PROTECTING YOUR RETIREMENT PLAN FROM THE NEW DEATH TAX PART 1
by: Begley Law Group
by Thomas D. Begley, Jr., CELA
THE SECURE ACT
The SECURE Act passed by Congress and signed by President Trump became effective on January 1, 2020. The provisions of the SECURE Act apply to Qualified Retirement Plans and IRAs. The law is designed to raise approximately $16 billion for the Treasury, and to prevent retirement plans for being used as wealth transfer vehicles. Unfortunately, the tax will be paid primarily by your children. The significant changes are as follows:
- Required Minimum Distribution (“RMD”) Date. Initial RMDs have been delayed from April 1 of the year following the year in which the Plan Participant attains age 72 rather than the current 70-1/2.
- The maximum age for contributions to a Traditional IRA has been eliminated, so long as you or your spouse are still working. Contributions may now be made at any age.
- Ten-Year Rule. Under the old law, an individual inheriting an IRA could take RMDs over the lifetime of the beneficiary. If a 44-year old child inherited his parent’s IRA, the child could withdraw from the IRA over the child’s remaining life expectancy in accordance with the tables, which would be 39 years.
Under the new law, the 10-year mandatory withdrawal will result in significantly higher taxes for beneficiaries, usually children, inheriting IRAs, because they will be required to take minimum distributions while they are still working and the income from the RMD will be added to their employment income and other investment income and it is likely to place them in a much higher tax bracket. Just as important is that the time over which your child must take RMDs is reduced, thereby decreasing the time for the tax-free build-up.
For example, if a parent dies leaving $500,000 in an IRA and an adult child age 44 is named as beneficiary, under the old law the income on the account would accumulate tax free and the money would grow until the child reaches age 83. Let’s assume a 6% growth rate in the account. The total to be distributed over the child’s lifetime would be $2,102,689.05. Under the new law, the distributions must be made over a period of 10 years, not 39 years, and the amount distributed would be reduced to $659,039.75. The difference is $1,443,649 that would not inure to your child’s advantage. In addition, if your child is still working, some of that retirement plan money will be withdrawn during your child’s lifetime and will be taxed on top of your child’s earned income in higher tax brackets.
THREE TYPES OF BENEFICIARIES OF RETIREMENT ACCOUNTS
- Non-Designated Beneficiary. If a retirement plan fails to designate a beneficiary, then on the death of the Plan Participant the Plan proceeds are payable to the decedent’s estate and must be withdrawn over a period of five years from the decedent’s death. Frequently, retirement plans name a spouse as primary beneficiary but fail to name a contingent beneficiary. If the spouse predeceases the Plan Participant or dies in a common disaster, then there is no designated beneficiary.
This results in significantly increased taxes. A contingent beneficiary should always be named on a retirement account.
- Eligible Designated Beneficiaries (“EDB”). An EDB is a spouse, a disabled or chronically-ill individual, an individual less than 10 years younger than the Participant, and minor children. These are discussed below. The 10-year rule does not apply to these beneficiaries.
- Designated Beneficiaries. Designated beneficiaries are named beneficiaries who do not qualify as EDBs. The 10-year rule applies to all designated beneficiaries.
ELIGIBLE DESIGNATED BENEFICIARIES
There are exceptions to the 10-year mandatory RMD for individuals classified as Eligible Designated Beneficiaries (EDBs).
- Inherited IRA – Spouse. A spouse who inherits an IRA from a deceased spouse may continue to receive benefits over the life expectancy of the surviving spouse. This is consistent with current law. The problem occurs on the death of the second spouse. The 10-year rule will kick in, unless the spouse’s beneficiary is an EDB.
- Disabled Beneficiaries. A disabled beneficiary of a retirement plan may continue to receive benefits over the life expectancy of the disabled individual. Again, the problem begins on the death of the disabled beneficiary. The 10-year rule will kick in, unless the disabled individual’s beneficiary is an EDB. To be considered disabled, a beneficiary must have received a Disability Determination from the Social Security Administration or a letter from a physician certifying to the disability.
- Chronically-Ill Individuals. Chronically-ill individuals may continue to receive benefits over the life expectancy of the chronically-ill individual. Again, the problem begins on the death of the chronically-ill individual. The 10-year rule will kick in, unless the chronically-ill individual’s beneficiary is an EDB.
- Individuals Less Than 10 Years Younger than the Participant. Individuals less than 10 years younger than the Participant may continue to receive benefits over the life expectancy of such individual. Typically, these would be siblings of the Participant. This only really provides a benefit in cases where the sibling is expected to live longer than 10 years after the death of the Participant. For example, if a Participant was 50 years but expected to die soon from a terminal illness, it would make sense to name a 48-year old sibling as beneficiary if that sibling is healthy and has a normal life expectancy. Again, the problem would begin on the death of the sibling when the 10-year rule would apply to the beneficiary at that time.
- Minor Children. Minor children of the Plan Participant may receive inherited benefits over their life expectancies, but only until they reach age 18. Thereafter, benefits must be paid out no later than 10 years after the child’s 18th birthday. Stepchildren and grandchildren do not qualify for this purpose.