It’s Time to Review Your Beneficiary Designations

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It’s Time to Review Your Beneficiary Designations

 Jill Kaz, CFP®, Financial Planner

September 18, 2020

It’s always a good idea to make sure the beneficiaries of your retirement accounts are still appropriate today. In fact, the beneficiary designation will govern over any estate plan or marital settlement agreement. We often see clients go through the effort, time, and expense to create a revocable living trust, only to simply list their trust as a beneficiary, assuming that it is a prudent move. Until this year, if your trust was in good order, naming it as a beneficiary was often a good idea. But with the recent passage of the SECURE Act, we all need to challenge our previous thinking on this topic.

This article will discuss the key changes that have occurred since the SECURE Act took effect, along with what trust owners and their heirs (beneficiaries) should keep in mind when it comes to estate planning.

The History of Trusts and Retirement Accounts

To fully understand the significance of the SECURE Act, it’s useful to understand the historical role of trusts in estate planning. For years, an IRA holder was only allowed to name an individual as a beneficiary on their accounts. If they chose to name a trust as the beneficiary, after the account owner’s death, the trust was required to empty the account — and pay tax on the distributions — within five years.

To overcome this challenge, estate planners began to use “see-through” trusts: a type of trust that serves as a link between a retirement account and the account beneficiaries. These trusts were structured so that the IRS could “see-through” the trust to confirm that the trust beneficiaries were individuals. That allowed owners to “stretch” distributions from the retirement account based on the oldest beneficiary’s life expectancy, rather than on the life expectancy of the original account holder. For example, a 25-year old who inherited her grandmother’s $1 million IRA would be allowed to stretch the distribution (and, accordingly, the tax burden) over nearly 60 years, which significantly extends the tax benefit of the IRA.

It was a great model for retirement savers and their heirs, and see-through trusts were the standard for years.

Enter the SECURE Act

The SECURE Act led to numerous changes, but most significant was eliminating the “stretch IRA” described above. (The new rule does not impact beneficiaries that are charities, estates, or trusts known as “non-see-through” trusts.)

Under the new rules, beneficiaries — excluding spouses and certain others* — must distribute the balance of an inherited account by the end of the 10th year following the original IRA owner’s death. In other words, if an adult child of the original IRA holder inherits the IRA in 2020, the funds must be fully distributed by December 31, 2031, the 10th year anniversary following the IRA owner’s death.

Taxes and Control

Losing the option to stretch the distributions creates new tax-planning challenges. Instead of potentially stretching required distributions over decades (depending on the age of the beneficiary), these distributions are now compressed into a much shorter time frame. As a result, the payouts — and the associated taxes — will be much higher and happen much faster. And if beneficiaries are in their prime earning years, the required distributions can lead to a much higher overall tax burden for them.

Additionally, before the passage of the SECURE Act, a primary benefit of listing a trust as a beneficiary was the degree of control afforded to the original account owner. An IRA owner could name a trust as beneficiary to limit beneficiaries’ access to or control over the proceeds in the retirement account. While “see-through” trusts may still serve a valuable purpose, the SECURE Act has curtailed the number of options available to both the trustee and the beneficiary in the future.

Conduit trusts were a popular option for stretching IRA distributions, as they were typically distributed every year and were taxed at the beneficiary’s tax rate and not the higher trust tax rate. However, under the SECURE Act, unless all beneficiaries are either a spouse or certain others*, the 10-year rule will apply. Even if an IRA has four named beneficiaries and only one is a “non-eligible designated beneficiary,” the 10-year rule will likely apply, so it is best to prepare accordingly.

Another “see-through” trust is a discretionary trust (also known as an accumulation trust), which still requires the trustee to withdraw the entire IRA by the end of the 10th year anniversary following the IRA owner’s death; however, the IRA proceeds may accumulate in the trust, be reinvested, and distributed per the trustee’s discretion, thus putting a lifetime obstacle between a beneficiary’s creditors and the IRA proceeds. Discretionary trusts offer a greater degree of control than conduit trusts; however, the assets that accumulate in the trust are taxed at the (typically much higher) trust tax rate.

What to Do Now

Whether your beneficiaries are individuals or a trust, the changes brought about by the SECURE Act will likely impact your estate planning, and now is a great time to review your accounts and your estate plan. We suggest identifying the primary and contingent beneficiaries of record for all retirement accounts you may hold, including IRAs, 401(k)s, and 403(b)s. Your plan custodian (e.g., Fidelity, Charles Schwab, etc.) can provide this information. If your beneficiaries are individuals, confirm they are still your desired beneficiaries.

If the beneficiary is a trust, we encourage you to contact your estate planner to see what (if any) changes need to be made in light of the SECURE Act. Ideally, by the end of your discussion, you should have answers to each of the following questions:

  • How does the SECURE Act affect my trust beneficiaries?
  • Does my current trust language offer enough flexibility to maximize my income tax planning strategies?
  • Should I consider changing the beneficiary designation? If so, what is the impact of doing so?
  • Should I remove the trust and name individuals as the beneficiaries?
  • If I am charitably inclined, should I consider gifting all or a portion of my IRA to charity or Donor Advised Fund?
  • For Illinois residents, how will the new Illinois Trust Code affect my trust?

Reviewing your beneficiary designations should be part of your estate-planning routine — especially if your estate plan includes a trust. The implications from the SECURE Act are clearly very technical and complex. If you have any questions about your retirement accounts or need more guidance before contacting your estate planner, we encourage you to reach out to your Strategic Wealth Partners team. As always, we are here to help.

 

*The exceptions to the 10-year rule are beneficiaries that are: spouses, minors, individuals not more than 10 years younger than the IRA owner (e.g., a sibling or partner), and disabled or chronically ill individuals.

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