SECURE Act Planning Strategies: Reviewing Beneficiary Designations

Secure Act Planning Strategies

Prior to the SECURE Act being signed into law, the use of certain types of trusts as beneficiaries was fairly common as an estate planning tool.  Many of those trusts and the language that they used may no longer be effective and may even represent a giant tax trap for the beneficiaries under the new rules.  As a result of this law change, reviewing beneficiary designations on IRA accounts is a prudent planning step.

In order for a trust to receive either the ten-year or stretch payout for eligible designated beneficiaries the trust must be a “See-Through Trust”.  All other trusts are subject to the accelerated five-year payout and could potentially be taxed at trust tax rates that reach the max 37% federal bracket at just $14,450 in income in 2023.  

There are two types of “See-Through” trusts – conduit trusts and discretionary trusts (also known as accumulation trusts).  Conduit trusts serve as a conduit between the IRA and the beneficiary, allowing funds to be paid out directly to the beneficiary and thus taxed at the individual’s income tax rate.  If these trusts pay out only RMDs, a beneficiary subject to the 10-year rule would not be able to access the funds until year 10 and then be forced to withdraw the entire sum unless additional provisions were added.

George had an IRA account with $1 million and named a conduit trust that only allows for RMDs to be taken as the beneficiary on his account with his daughter Georgina as the trust beneficiary when he passes away.  Because Georgina is subject to the 10-year rule, she does not have any RMD’s until year 10 at which point she must withdraw the entire amount and pay taxes at her income tax rate.  During the 10 years, the trust grows from $1 million to $2 million and in the year of withdrawal, she will realize that full amount as income with most of the funds being taxed at the top tax rate of 37%.

Discretionary Trusts give the trustee the power to pay out funds to the trust beneficiaries or hold and protect the funds in the trust.  Any funds held in the trust would be taxed at trust tax rates, which currently reach the top 37% tax bracket after just $14,450 in income in 2023.  For a beneficiary subject to the 10-year rule, any funds not withdrawn by year 10 will have to be withdrawn and either paid to the beneficiary directly (at their tax rate) or into the trust (at trust tax rates).

Sam has an IRA account with $1 million and lists a discretionary trust as the beneficiary on the account with her daughter Janet as the trust beneficiary.  Sam passes away and in the 10th year following her death, the inherited IRA has a balance of $1.5 million.  The funds must either be distributed directly to Sam (where they are no longer protected by and subject to the trust) or paid into the trust.  If the funds are paid to the trust, they will be subject to trust tax rates meaning every dollar of the $1.5 million over $14,450 will be subject to a 37% tax rate.

Those that have named no beneficiary or named their will or estate as beneficiary will also want to review and update their beneficiary designations.  In these circumstances, the IRA is not subject to the 10-year rule but instead becomes subject to a 5-year rule potentially magnifying the tax impact of accelerated distributions even more.

Michael has an IRA worth $1 million and does not name a beneficiary on his account.  His son, Michael Jr, inherits the account as part of his estate but because he was not named as a beneficiary directly, Michael Jr will be required to withdraw the entire amount in only 5 years.  Michael Jr earns $150,000 per year and chooses to take the money evenly over the 5 years to try to manage the tax impact as much as possible – taking about $200,000 per year.  Even with this tax-conscious approach, his marginal tax bracket still gets pushed up from the 24% rate to the 35% rate.

Adding contingent beneficiaries ensures that if something were to happen to your primary beneficiary the funds don’t become subject to the 5-year rule.  Additionally, it gives the primary beneficiary flexibility to disclaim the inherited funds should they not want or need them for any reason.

Consistently reviewing your estate plan as life events or laws change is always a good practice.  The SECURE Act and Tax Cuts and Jobs Act both introduced major changes to the estate planning landscape and those individuals that have not reviewed their estate plan to discuss the impact of these changes on their existing documents or designations should meet with their financial advisor and estate planning attorney to discuss whether changes may be appropriate.

Would you like to understand whether the content discussed in this post is appropriate for you and how it may fit into your overall financial plan?  Schedule an introductory phone call with our team here.

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Disclosure: The SECURE Act has wide-reaching impacts on retirement savings, tax planning and estate planning for many Americans. Be sure to consult your financial advisor and tax professional for guidance on what this new law means for you.

Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.  

Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.

This case study is for illustrative purposes only. Individual cases will vary. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Prior to making any investment decision, you should consult with your financial advisor about your individual situation.

Not all strategies are suited for all investors.  Prior to making an investment decision, please consult with your financial advisor about your individual situation.

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of the author and not necessarily those of Raymond James.

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