SECURE Act Proposed Regulations (Again!)

Take-Away: The SECURE Act Proposed Regulations are effective beginning in 2022. Whether we like these new rules or not, they must be followed, even when the Regulations are not yet final. The Proposed Regulations provide for complex, aka confusing, distribution rules, and also some needed flexibility when it comes to ‘fixing’ see-through trusts.

Background: As the Proposed Regulations are read more closely, more surprises become apparent. While some would say that there have been too many ‘missives’ from me already that deal with these Proposed Regulations, it is important that we become familiar with the rules when we advise clients, and in particular, the inheritors of traditional IRAs. While I apologize, yet again,  for covering the same topic (anon), there is a need to become familiar with the bewildering required minimum distribution rules. Key examples will be covered, but without too much background explanation.

1. Least-As- Rapidly Rule: The big surprise was the reinforcement of this existing distribution rule. This rule requires annual required annual distributions (RMDs) to continue once they are started by the previous account owner. This rule cannot be ‘turned off.’ While the rule does not require the beneficiary to take the same amount as the deceased IRA owner, it does require annual RMDs to continue to be taken by the designated beneficiary. This rule generally applies when the IRA owner dies after his/her required beginning date (RBD) of age 72. Effectively two different distribution rules apply when the IRA owner dies after his/her RBD. First, the designated beneficiary must continue to follow the least-as-rapidly rule, taking annual RMDs using their own single life expectancy to calculate the RMD. Second, the 10-year distribution also applies, meaning that the inherited account balance must now also be emptied after 10 years, i.e. nine years of RMDs are taken with the balance of the account taken on December 31 of the 10 anniversary of the IRA owner’s death.

• • Example: Felix dies in 2021 at age 75, after his RBD. The beneficiary of Felix’s traditional IRA is his grandson, Oscar. Oscar is the only a designated beneficiary of the inherited IRA. Oscar is thus subject to the 10-year distribution rule. However, Oscar must also take annual RMDs for years 2022 through 2030 and empty the inherited IRA account by the end of 2031. The RMD for 2022 is calculated using Oscar’s single life expectancy. If Oscar is age 25 in 2022, the factor used to calculate his annual RMD for 2022 would be 60.2. For 2023, Oscar’s RMD factor would be 59.2. In the 10^th year after taking RMDs for each of the prior calendar years, Oscar’s RMD is 100%.

2. Eligible Designated Beneficiaries and a Phantom RMD Period: There might actually be two different RMD periods involved when an older, i.e. eligible designated beneficiary is named to inherit an older individual traditional IRA account. While the EDB might choose to follow the decedent’s life expectancy RMD period, their own, shorter, period will still control RMDs.

• • Example: Roberta dies at age 74, after her RBD. Roberta’s IRA beneficiary is her older brother, Claude, who is age 80. Claude is an eligible designated beneficiary (EDB) because he is less than 10 years younger (he’s older) than the decedent IRA account owner. Claude can thus stretch annual IRA distributions from the inherited IRA. Claude has a choice. He can either take annual distributions using Roberta’s single life expectancy (15.6 years, or until Roberta would have reached age 95) or Claude  can use his own life expectancy to calculate RMDs, which is 10.5 years. Even though Claude might elect to use Roberta’s longer (15.6 years) life expectancy to calculate his annual RMDs from the inherited IRA, Claude is still required to empty (close out) the inherited IRA when he is age 91 (when his own life expectancy is less than 1.0), even though Roberta’s life expectancy had 4 more years to go.

3. Hypothetical Retroactive RMDs: This is yet another example of the at-least-as-rapidly rule. A surviving spouse is required to take ‘hypothetical retroactive’ RMDs. A surviving spouse is an eligible designated beneficiary. As such, as an EDB, the survivor can elect the 10-year distribution rule instead of the stretch IRA distribution rule if the IRA owner’s death occurs before their RBD. However, the IRS has created the concept of ‘hypothetical RMDs’ as a deterrent to make sure that RMDs are not avoided by a surviving spouse who would have otherwise been required to take those RMDs upon attaining age 72.

• • Example: Fred and Wilma ae both age 70 years. Fred dies with Wilma  named as Fred’s IRA designated beneficiary. As an EDB, Wilma can do a spousal rollover to her own traditional IRA, or she can elect to remain as the beneficiary of the inherited IRA. If Wilma elects to remain a beneficiary of Fred’s IRA, she can elect the 10-year payout. Since Fred died before his RBD, Wilma would have no annual RMDs during the next 10 years after Fred’s death. However, if Wilma later decides to rollover the balance of the inherited IRA to her own traditional IRA (which is her option at any time), Wilma may not be able to roll over the full amount of the balance of the inherited IRA. Before Wilma completes her spousal rollover to her own traditional IRA, she must calculate the hypothetical RMDs for each year that she was age 72 and older. These hypothetical RMDs apply retroactively and are not eligible for a spousal rollover. The years that Wilma was age 70 and age 71 are not considered because they were years before Wilma’s first RMD year.

4. Roth IRAs: Because the RMD rules do not apply to Roth IRA owners, the post-RBD rules, including the ‘at-least-as rapidly’ rule do not apply to Roth IRA beneficiaries. This is just one more example of the benefit of a inheriting a Roth IRA over a traditional IRA, along with the tax-free earnings from the Roth IRA.
5. Minor Designated Beneficiaries: A minor child of the deceased IRA owner is also an eligible designated beneficiary. Thus, life expectancy payments are permitted only until the minor reaches the age of majority, at which time the child must switch to the 10-year distribution rule. Of interest is that the Proposed Regulations also provide that an individual under age 18 is considered disabled if they have a medically determinable physical or mental impairment that results in marked and severe functional limitations that can be expected to result in death or to be of long, continued and indefinite duration. The Proposed Regulations also provide a ‘safe harbor’ by which if, as of the IRA owner’s death, Social Security has determined that an individual is disabled, they will be deemed to be disabled for this purpose as a disabled EDB.  To avoid having to consider different state laws, the Proposed Regulations also set the age of majority at age 21 for RMD purposes. A special rule exists that provides that if the deceased IRA owner dies before his/her RBD (likely to be the case with a minor child of the IRA owner as the designated beneficiary) the terms of the IRA custodial agreement may include a provision that allows the minor child (or any EDB for that matter) to choose either the 10-year distribution  rule or the life expectancy rule, or default to either. If the IRA custodial agreement is silent on this issue, the Proposed Regulations default to the life expectancy payout rule.

• • Example: Sally names her minor child, Bobby age 16, as the designated beneficiary of Sally’s traditional IRA. Bobby will have (custodial agreement permitting) a choice in how he takes distributions from the inherited IRA, since Bobby is an EDB. If Bobby elects a 10-year payout, Bobby must empty the inherited IRA by his age 26. Alternatively, Bobby could elect to take annual RMDs using his single life expectancy to calculate those annual RMD amounts. Note, though, that if Bobby elects to take annual RMDs, when he turns age 21, and the 10-year payout is mandated at that time, since Bobby was taking RMDs he may be required to continue to take annual RMDs until he is age 31, if the at-least-as-rapidly rule applies to this election. There appear to be inconsistent examples in the Proposed Regulations when dealing with minor children/EDBs and the election that is available to them when they inherit a traditional IRA.
  • Example: Dick dies at age 79. Dick named his disabled daughter Beth as the designated beneficiary of Dick’s traditional IRA. Beth is age 59 on Dick’s death. Beth qualifies as being disabled under IRC 72(m)(7) and thus she is technically disabled for purposes of being classified as an eligible designated beneficiary. Beth may elect under the inherited IRA to either delay taking any RMDs for a period of 10 years, or she may elect to take annual RMDs using her own single life expectancy, stretching the distributions over her life expectancy. Beth’s challenge in making this election is that she currently receives asset-based governmental benefits, and it is possible that she will lose her governmental  SSI and  Medicaid benefits. Should Beth delay taking any distributions for the next 10 years, or should she begin to take annual  modest annual RMDs, which could threaten her eligibility to receive governmental benefits? Dick should have been named a supplemental needs trust as the beneficiary of his traditional IRA; that trust could then be used to pay for services and goods that address Beth’s needs not paid for by SSI or Medicaid, but  without jeopardizing Beth’s governmental benefits.

6. Successor Beneficiaries: The Proposed Regulations require that if the IRA owner dies on or after the RBD and the beneficiary is a designated beneficiary, or an eligible designate beneficiary, successor beneficiaries must continue to take annual distributions that the designated beneficiary, or the EDB, was scheduled to take. Many thought that the successor beneficiary would have started a new 10-year period to take distributions on the death of the designated beneficiary, or EDB, of the inherited IRA.  In short, there is not another (new) 10-year delay in taking distributions by the successor beneficiary from the inherited IRA.
7. See-Through Trusts: The Proposed Regulations actually facilitate naming a trust as the beneficiary of a traditional IRA. Previously, if the trustee could accumulate some or all of the inherited IRA’s distributions, subsequent and remainder beneficiaries had to be ‘counted’ to determine the oldest trust beneficiary. Additionally, if a contingent remainder trust beneficiary was a charity, then the IRA owner was treated as having no designated beneficiary because the IRA distributions could be accumulated ad subsequently paid to the charity, i.e. there was thus no see-through trust. Moreover, if there was a power of appointment in the accumulation trust, all permissible appointees from the trust would also counted, making it a challenge to have all trust beneficiaries ‘identifiable.’

Conduit trusts were an exception to this ‘counting rule’ if all of the amounts the trustee received from the inherited IRA were paid out to the current trust beneficiaries (and on a current basis). In this situation, subsequent trust beneficiaries could be disregarded when identifying the oldest trust beneficiary whose life expectancy governed the RMDs paid to the trust. Note, however, that while a conduit trust was able to ignore all but the current trust beneficiaries, the protection of the trust was lost over time as the amounts received from the inherited IRA were distributed to the current trust beneficiaries, and thus subject to creditor claims.

Rule: The Proposed Regulations allow for more flexibility by disregarding certain contingent remainder beneficiaries and also clarifying that additions can be made to the class of beneficiaries and ignoring permissible appointees until the power of appointment is actually exercised in their favor. Specifically, a trust beneficiary whose interest is contingent on the death of a prior beneficiary whose sole interest is residual will be disregarded.

• Example: Steve creates an irrevocable trust for his daughter Sandy. The trust provides that Sandy is to receive all income from the trust for her lifetime. Steve’s IRA is made payable to the trust. On Sandy’s death, the trust is to be distributed to Sandy’s son, Bill. However, if Bill does not survive Sandy, then the assets in the trust are distributed  to the American Red Cross, a public charity. Under the Proposed Regulations, if Bill survives Steve and he has no interest in the trust during Sandy’s lifetime, then the American Red Cross will be disregarded as a trust beneficiary. However, in order to take advantage of this provision, there must be a prior remainder beneficiary (Bill) who would take payments from the trust outright on Sandy’s death.
• Example: Jane creates an irrevocable trust for the benefit of ‘all of my  grandchildren.’ Jane’s traditional IRA is made payable to this trust. After Jane’s death, her daughter gives birth to yet another grandchild for Jane. The Proposed Regulations make it clear that an addition to the class of beneficiaries of the trust (my grandchildren), such as the birth of an additional grandchild, will not cause the trust to fail the see-through-trust rules that require all trust beneficiaries must be identifiable on the death of the IRA owner whose traditional IRA is made payable to the trust.
• Example: Kevin creates an irrevocable trust for his children, creating separate shares for each child. Each child is entitled to receive discretionary distributions from the their trust share. Each child is also give a limited power of appointment to appoint assets held in their shares among any charity or  individuals other than the child, their creditors, or the child’s estate and its creditors. Thus the potential appointees of this limited  power of appointment would include older individuals and charities. Kevin’s IRA is made payable to this trust upon Kevin’s death. Under the Proposed Regulations, if the child’s power of appointment is exercised by September 30 of the year following Kevin’s death in favor of one or more identifiable beneficiaries, e.g. Kevin’s child’s lineal descendants, those individuals will be treated as having been designated in the trust. In sum, the Proposed Regulations provide that a power of appointment will not cause Kevin’s trust to fail the ‘identifiable beneficiary’ requirement merely because the permissible appointments of the power of appointment are not immediately identifiable. Note that  if the power of appointment is exercised after September 30 of the year that follows Kevin’s death, the additional beneficiaries added pursuant to the exercise of the power of appointment will be ‘counted.’

Similarly, as was reported earlier, even if the irrevocable trust could be modified, reformed, or decanted under state law, the see-through trust will not fail the identifiability requirement merely because state law permits the trust’s terms to be changed. Thus, a trust beneficiary who is technically removed from the trust by September 30 of the calendar year that follows the IRA owner’s death, is disregarded. Similarly, if a trust beneficiary is added to the trust after that date, he/she will be ‘counted.’ This is probably not too relevant in Michigan where there are limits on who can be removed, or added, as a trust beneficiary through the trustee’s exercise of a statutory decanting power, but it may be relevant if the trust contains its own more expansive decanting provision than what the state statutes otherwise permit.

Conclusion: These are just some of the examples that demonstrate the distribution ‘rules’ under the Proposed Regulations. They are complex, sometimes not intuitive, and lead to more questions than answers. The prior distribution rules were not well understood by many. Now it is safe to say that no one (probably including the IRS) understands any of the rules with any level of confidence.