The SECURE Act of 2019 imposes significant changes for inherited IRAs received from an account owner who dies post December 31, 2019.
The law previously allowed beneficiaries of inherited IRAs the ability to ‘stretch’ IRA distributions over their lifetime. This helped to reduce the tax burden of inherited IRA distributions by potentially extending distributions over many years, particularly for younger individuals.
The passing of the SECURE Act dramatically limits the ability to defer distributions from inherited IRAs received from a decedent who dies as of January 1, 2020 or later. The new law requires all inherited IRA assets to be distributed within 10 years of the IRA owner’s death, with a few exceptions, including for minor children.
The New Rule: 10 Years or Greater for Minors
The new rule provides flexibility for minors (and others, but we are focusing on minors and able children in this discussion). If a child is named as a beneficiary, the child can still ‘stretch’ IRA distributions over his or her lifetime up until the age of majority (typically age 18, sometimes 21 depending upon the state), or up until age 26 if still enrolled in school. Beyond that time, the child is limited to a 10-year window in which all remaining IRA assets must be distributed.
What potentially complicates this matter is if you direct IRA assets for your child to be held in Trust.
Planning for Children: Outright or in Trust?
Parents have always faced a decision of whether to leave assets outright to their children or in Trust. If assets are left outright, the child assumes full control of such assets at the age of majority.
The other option is to leave assets in Trust, with the ability to dictate when your child receives access to income or principal distributions.
Given the fact that many young adults have limited practical life experience in managing money, let alone large sums of money, we frequently advise leaving money in Trust.
Trust Distributions: 5 Years, 10 Years or Greater for Minors
If IRA assets are left to a beneficiary in Trust, the manner and timeframe during which IRA assets must be distributed depends upon how the Trust is written.
Some Trusts limit the distribution window to a short 5-year time horizon.
Many Trusts that were originally drafted with special IRA ‘stretch’ provisions still offer a longer time horizon, but this should be carefully reviewed with your attorney. On the presumption that your Trust language still qualifies for more than a 5-year IRA distribution window, the ultimate distribution timeframe during which IRA assets must be distributed largely depends upon the type of trust elected in your documents, either a Conduit Trust or an Accumulation Trust.
Accumulation Trusts, with proper language, are now generally limited to a 10-year distribution window, even if you die when your child is a minor.
Conduit Trusts, again with proper language, give the potential to extend IRA distributions until your child reaches the age of majority (or up to 26 if still in school), plus an additional 10 years thereafter.
Which to Choose: A Conduit or Accumulation Trust?
At first blush, you might immediately consider a Conduit Trust based upon the longevity of distribution potential outlined above for younger children. However, the ultimate decision should heavily consider whether such distributions are in your child’s best interests. The crux of the matter revolves around when assets will be distributed to your children, and in what magnitude.
An Accumulation Trust allows all income, including IRA distributions, to be accumulated. The downside to this type of Trust is that it limits the IRA distribution window to 10 years (even for minors). This shorter timeframe for minors could be tax punitive. However, the benefit is that the IRA distributions, along with other Trust income, can accumulate in the Trust. An Accumulation Trust places your Trustee in control of the assets, following your wishes for your child as outlined in your Trust.
Conversely, a Conduit Trust requires that all IRA distributions be distributed to the beneficiary outright versus held in Trust over a longer timeframe. The benefit to a Conduit Trust is that it has the potential to extend distributions over a longer time horizon for younger children, potentially reducing tax liabilities. However, the downside is that your child will receive all IRA distributions as they occur, potentially transferring larger amounts of money to your children at younger ages than you ever intended.
Is a Conduit Trust or an Accumulation Trust Best for Your Children?
There is no right or wrong answer as to which type of Trust is best suited for you and your children. That said, the primary points to consider include:
- The Age Of Your Children: If your children are very young, a Conduit Trust might still make sense as distributions could be stretched over a number of years.
- The Value Of Your Retirement Assets: The dollar amounts your kids stand to receive should definitely be considered. If your retirement assets are fairly small, perhaps a Conduit Trust makes sense. However, if your retirement assets are of significant value, an Accumulation Trust is worthy of consideration.
- Your Child’s Financial Maturity: If your child is old enough to evaluate his or her financial maturity, this should be a material consideration, with a favoring toward Accumulation Trusts if your child exhibits a need for greater financial acumen, or Trust protection.
- Your Child’s Financial Liability Exposure: If you have concerns about your child encountering a financial claim pertaining to a divorce, business or liability lawsuit, an Accumulation Trust might be best suited.
Scenarios for Consideration
We offer a number of hypothetical scenarios that might be of assistance in evaluating your own family estate planning considerations.
A 3-year-old beneficiary has the potential to extend distributions over a minimum of 25 years (15 years until the age 18 plus an extra 10 years), or a maximum of 33 years (if in school until age 26 plus an extra 10 years). A Conduit Trust’s potential for extending taxable IRA distributions over this timeframe might outweigh the loss of distribution control foregone by not electing an Accumulation Trust.
A 14-year-old inherits a $400,000 IRA with planned college attendance until age 22. With a Conduit Trust, distributions could extend over 19 years (9 years while in school plus 10 additional years), allowing distributions of roughly $21,000 per year (or greater for college needs), distributed to the child. If the child consumes distributions of $65,000 per year for college over 4 years ($260,000 total), the residual IRA value post graduation might be $140,000. This amount could be distributed over 10 years, perhaps equating to $14,000 per year being distributed to your child. Conversely, an Accumulation Trust would require all distributions to be paid over 10 years, likely requiring distributions of at least $40,000 per year from your child’s age of 14 to 24.
A 16-year-old child inherits a $1.5 million IRA with planned college attendance until age 22. With a Conduit Trust, distributions could extend over 17 years (7 years while in school plus 10 additional years), allowing distributions of roughly $88,000 per year, distributed to the child. While such distributions might be consumed by college expenses in early years, parents need to heavily weigh if the child is financially mature enough to receive such sizeable distributions at relatively young ages, extending from ages 16 to 32. With an Accumulation Trust, distributions must be paid over 10 years at a potentially higher tax burden, but all distributions can remain in the Trust, following the terms of the Trust as described by you.
A 24-year-old child who has completed all studies inherits a $1.5 million IRA. Under either a Conduit Trust or an Accumulation Trust structure, all distributions must occur over 10 years. With a Conduit Trust, your child will likely receive at least $150,000 per year of distributed income between the ages of 24 and 33. Conversely, with an Accumulation Trust, all distributed IRA assets can remain in Trust following the terms of your Trust, and permissible distributions as specified or granted to the Trustee.
A 40-year-old child inherits a $1 million IRA. Under a Conduit Trust, the child will likely receive at least $100,000 per year. Your child may or may not have the financial maturity to manage such distributions. Regardless, the assets will be transferred to your child’s name, potentially being subject to creditor claims in the event of a divorce or lawsuit. Conversely, if an Accumulation Trust is elected with mandatory distributions extending beyond age 40, any retained distributions are protected from creditor and spousal interests.
Hybrid Planning for Minor Children
If your child is under the age of 18, you face a dilemma of opting for a longer distribution timeframe under a Conduit Trust structure or a more protective structure with an Accumulation Trust. The reality is that your preferences might change between when your kids are young relative to as they grow closer to age of majority. One thought to consider is introducing a hybrid approach to your planning where you designate a Conduit Trust if your child is young, and Accumulation Trust if your children are older than a prescribed age. Such planning is more complicated and would entail higher attorney fees, but the benefits extended to your children could far outweigh the costs.
SageVest Wealth Management understands the importance of properly planning for family and loved ones. We’re happy to help you evaluate what personalized planning considerations are best relative to your personal preferences, family structure, beneficiary age(s), and asset composition. Please contact us to discuss further.
Disclaimer: The points noted above should not be construed as legal advice. You are advised to consult with your attorney for legal advice, particularly before implementing any changes in your legal documents or beneficiary designation language.