The SECURE Act: The IRA Stretch is NOT Dead!
But Many Clients Will Need to Change Their Estate Plans
The Stretch is not dead; there’s just no more lifetime Stretch. I’m an optimist :)
A retirement plan can be stretched for 10 years at the most. That is, a non-spouse beneficiary (e.g. a child) has to withdraw the entire amount WITHIN 10 YEARS. Technically, there is now only 1 RMD – in year 10.
However, there are exceptions known as an Eligible Designated Beneficiary or “EDB” and below are some of those who can still use their life expectancies to calculate RMDS for the Stretch:
Spouse (full stretch)
Minors/Young Adult Children (partial stretch)
Disabled/Chronically ill (full stretch)
Individual no more than 10 years young than the plan participant (full stretch)
MINORS, YOUNG ADULTS, ADULT KIDS WHO CAN’T HANDLE MONEY & ASSET PROTECTION
As just stated, your clients’ minor kids will qualify as EDBs and thus be eligible to stretch their parent's retirement plan for a portion of their lives.
Example: Your client dies and leaves their IRA to their 5 year old child. That child can use their remaining life expectancy to calculate RMDs for Stretch purposes but ONLY UNTIL 18, the age of majority in SC. At 18, the 10 year rule kicks in and so by the time the child is 28, the entire plan will have to be withdrawn and income taxes paid on those funds.
If left outright to a minor child, the child (child’s conservator) could withdraw from the plan all in one lump sum, incrementally over a period of time or use the minor’s life expectancy, but once 18 THE CHILD GETS FULL CONTROL, WHICH IS WHAT MANY CLIENTS DO NOT WANT.
If instead it’s payable to a “Conduit” trust (a trust that states that the RMD is to be paid to the trust each year and then is REQUIRED to be paid out to the beneficiary that year) and depending on the way the trust is drafted, a similar result could occur with distributions – one lump sum, incrementally or using the minor’s life expectancy. The child can be restricted from getting control at 18, though. The Conduit trust has been for many years the default way of leaving a retirement plan to a minor or young adult to better ensure the Stretch.
But for many trusts, now it DOES NOT MATTER what the trust says about age restrictions and the ability to stretch retirement plans, to some degree.
Many of your clients’ plans will not work the way your clients expected them to.
SCENARIOS TO CONSIDER:
DO (OR COULD) YOUR CLIENTS FALL INTO THESE CATEGORIES?
Child in School
Apparently there is an exception if the child is in higher education WHEN THE CLIENT DIES. Here, the beginning of the 10 year period can be delayed until the child finishes school or turns 26, whichever happens first. But a straightforward reading of the law suggests this does NOT APPLY if the client dies when the child is 18 but HAS NOT BEGUN any higher education.
Example: One child has been in college 6 months and gets to delay the start of the 10 year rule until possibly 26 – so all cashed out by age 36. Another client dies 6 months BEFORE the child intends to start college and the 10 year rule begins then – all cashed out by 28. Seems pretty unfair.
Death of Minor Child
When a minor child (or any EDB) dies, the 10 year period starts REGARDLESS of who the remainder beneficiary is.
Example: Client’s plan creates Conduit trusts at his death for each of his two minor kids – everything in equal shares to the minors, then to the survivor of the two kids. Child 1 is 8 years old and Child 2 is 3. Retirement plan is worth roughly $800,000 so each child is entitled to benefit from $400,000 of the plan. Child 1 takes RMDs each year but 3 years later dies at age 11. So Child 2 now takes Child 1’s share (most client’s estate plans with minors would play out this way).
According to the new law, Child 2 who is now 6, will have to withdraw the original $400,000 that Child 1 was receiving WITHIN 10 YEARS! That is, Child 2 can’t wait until they’re 18 to start the clock FOR WHAT CHILD 1 WAS RECEIVING and so must cash it out by age 16!
A variation of this: Client passes when Child 1 is 19 and in school. Child 1 takes RMDs and finishes school at 22. The 10 year period begins. 4 years later Child 1 dies with the remainder beneficiary, Child 2, being 11. Child 2 now has to cash out Child 1’s share by age 21. Some experts even think Child 1 might have to cash out WITHIN 6 YEARS (the remaining period Child 1 had). Regardless, it’s bad either way!
Stepchildren / Grandchildren / Nieces & Nephews
Stepparents often view their stepchildren as their own kids.
Example: Stepdad dies leaving his significant retirement plan in conduit trust to his 5 year old stepchild, not being concerned about the child getting full control until 28 or possibly later.
Not so fast – the rule for minors ONLY applies to a CLIENT’S minor child; not to stepchildren, grandchildren, nieces, nephews or other minors. Here, the 5 year old has to withdraw it all by the time he’s 15!
Minors CANNOT wait until 18 if they inherit what became an INHERITED IRA prior to 2020.
Example: Client has a $300,000 Inherited IRA from his mom when she died in 2018. Client dies in 2020 naming a Conduit trust for his 3 year old son as beneficiary of his Inherited IRA. The 3 year old child has to withdraw the entire plan within 10 years – all cashed out by age 13!
These scenarios are based on a straightforward reading of the way the law is currently written.
There are so many more scenarios to consider – what if a retirement plan is left to a single trust with MULTIPLE beneficiaries? – but that’s far beyond the scope of this article.
SO WHAT DO WE DO NOW?
As you can see from the examples above, people leaving retirement plans to minors, young adults or immature adults should consider updating their plans.
Conduit Trust: Could Be Really Bad . . .
For non-EDB adult kids with their heads screwed on straight, this is not necessarily a bad idea, still. It’s been somewhat common practice to run a retirement plan through a Conduit trust to better ensure the Stretch and provide asset protection. For these types of beneficiaries I don’t think the trust, as a beneficiary, necessarily must be changed now. Depending on the trust terms, the plan could be withdrawn incrementally over 10 years, thus getting a 10 year Stretch. The plan is still provided more asset protection than it otherwise would have but that’s only for 10 years max. If your goal is to provide more protection, then an accumulation trust is necessary.
Minors / Young Adults / Immature Children
A conduit trust still allows the child to use their own life expectancy for RMD calculations, but again, generally only until age 18 (possibly later). Forcing the plan to be distributed to the child by age 28 may or may not be what the parents want.
Is your client okay with their kid in their 20’s getting control of the client’s entire retirement plan? – Maybe yes, maybe no.
Or, what if one of the scenarios above occurs and a minor child has to cash out $400,000 by the time they’re 12?
Some parents have no issue with their children receiving their inheritance outright at a young age; other parents are far from okay with that. Generally, THE BIGGER THE PLAN, THE BIGGER THE CONCERN.
Additionally, now a MAJOR PROBLEM can occur with a Conduit trust: Remember, once 18, RMDs do not exist anymore for the child; only one final RMD at 28. EVEN IF the trustee finds the child capable and wishes to distribute payouts from the plan to the child incrementally to reduce the tax bill, the trustee may not be able to do so – the TRUST TERMS CONTROL. This is referred to as the CONDUIT TRUST TRAP; any remaining amount must come out of the plan and to the beneficiary in one lump sum – one final RMD. Tax planning is out the window and asset protection is compromised when the final payment comes out.
To get around this issue the trustee must have the DISCRETION to do so. If there’s no discretion, then perhaps a big tax bill in 10 years.
If flexibility is desired, does your client’s plan include that discretion?
So, depending on your client’s concerns, a Conduit Trust may be very inappropriate for minors, young adults or immature children. At the very least, it should be reviewed.
Accumulation Trust: Who Should Consider It?
If you want to allow a mature child the opportunity to receive better asset protection of the plan, then an accumulation is the way to go. It can even be drafted to give the child the discretion to withdraw any payouts from trust or allow them to accumulate: Leave them in if the child has or suspects that creditor issues are or will be a problem (higher tax rates) or take them out if no creditor concerns (taxed at child’s individual rate). It’s a balance of tax rates (kept in trust = high tax rates) against asset protection. However, it doesn’t matter how low the lowest tax rate is if ALL of the payout will go to the creditor. Don’t let the tax tail wag the dog!
If the client’s child is ALREADY in the highest or a high tax bracket, then what do the tax rates matter? Leave it to the kid outright and he’s hit with high taxes. Leave it in trust for him and it's STILL subject to high tax rates. So, why not leave it in trust where it's better protected and the kid can even have pretty much full control under SC law?
Or, maybe your client’s child is not in a high tax bracket now but any inheritance, including retirement and non-retirement plan assets, will only push them further up the tax ladder. Accumulation trusts can make a lot of sense in these contexts.
Minors / Young Adults / Immature Children
If you want to better restrict a beneficiary from being able to get control of funds, then think Accumulation trust because any payouts to the trust are NOT REQUIRED to be paid out to the child. But as we know already, if a plan is accumulated in trust then high tax rates.
For many of your clients, it’s going to come down to what is more important to them: CONTROL or TAXES.
Multi-Generational Spray Trust
Any number divided by a large number results in a smaller number. This holds true with distributions involving retirement plans.
While the distributions must be made within 10 years, by distributing the retirement plan to an accumulation trust with multiple beneficiaries (children, grandchildren, nephews, nieces, etc) at the same time over the 10-year period, the distributions received BY EACH BENEFICIARY WILL BE SMALLER, and the resulting tax liability per beneficiary will be reduced.
Since the new rule accelerates taxes to a beneficiary based on 10 years, it can make a lot of sense to provide discretion in the trust to allow the IRA funds to be disclaimed from one generation to the next.
If your client is in a high tax bracket and doesn’t need the plan, they can disclaim some or all of the plan so the plan ends up with their kids who are likely in a much lower tax bracket.
Charitable Remainder Trust (CRT)
This technique, more than any other, may allow you to get as much of a Stretch as possible.
For your charitably inclined clients, a CRT would allow them to name their kids to receive an income stream from the retirement plan for a period of time, with the remainder going to a charity named in the trust.
When the trust is created, it must be designed so that the charity will ultimately get at least 10 percent of the value of the initial contribution. The payouts to the kids can be for a term of years, a single life, joint lives, or multiple lives. Distributions from the retirement plan to the CRT are not taxed but distributions from the CRT to the kids will be subject to income tax. However, DISTRIBUTIONS TO THE KIDS WILL BE SMALLER and therefore subject to less income tax liability.
Some commentators have suggested just buying more life insurance. That’s one way to go and might make sense but I’ll let you run the numbers and discuss with your clients.
If your client ALREADY has a policy in place and intends to keep it, funneling those proceeds to the trust to pay the taxes is certainly an option worth considering.
An obvious response to this new law will be increased Roth conversions for the IRA owner. This can especially make sense if your client is in a lower tax bracket than trust tax brackets. He can take the tax hit at a lower rate than what his future beneficiaries will encounter. There are trade-offs as I’m sure you’re aware of, though.
WORKING TOGETHER – REVIEW YOUR CLIENTS' PLANS !
Inherited retirement plans will not provide the same benefits post-SECURE Act. By working together, we can help our clients navigate the new rules and implement strategies that make sense for them. I’m hopeful that in time new strategies will emerge that will better address the issues we are now presented with. We will let you know as soon as we know. In any event, I encourage you to review your client’s estate plans to see if it needs updating, possibly incorporating one or more of the above solutions.
Contact Hamrick Law to discuss how we can tackle the SECURE Act together!
Disclaimer: Certain assumptions were made throughout this article and we are still waiting on the IRS to clarify its position on some of the scenarios above, which could take quite some time. However, all we can go on at this time is a straightforward reading of the new law. As always, you should not act upon this information without first seeking qualified professional counsel on the specific matter.