Trust Reformations

Take-Away: There is a new election buried in the SECURE Act 2.0 that may impact spousal beneficiary designations or trusts where a surviving spouse is the sole beneficiary. This election can either produce more benefit for the surviving spouse, or it can lead to a costly mistake.

Background: The SECURE Act 2.0 provides many new rules that are designed to encourage more retirement savings by individuals. Other than the immediate delay in the required beginning date (RBD) from age 72 to age 73, few changes impact the existing retirement plan distribution rules. One change provides a perceived ‘fix’ to the multi-beneficiary trust (AMBT) but that is not the subject of this missive. The other change creates a potential risk for a surviving spouse, but it can also provide a potential financial benefit when a conduit trust is created for a surviving spouse.

Situation: This SECURE Act 2.0 change, Section 327, impacts the relatively narrow situation where the deceased retirement account owner is younger than their surviving spouse.

Existing Rules: We are familiar with these rules when a surviving spouse is named as the beneficiary of the decedent’s retirement account. A short recap will help explain the SECURE Act 2.0 change.

1. Spousal Rollover: The first option, some will say best, is for a spousal rollover, moving the inherited retirement account to the survivor’s own IRA. The survivor is then the ‘owner’ of the retirement assets, not just the beneficiary of the inherited retirement assets.

2. Delayed Spousal Rollover: A second option is a delayed spousal rollover. The result is that the surviving spouse remains as the designated beneficiary of the deceased spouse’s retirement account until the date that deceased retirement account owner would have turned age 73 (the decedent’s required beginning date.) The survivor is treated as the ‘owner’ (‘employee’) if he/she dies before their RBD. In short, the delay is until the decedent would have attained age 73, at which time, or just before, the survivor rolls the inherited retirement account to his/her own IRA and thereafter acts as the owner of the inherited retirement assets.

This second option is sometimes used when the survivor needs to access the retirement funds; if he/she is under age 59 1/2, then with a rollover to their own IRA, they will pay the 10% early withdrawal penalty when accessing the rollover account. If the surviving spouse remains as the designated beneficiary of the decedent’s retirement account, the survivor can access the retirement funds without having to pay the 10% penalty. At any later date, the survivor can make a rollover of the inherited retirement account assets to his/her own IRA.

Example #1: Harry dies at age 65 years. His wife, Wanda, is age 72 years. Wanda could hold Harry’s inherited IRA until Harry would have reached age 72 years. Thus, Wanda gets to delay taking any distribution from Harry’s retirement account for another 6 years. This is the case even though Wanda has her own IRA, and she must take required minimum distributions (RMDs) from her own IRA, while Harry’s retirement account is permitted to grow. [Regulation 1.408-8, A5(b).]

Example #2: Harry dies at age 40. Wanda can defer taking any distributions from Harry’s retirement account until Harry would have been age 75 (under the new, later, RBD rules created by the SECURE Act 2.0.) 35 years of delay before taking any taxable distributions from Harry’s retirement accounts.

3. Conduit Trust: If the surviving spouse is the sole beneficiary of a trust created by the deceased spouse and the deceased spouse’s retirement account is made payable to that trust, e.g. a bypass or marital trust, then the trust is subject to the SECURE Act’s 10-year distribution rule. As a generalization, the SECURE Act 2.0 does not affect the use of a conduit trust for the surviving spouse. [Regulation 1.401(a)(9)-5, A7(c)(3), Example 2.]

4. “Anti-gaming” Rule: The SECURE Act Proposed Regulations allow the surviving spouse to elect to use the 10-year distribution rule if the deceased spouse died before his/her required beginning date (RBD.) However, if the survivor engages in a rollover before the 10th year of the deceased spouse’s death, the survivor will have to make-up for what would have been his/her required minimum distribution (RMD), using the Single Life Expectancy Table to calculate the survivor’s RMDs, if any, less what was actually taken by the survivor. The new SECURE Act 2.0 can impact this ‘make-up’ scheme.

New Section 327: This new SECURE Act 2.0 section requires the surviving spouse to make an affirmative election to benefit from the delayed required beginning date (RBD). The ‘good news’ with such an affirmative election is that the surviving spouse, or the trustee of a conduit trust established for the surviving spouse, will be able to use the more advantageous Uniform Lifetime Table and not the less favorable single life table to calculate RMDs.

Risk: The risk or harm that results from this change is that this is currently an automatic election under the SECURE Act. With the SECURE Act 2.0 it will now require a formal election made by the surviving spouse or trustee of a conduit trust. Many surviving spouses, or their advisors, will lose this special delayed RMD the enables the use of the more favorable Uniform Lifetime Table (i.e. resulting in a lower taxable RMD amount) starting in 2024- recall that the election is automatic through 2023, so nothing needs to be formally elected now but that changes beginning in 2024 by requiring an affirmative election (not automatic.)

Reward: If a conduit trust is named as the beneficiary of the deceased spouse’s retirement account, then the trustee makes the affirmative election, which prohibits a knee-jerk rollover by the surviving spouse (i.e. the trustee does not have its own IRA into which the inherited retirement account can be rolled)which, in turn, means that the inherited retirement account, made payable to the conduit trust, will have use of the more favorable, i.e. smaller, RMDs because the Uniform Lifetime Table will be used to calculate the RMD payable to the conduit trust (and then ‘out’ from the trust to the surviving spouse.’

Conclusion: What is the impact of such an affirmative election? It is interesting to note that the estimated cost to the government, i.e. the benefit to taxpayers, is estimated to be $1,101,000,000 over the next 10 years with the switch to the more favorable Uniform Lifetime Table used to calculate RMDs. This may be one good reason for spouses to use conduit trusts, to place the election in the hands of a professional trustee, not to mention gain the creditor protection of a trust that receives the distributions from the inherited retirement account.