closer to 21!) The IRS gives 21- year-old Lilah a life expectancy of 62.1 years. Therefore, in the first year after my death, Lilah would be required to take out 1/62.1 of the account (approximately, $16,103) and report that amount as taxable income. Each year she ages, her life expectancy decreases and the required distribution increases until the account is either fully distributed or she dies. If she dies before full distribution, then her heirs continued to realize the income tax at the same rate as Lilah would have (i.e., using her hypothetical life expectancy under the IRS rules) until the account is fully distributed. This ability to "stretch out" the income tax on retirement accounts over a lifetime was one of the major benefits to saving through a retirement account prior to January 1, 2020.

The SECURE Act largely removed the stretch; the general new rule is the 10-year rule. Using the same example as above, Lilah inherits the $1,000,000 retirement account. Now, because the SECURE Act did away with her annual "required minimum distributions," she will not have to receive and report annual taxable income from the retirement account. Instead, she must fully distribute the retirement account at any time within 10 years, which is a significant acceleration in realizing the applicable income tax when compared to the 62.1 years available under the old rules.

Perhaps the most important consequence of this change relates to a specific trust type common to estate planning. Some estate plans create a trust to receive retirement accounts and pay the retirement account distributions to the beneficiary over her lifetime. These "conduit trusts" were designed to prevent the beneficiary from simply cashing in an inherited retirement account and realizing all of the income tax at once. Instead, the conduit trust made it mandatory under the old rules that the retirement account enjoy the benefit of the lifetime stretch and provide a lifetime income stream for the beneficiary. 

The problem is that the law changed to eliminate the stretch, but the terms of the trust do not automatically update with the law. A retirement account payable to the same conduit trust, providing only required minimum distributions to the beneficiary, would not receive any distributions for 10 years (leaving the beneficiary high and dry) and then distribute the entire amount to the beneficiary in one giant tax event after 10 years. This result is clearly contrary to purpose of setting up such a trust under the old rules. Therefore, it is very important to review estate plans with trusts that include retirement savings to understand the consequences under the new SECURE Act rules.

There are some exceptions to the new 10-year payout rule to note, but they are limited in scope. First, a spouse may still inherit a deceased spouse's retirement account with the special rules provided for a “spousal rollover.” This favorable treatment allows for the surviving spouse to treat the retirement account as if it were always her own. Thus, contributions can still be made to the account by the surviving spouse for her lifetime—the SECURE Act now has no age limit on contributions—and the surviving spouse need only take required minimum distributions if older than age 72. (This age was also raised from its previous 70.5 by the SECURE Act.)

Another important carve-out relates to disabled and chronically ill beneficiaries. Individuals that fall under these categories as defined by the IRS are entitled to the old stretch rules. The stretch is also still available to supplemental needs trusts for the benefit of a disabled or chronically ill individual.

In light of these changes, there are some planning options to consider. First and foremost, it is important to review existing trusts, or wills with trusts, to understand the new income tax consequences. Second, some are considering Roth conversions so that when their beneficiaries distribute the retirement account(s) within 10 years, the distribution from the Roth will not be taxable. Third, others are using retirement assets to purchase life insurance, which is inherited free of income tax by beneficiaries. 

The last option that I will cover is the creation of a charitable remainder trust to receive a retirement account on death. This trust is designed to pay a certain amount to an individual beneficiary for a period of years, or for their lifetime, and distribute the remainder to charity on the termination of the trust. In this case, the retirement account is fully distributed to the charitable remainder trust; however, no income tax is realized because the trust has a charitable beneficiary (and satisfies some other technical requirements). The distributions to the individual beneficiary are taxable income to the beneficiary when received; the charity receives whatever is left over when the trust ends free of income tax. In the event you have charitable intentions, this can be an excellent strategy to accomplish quality income tax planning with your retirement accounts, support the family, and benefit charity all at the same time.

Nicholas S. Proukou, Esq. is an Associate in the firm Family Wealth & Estate Planning Department.  He can be reached at 585-987-2866 or Nproukou@woodsoviatt.com.