Recently Proposed IRS Regulations on New 10-Year RMD Rule Are a Surprise – Part 3

This is the third of a three-part presentation on recently issued IRS proposed regulations explaining the Setting Every Community Up for Retirement Enhancement (SECURE) Act rule for required minimum distribution (RMDs) on inherited IRAs and qualified retirement plans and the 10-year payment rule. The rules apply to RMDs of beneficiaries of traditional IRA owners and workplace retirement plan participants who die after Dec. 31, 2019.

The proposed regulations are a surprise to many financial advisors. The first column discussed how the 10-year payment rule applies to inherited traditional IRAs and to workplace retirement plans including the Thrift Savings Plan (TSP). The second column discussed the 10-year payment rule for inherited Roth IRAs and Roth retirement plans and the proposed regulations for successor beneficiaries of the original beneficiaries of traditional IRAs and workplace retirement plan participants.

This third column will discuss how the SECURE Act plan affects trusts as IRA and workplace retirement plan beneficiaries.

Naming a Trust as a Beneficiary

In certain situations, it may be beneficial for estate planning purposes and for other reasons to name a trust as the beneficiary of an IRA or a workplace retirement plan rather than individual beneficiaries. Some reasons that a trust ay be appropriate:

(1) An IRA owner or a retirement plan participant wants to provide for a child of a prior marriage and a trust is the best way to accomplish this; or

(2) An IRA owner or a retirement plan participant leaves retirement plan assets to a child, and the child is not capable of responsibly managing investments and/or asset distributions. A trust such as a “spendthrift” trust is the best way to manage the IRA distributions.

Qualified Trusts

Only certain trusts qualify as a designated beneficiary of an IRA or of a workplace retirement plan. The word “qualify” is with respect to required minimum distributions (RMD) purposes. Note that a non-eligible designated beneficiary (non-EDB, such as an adult child as defined in the SECURE Act) of an IRA, or a workplace retirement plan is subject to required minimum distribution rules as explained below.

All of the following requirements must be met for a trust to be treated as a designated beneficiary:

• The trust is valid under state law

• The trust is irrevocable, or will become irrevocable by its terms upon the death of the individual (IRA owner or retirement plan participant)

• The trust beneficiaries are identifiable from the trust document, and

• A copy of the trust instrument is provided to the IRA trustee/custodian or retirement plan administrator.

Effect on RMDs

If the trust meets the four requirements above no later than September 30 of the year following the IRA owner’s or retirement plan participant’s death, then the trust beneficiaries are considered beneficiaries for the purpose of computing the RMDs.

If one of the trust beneficiaries is not an individual (for example, a charity), then the traditional IRA owner or retirement plan participant is treated is not having a designated beneficiary for computing post-death RMDs. In that case, if the traditional IRA owner or retirement plan participant died on or after his or her required beginning date (RBD), post-death RMDs will be based on the owner’s single life expectancy. Otherwise, post-death RMDs must be completed by the end of the fifth year following the year of the traditional IRA owner’s or retirement plan participant’s death.

SECURE Act Effect on Naming Trusts as IRA Beneficiaries

Because of the SECURE Act 10-year payment requirement on non-EDBs, trusts have been downgraded as an IRA planning strategy. The recently issued IRS proposed regulations do not change that. This is because most trust beneficiaries (non-EDBs) will have to withdraw the entire amount of an inherited traditional or Roth IRA within 10 years of the death of the IRA owner. However, the recently issued regulations do clarify some of the confusion that the SECURE Act created within the area of trusts.

In particular, the IRS regulations retained the existing “see-through” rules for trusts. Under the ” see-through” rules for trusts, trust beneficiaries can be treated as beneficiaries of the IRA if the trusts have certain requirements. The IRS retained the existing distinction between “conduit” and “accumulation” trusts in which trust beneficiaries must be considered for payouts from the IRA to the trust.

“Conduit” trusts are a means to pass distributions from the IRA to the trust beneficiary. When a conduit trust is the beneficiary of an IRA, the post-death distributions are first paid from the IRA to the trust and then from the trust to the beneficiaries of the trust. If a conduit trust qualifies as a “see-through” trust, then only the trust’s income beneficiaries are considered in determining life expectancy for RMD purposes. If there is more than one income beneficiary, then the RMDs will be based on the age of the oldest beneficiary. The life expectancy of contingent or remainder trust beneficiaries are not considered. The following example illustrates:

Example.  Jennifer died in 2021. The beneficiary of her traditional IRA is a “see-through” conduit trust that leaves income to her surviving spouse Walter. Walter is considered an income beneficiary for life. At Walter’s death any remaining IRA funds go to Jennifer’s adult children (“remaining” beneficiaries). For purposes of determining IRA payments to the trust, only Walter is considered. Jennifer’s children can be disregarded. Also, Since Walter is a spouse and therefore an EDB, once Walter reaches his requirement beginning date his RMDs can be paid to the trust based on his life expectancy.

An “accumulation,” (also known as a “discretionary” trust) does not have to pay out all IRA distributions to the trust beneficiaries. The trust trustee is given discretion to pay some, all, or none of the IRA distributions to the beneficiaries. The problem is that whatever amount of IRA distributions that are not paid out will accumulate in the trust and taxed in the trust.

It is important to point out that trust tax rates are significantly higher than individual tax rates. The end result is that significantly more in federal income taxes will be paid if the IRA distributions remain in the trust and not distributed to beneficiaries.

If an accumulation trust qualifies as a “see-through” trust, then both the income and remainder trust beneficiaries should be considered in determining payouts from the IRA to the trust. The age of the oldest income or remainder trust beneficiary is used to calculate RMDs on the inherited IRA.

Note that the recently issued IRS proposed regulations on the SECURE Act rules for RMDs do not change the fact that non-EDB individuals will still need to empty an inherited IRA within 10 years following the year of death of the original IRA owner or workplace retirement plan participant.