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How SECURE Are Your Finances?

Dan Rahill, Managing Director, Wintrust Wealth Services

The SECURE Act, signed into law at the end of 2019, significantly changes retirement plan distribution rules, affecting everything from required minimum distributions (RMDs) to inheritance and estate planning. As a result, investors with IRAs and retirement plans need to revisit—and maybe reconsider—beneficiary designations, estate plans, and trust provisions.

Prior to the Act, a taxpayer who inherited a retirement account could defer the income taxes and extend the period of tax-free growth by taking distributions from the account as slowly as possible throughout their lifetime. But these inherited accounts, generally referred to as “stretch IRAs,” won’t stretch nearly as far moving forward.

Under the SECURE Act, taxpayers who inherit traditional and Roth IRAs, and similar retirement plan accounts, will likely have to draw down account balances and pay taxes on the income much sooner than previously expected thanks to a new “10-year rule.”

How Far Can You Stretch?

Putting the 10-year rule in practice, non-spouse designated beneficiaries of IRAs are now required to take distributions over just 10 years instead of over their lifetimes. However, this provision is not retroactive, meaning it’s generally only effective for beneficiaries inheriting retirement accounts after Dec. 31, 2019.

Making matters somewhat more complex, the SECURE Act changes the treatment of the two preexisting categories of designated beneficiaries and adds a third “eligible designated beneficiaries” category. Under the new law, eligible designated beneficiaries are the only beneficiaries who can stretch retirement account distributions beyond 10 years. Who qualifies as an eligible designated beneficiary?

  • Surviving spouses of participants
  • Minor children of participants (Other minors, such as minor grandchildren, do not qualify)
  • Disabled individuals
  • Chronically ill individuals
  • Individuals who are not more than 10 years younger than participants.  

One caveat worth noting here is minor child must begin distributions that deplete inherited retirement accounts within 10 years once reaching majority age. And, while the SECURE Act does not change the definition of a designated beneficiary—meaning all individuals and “see-through” trusts remain designated beneficiaries—under the new rules, all designated beneficiaries (who are not eligible designated beneficiaries) must also draw down inherited retirement account balances within 10 years. 

The SECURE Act also did not make any direct changes to non-designated beneficiary rules, which impact charities, estates, and “non-see-through” trusts. So, non-designated beneficiaries are required to distribute all inherited retirement account assets over five years if the owner dies prior to their RMDs beginning, or over the decedent’s remaining single life expectancy (had they lived) if distributions had started before death.

Reconsidering the ‘Right’ Beneficiary

Considering the new 10-year limitation, retirement account owners should revisit who their beneficiaries are if their intentions are to defer plan distributions for as long as possible. Only spouses, disabled and chronically ill individuals, individuals not more than 10 years younger, and minor children of the participant (until the age of majority) are not subject to the 10-year rule.

For example, an owner may want to designate their surviving spouse for a larger portion of the distribution upon death, and then the surviving spouse can later name a non-spouse beneficiary of the account. This would defer the beginning of the 10-year distribution for the lifetime of the surviving spouse, who would mostly likely take lesser lifetime annual distributions.

To Roth or Not to Roth

In addition to revisiting beneficiary designations, retirement account owners should also consider converting traditional IRAs into Roth IRAs, which can be inherited tax-free. A Roth conversion involves transferring money from a traditional IRA or other retirement plan to a Roth IRA. Conversions are a taxable event, triggering income tax at the time of conversion, but spreading the converted amounts across the next several tax years allows taxpayers to capitalize on temporarily lowered income tax rates set to expire in 2026. The benefit is that once the assets are inside the Roth IRA, future withdrawals are tax-free and there are no RMDs.

In my experience, Roth conversions make the most sense if the IRA or retirement account is intended for heirs who may inherit the account in their peak earning years and be in a tax bracket as least as high as the account owner’s. After conversion, heirs will not owe any tax on distributions and the entire account withdrawal can be deferred until the end of year 10. This strategy allows the beneficiary’s account to grow tax-free for an additional 10 years after inheritance.

Ideal timing for a Roth conversion is often after retirement but before RMDs begin. This is typically when the taxpayer is in a lower tax bracket. To minimize the amount of taxes paid during conversion, taxpayers could consider spreading the conversion out over several years to ensure they stay within certain (i.e., lower) tax brackets.

For example, a married couple filing jointly would want to keep their taxable income below $326,600 to stay in a 24 percent or lower tax bracket. If their taxable income were to rise to $326,600 to $414,700, they would be taxed at a rate of 32 percent and 35 percent if their income rose to $414,700 to $622,050. Finally, taxable income above $622,050 is taxed at the highest rate of 37 percent, which would correspondingly reduce the benefit of the Roth conversion.

It’s important to emphasize that today’s lower tax brackets are only scheduled to remain in effect until 2026 and will rise to higher pre-2018 rates barring another tax law change. Roth conversions should therefore be considered now to take advantage of current tax rates.  

Streaming Income?

Charitable remainder trusts (CRTs) are often established to generate income for the grantor over their remaining life. This generally involves donating appreciated investments to a trust to avoid capital gains tax and generate a charitable income tax deduction as well as an income stream. At death, the remainder is given to specified charities.

The SECURE Act has sparked renewed interest in CRTs as named retirement account beneficiaries. Why? Because a child can be named as the income beneficiary of the trust, which allows the child to stretch the distributions out for more than 10 years. Upon the child’s death, or at the end of the trust’s term, the remaining assets will pass to the named charities.

Rethinking See-Through Trusts

Additionally, there are two types of see-through trusts that qualify as designated beneficiaries of a retirement plan account that estate planners often used in conjunction with stretch IRAs. The first is a “conduit trust,” which passes out all the distributions it receives from the retirement account to the beneficiaries. The second type is an “accumulation trust.”

Previously, many estate plans included conduit trusts as beneficiaries for IRAs because the structure required that all distributions from the retirement plan are immediately disbursed to the beneficiary. Very few contained provisions contemplating mandatory lump-sum distributions within 10 years. Estate planners generally avoided using accumulation trusts because the rules regarding the computation of the relevant beneficiaries’ life expectancies were unclear. Now, however, the beneficiaries’ life expectancies will no longer be a factor in determining the payout period due to the 10-year rule. So, use of these trusts should be reconsidered as soon as possible.

Long Live Life Insurance

Life Insurance is also earning renewed post-SECURE Act estate planning attention. Life insurance beneficiaries are often the same beneficiaries who inherit retirement accounts, including trusts. For large estates, life insurance can be used outside the estate through irrevocable trusts or ownership by the beneficiary, which removes the ultimate life insurance proceeds from the estate. Funds used to pay insurance premiums are also removed from the estate.

Life insurance is flexible and customizable for clients and, unlike IRA distributions, is without concern for RMDs, who the beneficiaries are, what their life expectancies may be, or whether the trust qualifies as a see-through trust with designated beneficiary tax status. Furthermore, life insurance proceeds paid to a trust after death will be free from income tax and can follow the intent of the insured without having to worry about working around the many IRA rules for beneficiary access and distributions.

A Small, Final Windfall

If the SECURE Act hasn’t given you enough to reconsider, here’s one positive point worth noting. Traditional IRA owners can now begin RMDs at age 72 instead of age 70.5 for those who did not reach age 70.5 by 2019’s end. This extension allows participants to defer distributions and grow their savings for a slightly longer period.

Additionally, individuals can now contribute to traditional IRAs after age 70.5 if they have earned income. This provision is effective for contributions made for tax years beginning after Dec. 31, 2019. Roth IRAs and 401(k) plans already allowed participants to continue making contributions if they continue working past age 70.5, so this change brings traditional IRAs in line with other contributory plans.

The SECURE Act is a significant piece of legislation for retirement account owners and their beneficiaries. It is in your best interest to consult your financial advisor on how to maximize the benefits of this new law.

Disclosure: This information may answer some questions, but is not intended to be a comprehensive analysis of the topic. In addition, such information should not be relied upon as the only source of information, competent tax and legal advice should always be obtained. Securities, insurance products, financial planning, and investment management services offered through Wintrust Investments LLC (Member FINRA/SIPC), founded in 1931. Trust and asset management services offered by The Chicago Trust Company, N.A. and Great Lakes Advisors LLC, respectively. Investment products such as stocks, bonds, and mutual funds are: NOT FDIC INSURED | NOT BANK GUARANTEED | MAY LOSE VALUE | NOT A DEPOSIT | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY.