Review of Retirement Account Beneficiary Designations under the SECURE Act

8 min

On December 20, 2019, Congress passed the Setting Every Community Up for Retirement Enhancement Act (the "SECURE Act"), which codifies sweeping changes to rules governing distributions from your qualified retirement plan (such as a 401(k)) or IRA (together referred to as "retirement accounts"). The SECURE Act, which became effective on January 1, 2020, affects not only distributions during your lifetime, but also the way in which your retirement assets are distributed to your beneficiaries after your death. Significantly, the new rules may impact the timing of and amount of tax paid by beneficiaries on distributions of the retirement assets and ultimately may affect the value of those retirement assets in the hands of the beneficiaries.

SECURE Act Impact During Your Life

For the person who created the account, the SECURE Act increases the age at which the account holder must begin taking required minimum distributions (RMDs) from April 1 following the year in which they reach age 70½ to April 1 following the year in which they reach the age of 72. Furthermore, the SECURE Act removes the age cap for funding traditional IRAs, which under the old law prohibited contributions to traditional IRAs by individuals over age 70½.

SECURE Act Impact After Your Death

Unlike stocks, real estate, and most other assets, retirement accounts do not receive a step-up in income tax basis at the death of the account holder. This means that the income generated during the account holder's lifetime is not "wiped away" at your death. At the account holder's death, the account balance must be withdrawn by the named beneficiary in accordance with complex rules, governed by the identity of the named beneficiary and his relationship with the account holder. Whatever the applicable distribution period, withdrawals from the inherited account will generally be taxed as ordinary income to the beneficiary in the year of the distribution.

Pre-SECURE Act rules divide beneficiaries into two classes: "Designated Beneficiaries" and "Non-Designated Beneficiaries." Designated Beneficiaries include individuals and certain qualified trusts and allow the beneficiaries to withdraw the inherited account over the beneficiary's remaining life expectancy. This lifetime deferral of the account withdrawal is what is referred to as the "Stretch IRA." When a Designated Beneficiary stretches out distributions over such Designated Beneficiary's lifetime, the undistributed retirement assets are permitted to grow income-tax free until such retirement assets are required to be distributed. In contrast, the pre-SECURE Act rules require that Non-Designated Beneficiaries, including estates, charities, and non-qualifying trusts, withdraw the entire inherited account by the end of the fifth year following the account holder's death.

The SECURE Act eliminates the "Stretch IRA" and provides that Designated Beneficiaries must receive the entire account by the end of the 10th year following the account holder's death. There are no RMDs during the 10-year period, but the entire account must be fully distributed, with the income taxes then due, by the end of the 10 years. However, the SECURE Act adds a third class of beneficiaries – "Eligible Designated Beneficiaries" – and excepts these beneficiaries from the 10-year rule. These Eligible Designated Beneficiaries are limited to (i) spouses, (ii) disabled and chronically ill individuals, (iii) minor children of the account holder (until they reach the age of majority), and (iv) beneficiaries who are less than 10 years younger than the account holder. The Non-Designated Beneficiaries are still required to follow the old five-year pay-out rule.

Briefly, the following are a few considerations for naming beneficiaries under the new SECURE Act rules:

  1. Spouse as Beneficiary. Spouse beneficiaries are Eligible Designated Beneficiaries under the SECURE Act, so the existing rules applicable to spouses remain unchanged. If the spouse is the named beneficiary of the account, he or she has the option to roll over the remaining benefits to his or her own plan. The rollover option is available for both traditional and Roth accounts, and, because the spouse is treated as the account holder, he or she may continue to contribute to the account and may also defer taking RMDs prior to April 1 of the year he or she turns 72. If, however, the spouse does not roll over the account, he or she is still an Eligible Designated Beneficiary, and the Stretch IRA rules will still apply, just as under the pre-SECURE Act rules (i.e., he or she may still defer the distributions from the account over his or her life expectancy). The takeaway is that if your designation named your spouse as the beneficiary under the old rules, there should be no change to the consequences of your spouse inheriting the account under the new rules (with certain exceptions when leaving assets to trusts for spouses).
  2. Non-Spouse Individual as Beneficiary. Under the pre-SECURE Act rules, if a non-spouse individual, such as the account holder's child or sibling, was named as the beneficiary of the account, the RMDs were determined by reference to the life expectancy of the beneficiary (or, in certain cases, the account holder's life expectancy, if longer). Under the SECURE Act, unless the individual qualifies as an Eligible Designated Beneficiary, the non-spouse individual must withdraw the retirement account by the end of the 10-year period.

    As mentioned above, the SECURE Act provides certain exceptions to this 10-year rule in the case of those qualifying as Eligible Designated Beneficiaries, such as (i) a disabled or chronically ill individual, (ii) a beneficiary who is less than 10 years younger than the account holder, or (iii) a minor child of the account holder. An Eligible Designated Beneficiary may still withdraw the inherited retirement account over his or her life expectancy. However, it is important to note that once the account holder's minor child reaches the age of majority (or the age of 26 in certain cases), the inherited account must be distributed within the following 10-year period. Further, the minor child exception applies only to the children of the deceased account holder and does not apply to grandchildren or non-relative minors. If your beneficiary designation names your child, grandchild, or sibling as a beneficiary, you should review your designations and consult your advisors to understand what consequences have changed regarding your intended beneficiary.

  3. Trusts. Under the pre-SECURE Act rules, if a qualifying trust was named as the beneficiary of the retirement account, the RMDs were generally based on the life expectancy of the oldest trust beneficiary (or, in certain cases, the account holder's life expectancy, if longer). Now, the new 10-year pay-out period will apply, unless the trust beneficiary qualifies as an Eligible Designated Beneficiary. Prior to the SECURE Act enactment, many practitioners utilized "conduit trusts," which require that all distributions from the inherited account that are paid to the trust are paid outright from the trust to the beneficiary during the same year of the distribution. However, under the SECURE Act, that same conduit trust may now require distribution of the entire retirement account to the beneficiary within 10 years following the death of the account holder. This not only accelerates the income tax due, but also accelerates the time when the beneficiary has the assets in his or her individual name. Depending on the financial literacy and creditor concerns of the trust beneficiary, this may be a troublesome result. Furthermore, depending on how the conduit trust was drafted, the trust itself may no longer qualify as a Designated Beneficiary, and the retirement account will be required to be fully distributed within 5 years of the account holder's death. Again, if your existing retirement account beneficiary designation names a trust as the beneficiary, you should review both the designation and the trust language with your advisors to understand how the two interplay under the new SECURE Act rules.
  4. Charities. Leaving retirement accounts to charities has always been a tax-efficient planning tool for those who are charitably minded, as the account will not only receive an estate tax deduction, but the charity will not pay income tax on the accumulated income. Structuring the client's estate plan in such a manner frees up other assets – those assets receiving a basis step-up at death – for the noncharitable beneficiaries. This structure may be even more enticing for clients under the new SECURE Act rules, because of the elimination of the Stretch IRA.
Planning Takeaways

The good news is that the SECURE Act does not change the method of designating a beneficiary to receive inherited retirement assets. If you have existing beneficiary designations in place, those designations are still valid, but the rules applicable to those named beneficiaries may have changed. The SECURE Act has implemented lifetime benefits as well, such as the deferral of the date for the account holder to begin taking RMDs and the elimination of the age limit on contributions to traditional IRAs.

The bad news is that the SECURE Act severely limits the ability to defer distributions from the retirement account to non-spouse beneficiaries, such as your children and siblings, accelerating the income tax due. As a result, the SECURE Act introduces a host of new considerations that must be taken into account in structuring your estate plan to maximize the benefit of your retirement assets and to protect your beneficiaries, especially if your current beneficiary designations name a trust to receive the account upon your death. If you have assets in a qualified plan or IRA, we recommend that you contact us to review your estate plan as soon as possible, to ensure that it disposes of those assets in the most appropriate manner, taking into account the SECURE Act changes.