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The SECURE ACT: Goodbye to Lifetime Payouts for Many Beneficiaries

By the time many people reach retirement age, a significant portion of their retirement “nest egg” is kept in an IRA, employer sponsored retirement plan such as a 401(k), or other similar plan. For many years, federal tax laws have incentivized workers to put money into these accounts because the contributions give the participant a tax deduction. It of course makes sense that workers would sock away as much money as possible into an account of this sort. For the purposes of this article, these accounts will be referred to as an “IRA,” even though other types are treated the same way.

It used to be that folks could pass down an IRA to the next generation, either outright to the beneficiaries of their choice (very often their children) or to a trust. If a participant left the account outright to their children, each child had a choice to either take a lump sum of the funds or turn their portion into a “stretch” account of their own, where they could take distributions for the rest of their lifetime. Choosing the “stretch” option meant that the child would receive significantly more money over time, because the funds were able to continue to grow tax-free while in the account. The lump sum choice meant a larger portion of the funds would go toward paying taxes. Many people have relied on the idea that their life savings could continue on for their children in a stretch IRA, by doing nothing other than naming designated beneficiaries on the account (assuming that the beneficiaries would make the wise choice of a stretch plan).

Just before the end of 2019, Congress passed legislation called the SECURE ACT that dramatically changes the way that people can pass down their IRA. Now, the outright beneficiaries who can choose the stretch option are limited to only 5 categories. These are called “eligible designated beneficiaries” (“EDB”) and include 1) the participant’s spouse; 2) the participant’s minor child; 3) a disabled beneficiary; 4) a chronically ill beneficiary; or 5) a beneficiary who is less than 10 years younger than the participant.

If a beneficiary does not fit into one of the 5 EDB categories, he or she must withdraw the entire inherited portion of the account within 10 years. All withdrawals are subject to income tax. The effect of this is, when a beneficiary is required to take out certain amounts of money, that money is added to his or her taxable income. If the withdrawal amount is significant, it could move the beneficiary into a higher tax bracket. Of course, the higher the tax bracket, the less money the beneficiary actually gets to keep.

Sometimes people are not comfortable with the idea of a beneficiary having full access to their inheritance all at once. If a person’s top priority is making sure that a given beneficiary does not have access to large sums of money, a certain type of trust can be used to accomplish this. In this type of plan, the IRA would still have to be paid out pursuant to the new rules, but those funds would remain in the trust instead of passing through directly to the beneficiary. There is a big cost to this approach: the funds are taxed at the trust income tax rate (which is almost always higher than an individual income tax rate). So, while a trust can prevent a beneficiary from spending the funds all at once, a big chunk of the funds will have to be used to pay the tax bill.

Another big change from the SECURE Act is the timing of the distributions. Before the SECURE Act, a beneficiary using the “stretch” option would receive distributions based on their life expectancy, and was required to take a certain amount out each year. Now, as explained above, the total distribution must be completed in 10 years, but the beneficiary can take the entire distribution in year 1, in year 10 or however he or she wants to receive the distribution within those 10 years.

The SECURE Act has given us a few perks: mainly that minimum distributions do not have to start until age 72, instead of at age 70½. What stands out to us as estate planners, though, is the effect that the new law will have on middle class people with large IRAs. If passing on the most amount of money possible to children or other beneficiaries is a priority, many folks will need to re-strategize to reach their goals.

 

*This post was written based only on the legislation passed in 2019 and early commentary relating to it; future regulations could clarify or change the interpretations discussed here. Stay tuned as we learn more.