Back to Missives
George F. Bearup, J.D. Senior Legal Trust Advisor

30-Dec-19

SECURE Act- III Dealing with the 10-Year Payout Rule

Take-Away: Last week provided a broad overview of the SECURE Act’s changes to retirement plan contributions and distribution. The next couple will dig a bit deeper into the substance of those changes, and in particular on retirement plan distributions to trusts. This summary deals with the 10-year payout rule for inherited IRAs and qualified plan retirement accounts. Despite the SECURE Act’s sweeping changes, some of the ‘old’ retirement plan distribution rules remain in place.

Old Required Minimum Distribution Rules: There were two basic rules with regard to distributions from retirement plans and IRAs. For ease of reference, this summary will only refer to IRA owners and the designated beneficiary of that IRA, but these same rules apply to distributions from an inherited qualified plan, like a 401(k). [IRC 401(a)(9)(B).]

  • Basic Rule: Upon the death of the IRA owner, the balance of his/her IRA had to be distributed in annual installments over the life expectancy of his/her designated beneficiary, or if elected by the designated beneficiary or required by the applicable qualified plan, under the second method, or more rapidly.
  • Second Method: If the benefits were not left to a designated beneficiary, the inheritor of the IRA had to withdraw the inherited benefits within 5 years of the IRA owner’s death, if the IRA owner had died prior to his/her required beginning date (age 70 ½), or otherwise in annual installments over what would have been the remaining life expectancy of the IRA owner had he/she not died if the IRA owner died after his/her required beginning date. In short, this second method of distribution depended upon the age of the retirement account owner at the time of his/her death: younger than 70 ½, the payout was 5 years, over 70 ½ the payout was over the age-of-death’s assigned life expectancy.
  • Designated Beneficiary: This key concept was, and still is, defined as an individual or group of individuals named as beneficiary by the IRA owner, or a trust named as the IRA beneficiary if the trust meets the IRS’s requirements to be treated as a see-through trust, in which case the life expectancy of the oldest trust beneficiary provides the applicable distribution period. If the designated beneficiary dies prior to the end of his/her normal life expectancy payout period, the next beneficiary in line steps into the decedent-beneficiary’s shoes and can withdraw over the remaining life expectancy of the original designated beneficiary (not the next beneficiary’s life expectancy.)
  • Surviving Spouses: Special rules exist for the surviving spouse who alone possesses the option to roll over the inherited IRA assets to his/her own retirement account. Other designated beneficiaries do not have this option, only surviving spouses. Note, that this spousal roll over option is not a part of these required minimum distribution rules.
  • Rearranging beneficiaries: Another special rule permits the ‘re-arranging’ or removal of named designated beneficiaries by September of the year that follows the IRA owner’s death. Through disclaimers and cashing out older beneficiaries a more favorable required minimum distribution (RMD) period might be attained.

Two Categories: Accordingly, there were two categories of IRA beneficiaries, one of which was further divided into two subcategories.

  • Non-Designated Beneficiary: A beneficiary who is not a designated beneficiary, such as the IRA owner’s estate, a charity, or a trust that does not comply with the see-through trust rules, either had a 5-year payout rule if the IRA owner died prior to his/her required beginning date (age 70 ½, going forward, age 72), or the IRA owner’s remaining life expectancy if the IRA owner died after his/her required beginning date.
  • Designated Beneficiary: Individuals, or see-through trusts, were entitled to use either the life expectancy payout rule, or the non-designated beneficiary payout rule, if that was more favorable. A designated beneficiary could be either the surviving spouse of the IRA owner (one set of rules) or a non-spouse beneficiary (another set of rules.)

SECURE Act Changes: The SECURE Act does not replace most of the prior rules just described. Nor does it change the definition of a designated beneficiary. Rather, the SECURE Act adds a new Code Section, IRC 401(a)(9)(H). This new Code Section layers on top of the existing rules new payout periods that will apply to all designated beneficiaries. This ‘layering’ reflects the intention to preserve as much as possible of the existing IRA distribution rules with regard to required minimum distributions.

  • 10-Year Payout: The new rule uses a 10-year payout rule to replace the Basic life expectancy payout method, but with five categories of eligible designated beneficiaries who are excepted from the 10-year mandatory payout.
  • 5 Exceptions- Eligible Designated Beneficiaries: The five exception categories of eligible designated beneficiaries are entitled to a modified version of the Basic life expectancy payout. Those eligible designated beneficiaries are: (i) surviving spouses; (ii) disabled individuals; (iii) chronically ill individuals; (iv) minor children of the deceased IRA owner; and (v) beneficiaries who are less than 10 years younger than the deceased IRA owner.
  • SECURE ACT’s Three Categories of Designated Beneficiaries: With the SECURE Act, there are now three categories of designated beneficiaries, one of which has 5 subcategories.
  • 1-Beneficiary who is Not a Designated Beneficiary: If the IRA owner’s estate, a charity or a trust that does not meet the see-through trust rules are the named beneficiaries, the same 5-year payout rule applies if the IRA owner dies prior to his/her required beginning date (now 72 years). Or, if the IRA owner dies after his/her required beginning date (age 72) over the IRA owner’s remaining life expectancy period. In short, these rules were NOT changed by the SECURE Act.
  • 2-Designated Beneficiary: This rule applies to individuals and to see-through trusts. Unless the designated beneficiary meets the definition of an eligible designated beneficiary, he/she must withdraw the inherited benefits within 10 years after the IRA owner’s death.
  • 3-Eligible Designated Beneficiary: These eligible designated beneficiaries are still entitled to use a modified version of the life expectancy payout method.
  • Surviving Spouse: The IRA owner’s designated beneficiary surviving spouse can still use the life expectancy payout method. On the survivor’s death, this exception ceases to apply, and the 10-year payout rule then kicks in. [IRC 401(a)(9)(e)(ii)(l).]
  • Minor Child of the IRA Owner: The life expectancy payout method applies to a designated beneficiary child of the IRA owner who has not yet reached majority. When the child attains majority, the 10-year payout then rule applies. [IRC 401(a)(9)(E)(ii)(ll).]
  • Disabled Beneficiary: The life expectancy payout method applies to a designated beneficiary who is disabled within the meaning of the Tax Code.[IRC 72(m)(7).] Upon the disabled beneficiary’s death, the 10-year payout rule then applies.
  • Chronically Ill Beneficiary: The life expectancy payout method applies to a designated beneficiary who is chronically ill within the meaning of the Tax Code. [IRC 7702B(c)(2).] Upon his/her death the 10-year rule will then govern future payouts.
  • Less than 10 Years Younger Beneficiary: The life expectancy payout method applies to a designated beneficiary who is not more than 10 years younger than the IRA owner. Upon that beneficiary’s death, the 10-year payout rule then applies.

See-Through Trusts: As we have covered in the past, there are two types of see-through trusts that could qualify as a designated beneficiary of an IRA.

  • With a conduit type of trust, the lifetime beneficiary of the trust must receive, more or less immediately, the distribution from the IRA paid to the trustee of the trust. Thus, the conduit beneficiary is considered to be the sole beneficiary of the trust for required minimum distribution purposes, regardless of who will inherit the balance of the trust and remaining IRA assets on the death of the conduit beneficiary. Under these circumstances, the  conduit trust automatically qualifies as a see-through trust. [Treas. Reg. 1.401(a)(9)-5, A-7(c)(3), Example 2.]
  • With an accumulation type of trust, the trustee can accumulate the IRA distributions in the trust for possible later distributions to another trust beneficiary. Under this type of trust, all beneficiaries who might ever be entitled to receive such accumulations are ‘counted’ as beneficiaries for purposes of applying the required minimum distribution rules. Excluded from these potential trust beneficiaries are only those trust beneficiaries who are only a ‘mere potential successor’ to another trust beneficiary- who are admittedly hard to determine under the mere potential successor An accumulation trust qualifies as a see-through trust only if all of the ‘countable’ trust beneficiaries are identifiable individuals, and the oldest of them control’s the payout period. [Treas. Reg. 1.401(a)(9)-5, A-7(c)(1).]
  • With the SECURE Act’s change, if the beneficiary of a conduit trust is not an eligible designated beneficiary, the conduit beneficiary will receive outright distribution of 100% of the IRA within 10 years of the IRA owner’s death, which result may be totally contrary to the reasons why the IRA owner chose to name a see-through trust as the designated beneficiary of his/her IRA.
  • With the SECURE Act’s change, if the primary trust beneficiary is an eligible designated beneficiary, then the favorable treatment granted to an eligible designated beneficiary as an individual will be applied to the conduit Generally, only a conduit trust established for an eligible designated beneficiary will be entitled to use the life expectancy payout that is granted to the individual eligible designated beneficiary.
  • With the SECURE Act’s change, with the exception for certain types of trusts established for the sole benefit of a disabled for chronically ill beneficiary, an accumulation trust must take distributions from and deplete the entire IRA balance within 10 years after the IRA owner’s death.

Maybe a Payout of More Like 11 Years: The new rules require that all amounts must be distributed by December 31 of the year that contains the 10th anniversary of the IRA owner’s date of death. Accordingly, the payout deadline is December 31 of the 10th year after the IRA owner’s death, not the tenth anniversary of the IRA owner’s death. This means that the payout could conceivably extend closer to 11 taxable years for the designated beneficiary.

No More Mandatory Annual Installments: Unlike the earlier life expectancy required minimum distribution rules, no interim or annual distributions are required under the 10-year payout rule. The only requirement is that the all funds must be distributed from the IRA by December 31 of the 10th year after the IRA owner’s death. Distributions can be made at any time during the 10-year period, just so long as the IRA is totally empty by the 10-year December 31 deadline date.

Grandfathering To a Degree: The SECURE Act amendments apply to distributions with respect to IRA owners who die after December 31, 2019. Thus, those inherited IRAs which are currently subject to required minimum distributions using the designated beneficiary’s life expectancy will continue to be available. However, this new 10-year payout regime will apply once the original designated beneficiary dies prior to the end of his/her life expectancy.

  • Example: Martha died in 2015. Martha named her son, Sam, as her IRA designated beneficiary. Sam withdraws funds from Martha’s IRA using his 34.2 year life expectancy. Sam dies in 2030, having taken required minimum distributions over the interim years using his 34.2 life expectancy ‘draw-down’ from the IRA that he inherited from Martha. On Sam’s death, he named his daughter, Diana, age 35, as Sam’s successor beneficiary to Martha’s inherited IRA. Under the old rules Diana would simply step into Sam’s shoes and take distributions over the remaining 19.2 years of Sam’s life expectancy. Under the SECURE Act, the new 10-year rule will apply, and Diana will be subject to the 10-year payout rule.

Rhetorical Question: What if Diana was a chronically ill individual? Is Diana stuck with the 10-year payout? If Diana’s grandmother had named her as the designated beneficiary of her IRA,  Diana would have been able to take distributions from that inherited IRA over her own life expectancy as an eligible designated beneficiary? This might be a reason for Sam to disclaim some of the IRA that he inherits on Martha’s death, to expose and stretch some of those IRA assets over Diana’s life expectancy.

Conclusion: For an IRA beneficiary who is not a designated beneficiary the Tax Code’s distribution rules do not change. For every designated beneficiary of an IRA the new 10-year payout rule is  effective January 1, 2020, unless the beneficiary is one of the 5 excepted eligible designated beneficiaries.  Existing inherited IRAs that use the life expectancy payout distribution method are ‘grandfathered’ and are not subject to the new 10-year payout rule, but successor beneficiaries of those inherited IRA will be subject to that 10-year payout rule.