The Secure Act: They Changed the Rules in the Middle of the Game

The NBA regular season consists of 82 games.  As of the All-Star break, most teams have played about 50 games, and each of the teams with the best records are about to gear up for a run at a championship. But imagine that the Commissioner comes out with a pronouncement today that, for the remaining games of this season, because of the perceived “success” of the new scoring format introduced in this year’s All-Star Game, with a 4th quarter, and game-winner, determined based on a targeted score tied to the score totals of the first three quarters, this will now be the scoring format for all of the remaining games of the regular season. And, just for good measure, because today’s NBA game is now perceived to be too heavily weighted toward slam dunks and three-point shots, there will be two additional changes: the height of the basket will be raised from 10 feet to 12 feet, and the three-point line will be extended to 30 feet from the basket[1]. How might you think the players will react to such news? 

As extreme as this hypothetical sounds, the changes made to the rules governing the disposition of qualified retirement plans at the death of the account owner, made part of the recently enacted budget bill signed into law by President Trump on December 20, 2019, commonly called the “Secure Act,” are considered by much of the retirement planning community to be no less extreme. Some commentators have gone so far as to say, “Congress hates children simply.” Upon closer examination of the changes that have been made to the law, and the identity of the persons who likely will bear the major brunt of these changes, sadly, that’s not an unfair assessment.  

This article is our assessment of the more salient features of the Secure Act, with the primary focus on the new paradigm for planning when children are the desired beneficiaries of retirement plans, and one special note concerning naming a trust for the benefit of a spouse as the beneficiary of plan assets. It is not intended to be a comprehensive review of all the new changes in the law embodied in the Secure Act.

For over 30 years (for those fortunate enough both (i) to have been able to save for retirement, and (ii) upon attaining retirement age find themselves in a financial position not to need to draw down on the accumulated retirement fund), the go-to estate plan has been to take only the minimum distributions mandated by statute, and leave the balance to “designated beneficiaries” [not an estate, or a charity, or a trust that was not a “see-through trust”]. For these designated beneficiaries, payments were able to be drawn over the trust beneficiary’s life expectancy. That is, payments of the inherited IRA or other retirement plans could be “stretched out” such that the plan could remain in its tax-deferred status for years or even decades after the death of the account owner. With the life expectancy of a 45-year-old child being 38.8 years, or that of a grandchild or great-grandchild being potentially as long as 80 years, this estate plan was understandably very popular.

In essence, the Secure Act has changed the rules in the middle of the game and has eliminated this planning strategy for most people. The new rules are effective for those persons owning retirement plans who die after January 1, 2020. The new rules do not change the definition of a designated beneficiary. The new rules do not change the definition of a see-through trust. What has changed are the rules that govern how long a period of time over which payments can be stretched out, after the death of an account owner, to almost every category of designated beneficiary.  The most significant of these new rules is that all accrued benefits must be paid out, after the death of the account owner, over a term of not more than ten (10) years. This is to be contrasted with the prior rule, which offered the opportunity to have benefits paid out over a period of time measured by the life expectancy of the designated beneficiarY. Comparing this new rule for the 45-year old child beneficiary mentioned above, instead of a 38.8-year life expectancy payout period, the entire plan account now must be withdrawn before that child attains age 55.

The Secure Act has carved out an exception to the 10-year payout rule for five (5) distinct beneficiaries, each now called an “eligible designated beneficiary” (“EDB”). These five EDB’s are as follows:

All five of these EDB’s still qualify for a life expectancy payout. But the rules for each of these EDB’s also come with a twist. Upon the death of a surviving spouse, the exception ceases to apply, and a 10-year payout applies. Upon a minor child turning the age of majority, the exception ceases to apply, and a 10-year payout applies. Upon the death of a disabled beneficiary, the exception ceases to apply, and a 10-year payout applies. Upon the death of the chronically ill beneficiary, the exception ceases to apply, and a 10-year payout applies. And upon the death of the not more than ten years younger beneficiary, the exception ceases to apply, and a 10-year payout applies.  [Query: what happens if a chronically ill individual is no longer ill, or a disabled individual is no longer disabled.]

Whether under the old rules or the new rules, a surviving spouse is accorded very favorable treatment when it comes to inheriting retirement plan assets, including having options not available to other eligible beneficiaries, including (i) to roll over the inherited benefits to his/her own IRA or (ii) to elect to treat an inherited benefit as his/her own IRA.

For some, there is still concern about leaving any asset outright to a spouse and/or there is a desire to assure that whatever assets may not be needed or spent during the surviving spouse’s lifetime will be left to specific third persons. Thus, the use of trusts is mandated. There are at least three different types of trusts that qualify for Federal and/or state estate and/or inheritance tax exemptions, but only one of which allows the first spouse to control the ultimate disposition of the assets upon the death of the second spouse.

Any type of trust for the benefit of a surviving spouse can be designated as the beneficiary of retirement plan assets, but only if the trust is a “conduit trust” will a surviving spouse be entitled to all the minimum distribution benefits of a surviving spouse under the IRS’s rules, because the spouse will be considered the sole beneficiary of the plan. A spousal conduit trust will also benefit from the new rules on the beginning date by which required minimum distributions (“RMDs”) must begin, which is now the year the deceased participant would have reached age 72, as opposed to age 70-1/2.  This type of trust will continue to work just fine under the new rules, but only during the spouse’s life. Upon the spouse’s death, the new 10-year rule manifests itself.

However, what is important to note here is that not every see-through trust will be a conduit trust. There are two kinds of see-through trusts. The second one is an “accumulation trust.” If an accumulation trust for a surviving spouse is named the beneficiary of a retirement plan, it will not be eligible for the life expectancy payout, even if the spouse is sole life beneficiary. A common example of an accumulation trust, but which at first blush may not be thought to be one, is an “income only” marital trust or QTIP trust. Even though the spouse of a QTIP trust must be entitled to all of the income of the trust paid out currently because there will be a residuary beneficiary to receive the remaining principal of the QTIP trust at the spouse’s death, under the peculiar rules of see-through trusts, this type of trust would have to cash out all the benefits within ten years after the participant’s death.

Planning for minor children in the context of retirement plan assets has always been a struggle between the competing interests of avoiding the acceleration of the taxation of benefits and controlling the actual distribution of benefits to the child (the child’s control of the benefits). Under the pre-Secure Act rules, when a see-through trust could be created for a child, which could qualify for a life expectancy payout, the planning was not that difficult, because the minimum distributions were relatively small; and even if that RMD had to be distributed out of the trust to the child, most persons did not mind. And for those circumstances when even the RMD’s were considered more than an amount a client felt comfortable in making available to a child, the trust could be designed to allow benefits to be accumulated inside the trust as withdrawn, which would then be distributed out of the trust to the child in the discretion of the trustee in accordance with whatever standard of distribution the parent thought best; e.g., “support in reasonable comfort” or “best interest and general welfare,” until the child attained a more mature age— 35, 40, or 45.

However, under the new rules under the Secure Act, the entitlement to a life expectancy payout does not last for the child’s entire life. Instead, it lasts only until the child attains the age of majority (which is not so clear), at which point in time the trust becomes subject to the 10-year rule. Thus, all benefits would have to be distributed outright to the minor, if the minor is named as outright beneficiary, or if a conduit trust for the child is named beneficiary, within ten years after the child attained majority. This may or may not be what the parent wants. Best (worst) case scenario is a child receiving the entire balance in the retirement plan at age 28, or 31, or 36. [2]  Other important points and considerations about minor children as designated beneficiaries include the following: (i)  if the minor dies prior to attaining majority, the 10-year rule applies at that time; (ii) the life expectancy payout (until age of majority) applies only to the child of the account owner; i.e., not to grandchildren or any other children – nieces and nephews, etc. 

As first stated above, many parents (and others seeking to benefit young children) will face this planning dilemma: They will prefer not to give control to a very young child but also would like to avoid having distributions taxable to a trust at the highest marginal income tax rate.[3] The planning technique most commonly used prior to the Secure Act was a conduit trust for the young beneficiary, with its anticipated life expectancy payout and concomitant small RMD’s. But under the new rules under the Secure Act, this type of trust is not likely to qualify as an EDB for the same reasons described above on why a QTIP trust may no longer qualify as an EDB – that being, that there will typically be remainder beneficiaries of that trust upon the death of the child.  Thus, at best, this type of trust for the benefit of a minor child will have to cash out the entire plan benefit within ten years after the date of death of the account owner, with a slightly longer payout being available with a trust for the account owner’s own child, which can delay the full withdrawal until ten years after the child’s attaining majority. Therefore, in most situations after 2020, account owners are going to be forced to reconcile how the income taxes due by the beneficiary (individual or trust) attributable to his or her receipt of retirement plan distributions are going to be paid, and worry less about deferral of those taxes.  

The Secure Act is a real game-changer in the law regarding how tax-deferred retirement accounts will be taxed after the death of the account owner. The rules have changed for almost all designated beneficiaries, with the hardest hit being children of an account owner, and even harder hit being the minor children of an account owner. Accordingly, it is important that all our readers of this Newsletter review the beneficiary designations of all your retirement accounts in order to coordinate both your intended distribution schemes and the income tax consequences of same.  Please do not hesitate to contact us to discuss how these changes affect you and what options may be available for updating your estate plan.