The Secure Act: Demise of the Conduit Trust

In December 2019, Congress passed, and the President signed a new tax bill called The SECURE Act effective January 1, 2020.  The SECURE Act may greatly affect your estate planning in that it necessitates a 10-year IRA and retirement plan payout after your death. The new 10-year rule applies to all qualified plans; these include 401(k), 403(b), 457(b), ESOPs, Cash Balance Plans, 401(a) plans (defined contribution lump-sum distributions from defined benefit plans, and IRAs). IRAs are usually the rollover recipient vehicle of all these other plans.

The new 10-year rules do not apply to spousal rollover. When the owner dies, their spouse may roll over their spouse’s IRA into their own IRA.

The SECURE Act requires beneficiaries to withdraw all assets of an inherited account within ten years. There are no required minimum distributions within those ten years, but the entire balance must be distributed after the 10^th year. This change can be problematic for some beneficiaries, especially if they are in their 40s and 50s and at the peak of their earning years. Limiting the time frame in which someone can distribute money from an inherited account means potentially boosting the tax burden those distributions will cause.

This Act defeats the purpose of a “conduit” trust, which you may have incorporated into your revocable trust for the benefit of a child. A “conduit” trust provides that retirement benefits payable after your death are paid to the trust beneficiary for life with the balance remaining after the death of the beneficiary to be distributed as provided in the trust.

You may have incorporated a conduit trust (also known as a “see through” trust or “Designated Beneficiary Trust”) into your estate plan if, for example, you desire to have your retirement account payments be made to a child who you would like to receive payments for life but are concerned that if the retirement plan or IRA was given to them with no restrictions, they may cash the plan in and spend the funds imprudently.

Now the law will necessitate that by the 10^th year following your death, all the funds will be paid to the beneficiary.  If the beneficiary is a conduit trust, all these proceeds will be forced out to the trust beneficiary (i.e., a spendthrift child in the above example).

It may be appropriate to modify your trust to be an accumulation trust.  With IRAs that are payable to an accumulation trust, the proceeds will be paid to the trust beneficiary as set forth in the trust (e.g., retain the proceeds in trust and pay to my child for life. However, the substantial wealth paid to the trust over the 10-year period of time will be taxed at the highest trust income tax rate when paid to the trust, not when distributed to the beneficiary.

Let’s take a look at several methods to respond to the tax hit realized by the trust!

There are several methods to respond to the tax hit realized by the trust:

• The simplest is to purchase life insurance to cover the tax.

• Another approach is to employ the “pension maximization” strategy. Form a trust with children as beneficiaries. Use IRA distributions to transfer cash to the trust annually. There are no gift and estate taxes to the extent of the annual gift tax exclusion, which is $15,000 in 2019 and 2020. The trust takes out a life insurance policy on the Settlor, naming the trust as the beneficiary. The cash used to make annual gifts to the trust to pays insurance premiums. The life insurance benefit is tax-free to the trust and also tax-free when distributed to the beneficiaries, and the trust provides a lifetime payout to the child.

• Some planners see a possible solution in creative Charitable Remainder Trust (CRT) strategies. CRTs have some interesting features that make them a useful planning tool under the new SECURE rules, especially when coupled with other factors.

• You could look at the efficacy of Roth conversions prior to your deaths in order to avoid this tax.

The SECURE Act also contains the following provisions:

• Under the current law, beneficiaries who did not inherit their accounts from a husband and wife are, in some cases, allowed to withdraw required minimum distributions for the span of their lives, which could be a few years or a few decades. The amount of the distribution is calculated based on a few factors, including life expectancy and beneficiary age. This is sometimes called a “Stretch IRA.” The SECURE Act abolishes the Stretch IRA. When an IRA is inherited, the entire IRA has to be distributed to the beneficiary within ten years. That means the IRA has to be fully taxed within ten years, and the tax-deferred compounding ends. Though I refer to the Stretch IRA, the change also applies to 401(k) plans. Congress wants that money out of the tax-advantaged IRAs and subject to taxes.

• The bill eliminates the maximum age cap for contributions to traditional individual retirement accounts.

• The SECURE Act opens the gates for more employers to offer annuities as investment options within 401(k) plans.

• Previously, qualified account holders such as those with a 401(k) or IRA had to withdraw required minimum distributions (RMD) in the year they turned age 70.5. The SECURE Act increases that age to 72.

• The bill eliminates the maximum age for traditional IRA contributions, which was previously capped at 70.5 years old.

• Employer-sponsored retirement plans would also be available to long-term part-time workers. The SECURE Act drops the threshold for eligibility down to either a full year with 1,000 hours worked or three consecutive years of at least 500 hours.

• Under the SECURE Act, small employers will get a tax credit to offset the costs of starting a 401(k) plan or SIMPLE IRA plan with auto-enrollment, on top of the start-up credit they already receive.

The SECURE Act may enhance or severely disrupt your current estate and retirement plan. Please contact your tax, financial, and legal advisors to see if your plan requires adjustments.