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George F. Bearup, J.D. Senior Legal Trust Advisor

25-Jan-20

SECURE Act – Strange Results

Take-Away:  Learning the SECURE Act’s new distribution rules, and the exceptions to those rules, will be a new challenge. The SECURE Act provides several new ‘rigid’ rules and effective dates with regard to distributions from inherited retirement accounts. Those new rules can lead to some pretty strange results. A few examples follow-

Grandfathered Stretch Distribution Rule:  If a retirement account owner died in 2019, the existing stretch distribution rule continues to apply to the decedent’s inherited IRA. The rule changes if the owner died on January 1, 2020.

  • Example: Tom died on December 30, 2019 leaving to his Roth IRA to his 32-year-old son Steve. Steve is eligible to take distributions from that inherited Roth IRA over Steve’s life expectancy, which is about 50 years. Had Tom died two days later, on January 1, 2020, Steve would have been required to take the entire Roth IRA distribution no later than December 31 of the tenth year after Tom’s death. Result: Tax-free income for 50 years vs tax-free income for 10 years.

RMD- Age 72 Required Beginning Date:  An IRA owner who turned 70 ½ in 2019 is stuck following the existing RMD rules. Consequently, someone who turned that age in 2019 must take their first required minimum distribution (RMD) by April 1, 2020, and take a second RMD for 2020. Someone who did not turn 70 ½ in 2019 has until April 1, 2022 in order to take their first RMD.

  • Example: Fred turned 70 on June 30, 2019. Fred’s wife, Wilma, turned 70 on July 1, 2019. Both Fred and Wilma have IRAs. Fred must take his first RMD by April 1, 2020, since he turned 70 ½ in 2019, i.e. on December 30, 2019. Wilma, on the other hand, turned 70 ½ on January 1, 2020. Since Wilma did not turn 70 ½ in 2019, Wilma has until April 1, 2022 in which to take her first RMD from her IRA. Result: The difference in Fred and Wilma’s ages is only two days; however, the rigid RMD effective date rule results in a two-year difference when they must take their first RMDs.

IRA Contributions Beyond Age 70 ½: The old rules provided an individual who was still working and had earned income could not contribute to an IRA after age 70 ½. The new rule permits an individual with earnings to continue to contribute to an IRA beyond that former cut-off age. Yet that individual will still have to take RMDs if they are over 73.

  • Example: Becky, age 74, continues to work part-time as a business consultant. Becky has earned income for the year. Becky is now able to make a tax deductible IRA contribution for 2020. However, Becky is over age 72, which means that she is beyond her required beginning date. Accordingly, Becky must also take an RMD for the year 2020. Result: Becky will have money going into and out of her IRA in the same tax year- deductions for her contributions in, offset to some degree by her taxable RMD. [Becky might want to make a ‘back-door’ Roth conversion to avoid this ‘recycling’ of contributions into and out of her IRA.]

Special Stretch Distribution Rules:  In the past was covered the continuation of the stretch distribution option for eligible designated beneficiaries. However, the ‘death of the stretch’ does not  yet apply to inherited accounts of owners of collectively bargained retirement accounts,  governmental plan accounts, e.g. Thrift Savings Plan, 403(b) annuities, and 457(b) retirement accounts. The effective date for the 10-year rule upon death of an owner of one of these ‘special’ retirement accounts is December 31, 2021, not December 31, 2019 like it is for most other retirement accounts. Consequently, if an account owner in one of these plans dies in 2020, the individuals who inherit their retirement accounts will fall within the old stretch distribution rule.

  • Example: Bruce worked for several years for the federal government. Bruce participated in the Federal Thrift Savings Plan. Bruce retired early, but he left his retirement account with the Thrift Plan. The last 15 years of Bruce’s work history he was a paid consultant to law enforcement industry. When Bruce retired, he rolled his self-employed 401(k) account to a traditional IRA. Bruce dies in 2020, leaving both his Thrift Savings Plan account balance and his IRA to his ward Robin. Robin is subject to two separate distribution rules. Robin must take RMDs from the inherited IRA over the SECURE Act’s 10-year distribution period. With regard to the inherited Thrift Savings account balance, Robin rolls that balance into an inherited IRA account, but he is permitted to take stretch distributions from this ‘rolled’ inherited account because Bruce, a participant of the Thrift Savings Plan,  died prior to December 31, 2021. Result: Robin inherits two retirement account from Bruce on Bruce’s death, but each account will have different required distribution rules, which Robin must keep straight.

10-years Younger Than Account Owner Eligible Designated Beneficiary:  One of the five eligible designated beneficiary classifications that are permitted to continue to use the old stretch distribution rule is when the account owner’s designated beneficiary is less than 10 years younger than him or her. These designated beneficiaries are able to continue to take required minimum distributions over their life expectancy.

  • Example: Moe, Larry and Curly are brothers. Moe is age 70, Larry is age 61, and Curly is age 59. Moe dies in 2020, leaving his traditional IRA 50% to his brother Larry, and 50% to his brother Curly. Since Larry, age 61, is less than 10 years younger than Moe, Larry is an eligible designated beneficiary. Consequently, Larry can take stretch distributions using his life expectancy from the inherited IRA. Note that Larry’s life expectancy at age 61 years is just over 20 years. Curly, age 59, Moe’s youngest brother, is more than 10 years younger than Moe. Accordingly, Curly is not an eligible designated beneficiary. Instead, Curly must take his distribution from the inherited IRA over 10 years. Result: The older designated beneficiary, by two years, has twice as long to take taxable distributions from the inherited IRA than does the younger designated beneficiary.

Time to Determine Eligible Designated Beneficiary: The SECURE Act provides that the time [i.e. snapshot date] to determine whether a designated beneficiary is an eligible designated beneficiary is made as of the date of death of the retirement account owner. Sounds straightforward. Yet-

  • Example: Martin dies in 2020. Martin names his son Charlie, age 30, as the beneficiary of Martin’s traditional IRA. Since Martin died in 2020, Charlie is bound to follow the SECURE Act’s 10-year distribution requirement. Later in 2020, Charlie is in a tragic motorcycle accident, sustaining a close head injury that leaves Charlie completely disabled. While Charlie could clearly meet the definition of a disabled designated beneficiary in order to qualify as an eligible designated beneficiary, Charlie cannot meet that definition, as Charlie was not disabled on the date of Martin’s death. Result: Even though Charlie is clearly disabled, he is not an eligible designated beneficiary, and he will have to take distributions from his late father’s IRA over the SECURE Act’s required 10-year distribution period.

IRA Owner Dies in 2019- Beneficiary Dies in 2020:  If the IRA owner died in 2019, their designated beneficiary is permitted to continue to use the old stretch distribution rules. When that designated beneficiary dies, the SECURE Act’s 10-year distribution then applies.

  • Example:  Samantha died in 2019. Samantha (‘Sam’) left her traditional IRA to her daughter Tabitha, age 48. Since Sam died in 2019, Tabitha is able to take stretch distributions from Sam’s IRA that she inherited. Tabitha dies under mysterious circumstances on January 2, 2020. Tabitha named her son, Darren, as the successor beneficiary to Sam’s IRA. Darren is now subject to the SECURE Act’s 10-year distribution rule, even though Tabitha could have taken distributions for the next 40 years. Had Tabitha died two days earlier, in 2019, Darren would have been able to use Tabitha’s life expectancy to take distributions from the inherited IRA. Result: The benefit of the stretch distribution rule only exists as long as the designated beneficiary is alive.

Conclusion: No one ever said that Tax Code’s retirement plan distribution rules were easy to understand and apply. No one will ever say that the SECURE Act simplified existing distribution rules, other perhaps than the flat 10-year distribution rule applicable to most inherited IRAs. These examples demonstrate that the new ‘rules’ can lead to some ‘unfair’ results, simply due to timing.