The Recent Death of Stretch IRAs Could Mean Your Estate Plan is a Mess

In the good ole days of “stretch IRAs” (i.e. before 2020 – more on that to come), children or grandchildren could inherit an IRA or other retirement account and stretch distributions over their respective lifetimes, thereby exploiting the tax-favored treatment of these accounts well beyond the original owner’s lifetime – often an additional half century or longer. One commonly recommended strategy for individuals with a meaningful IRA (or other retirement plan) balance was to name a “look-through” trust for their children and/or grandchildren as beneficiary of the account rather than the individuals, directly. Although this approach was not ideal for all situations, these qualifying trusts generally delivered a win-win-win scenario.

Such trusts directed that the required minimum distributions (RMD) set by the IRS for an inherited retirement account would pass through to the underlying beneficiary(ies) each year. Properly setting up the look-through trust as the beneficiary of a retirement account with the necessary language ensured that the inherited account would qualify for the most tax-favored distribution schedule (the so-called “stretch”). This resulted in deferring taxes as long as possible or, in the case of an inherited Roth account, retaining the benefit of tax free growth as long as possible. The approach helped avoid the high tax rates within the trust, created a multi-year tax-efficient legacy that was hard for the beneficiary to mess up, and added an element of creditor protection. The win-win-win result meant that the ideal estate plans often included a look-through trust unless unique circumstances warranted something different.

When the SECURE Act recently became law in December 2019, it effectively squashed the stretch strategy by requiring that most non-spouse retirement account beneficiaries distribute retirement accounts inherited after December 31, 2019 within a 10-year period (qualified with “most non-spouse beneficiaries” because there are eligible designated beneficiaries such as siblings and disabled individuals who still qualify for stretch treatment).

To be clear, this is not a favorable development and will effectively reduce the benefit of IRAs, Roth IRAs, and other retirement accounts as estate planning vehicles.

By significantly changing retirement plan distribution rules, the SECURE Act has an immediate impact on future estate planning and on existing estate plans. There is another article to write on beneficiary designation planning after the SECURE Act – the intent here is to explain the important impact it has on existing look-through trusts.

From a big-picture perspective, look-through trusts can be set up in one of two ways: as conduit trusts or as accumulation trusts. The conduit trust setup is what has been described thus far – required minimum distributions from the retirement account go into the trust and then are passed through to the beneficiary during the same tax year.

Alternatively, the accumulation trust still qualifies as a look-through trust for required distribution purposes but does not mandate that the required distributions pass through to the beneficiary. The trustee has discretion on whether to retain funds from the required distribution in the trust or distribute to the beneficiary. Leaving retirement account or IRA distributions in the trust results in higher tax rates but has clear utility if the beneficiary is a child with disabilities, spending problems, or drug dependency issues.

Importantly, there is a potential big problem with conduit look-through trusts under the SECURE Act distribution rules. Imagine someone names a conduit look-through trust as beneficiary of a $1 million IRA and then dies in 2020. Furthermore, the trust language directs that required minimum distributions from the IRA, starting in the year after death, be paid to the trust and passed through to the individual beneficiary.

Except now there is no required distribution in 2020. Or 2021. Or 2022. Or any of the first 9 years after death. Only in the 10th year is there a required distribution and all the funds in the IRA get paid in that one year, likely creating a massive tax liability and terribly tax-inefficient planning. So, the tax benefit that was intended with the look-through trust is basically non-existent and the idea of parsing out distributions over the beneficiary’s lifetime is destroyed.

The result of most accumulation look-through trusts is only slightly better. There remains the issue of no required minimum distributions until one massive lump-sum distribution in the 10th year. This results in the same unavoidable mess of a massive tax liability in year 10. There is, however, still a control benefit as the beneficiary does not necessarily receive the full $1 million plus the 10-years of growth all in one payment. Because the trustee has discretion, he/she can choose to distribute from the trust over time, as he/she deems appropriate.

Does this all mean that retirement account owners should no longer name look-through trusts as beneficiaries of these accounts? No – but It does mean that the language of any look-through trusts named as beneficiaries needs to be carefully examined. If the trust language simply mandates that the retirement account required minimum distributions be paid to the trust each year without any discretion, there is likely a big problem that needs to be immediately addressed.

Language that gives some discretion to the trustee offers a much better solution under the new law. Consider the following language:

If any trust created under my Will becomes the beneficiary of death benefits under any qualified retirement plan, my Trustee shall withdraw from the trust’s share of the plan, in each year, the required minimum distribution required under Section 401 (a)(9) of the Internal Revenue Code. My Trustee may withdraw such additional amounts from the trust’s share of the plan as my Trustee deems advisable; but, only if the dispositive terms of the trust authorize my Trustee to immediately distribute the withdrawn amount as provided below.

Note that the part in bold here gives the trustee discretion to withdraw additional funds from the retirement account beyond the required minimum distribution. Even though there may not be any required distribution in the first nine years after death, the trustee has authority to more evenly withdraw funds from the retirement account in each of those years and pass them through to the beneficiary so that the tax impact is potentially spread over 10 years at lower tax rates.

The bottom line is that the new law has a dramatic impact on IRA and retirement plan beneficiary designations. Trusts that worked perfectly well in 2019 as beneficiaries may be disastrous in 2020. And because of the dramatic change, it’s not just trusts as beneficiaries that need to be re-examined – it’s the entire big picture of how IRAs and retirement accounts now fit into the estate plan.