The U.S. Senate is considering legislation that may fundamentally change one of the most tax-efficient ways to transfer assets between generations — the ability for beneficiaries of IRAs and other retirement accounts to “stretch” distributions across their own life expectancy. The most common scenario under the current rules looks something like this:
- A parent builds up a large (tax-deferred) retirement account while working.
- The parent then names their child as beneficiary of the retirement account (IRA, 401(k), 403(b), 457 plan, etc).
- Upon the parent’s death, the beneficiary then takes required distributions each year thereafter, based on the child’s life expectancy. A 40-year-old beneficiary, for example, would have the ability to stretch out distributions over the next 42 years.
The IRS does not like this arrangement much, as it means that Uncle Sam may have to wait a really long time to collect income taxes on the parent’s earnings — the parent does not pay income tax on the contributions to the retirement account while working and then, following the parent’s death, the child may stretch those taxable withdrawals over the rest of his or her lifetime. Consider: if a worker starts contributing to a retirement plan in his or her 20s, it may be over 100 years before the IRS collects taxes on those wages!
The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 would change these rules by eliminating the stretch provision and forcing tax-deferred retirement accounts to distribute within ten years of the account owner’s death. There’s are several small exceptions to this new ten-year rule, but they are largely in the margins. The ten-year rule applies to IRAs of all sorts, Roth IRAs, all qualified plans (including 401(k)s), profit-sharing plans, cash balance plans, and lump-sum distributions from defined benefit plans.
If the SECURE Act of 2019 is signed into law, here are some things parents ought to be thinking about:
- How would “forced” distributions over ten years affect your children’s tax status? This is especially important if your children are high income earners, as these distributions (except those from Roth IRAs) will be taxed as additional ordinary income each year.
- If your estate plan includes naming Revocable Living Trusts as an account beneficiary, then the estate plan may need to be revisited. “Conduit trusts” are often set up for the kids because they offer ongoing asset protection when children inherit IRA assets. These arrangements may no longer work if the account must be distributed entirely in ten years.
- If charitable planning is part of your estate plan, it is worth revisiting the plan in light if the new rules pass to determine the most efficient strategy. If children cannot stretch the distributions over 30-40 years of withdrawals, it may make sense to name charitable beneficiaries or engage in other types of planning — naming a charitable remainder trust as the account beneficiary, for example.
- The ten-year rule applies to Roth IRAs as well, so families may want to strategize by naming different beneficiaries for the IRAs vs Roths, depending on the tax status of different children.
Guessing which bills will be signed into law (and what they will ultimately look like when they do) is difficult in the current political climate. The SECURE Act enjoys bipartisan support and passed the House easily. The legislation is currently tied up in the Senate, where it may or may not go to committee and undergo changes. The Arnerich Massena Wealth Management team will continue to follow these developments and will keep our clients apprised of the changes. Please contact us if you have questions about how this legislation may affect your planning.