While the Setting Every Community Up for Retirement Enhancement Act of 2019 (the “SECURE Act”) significantly limited the income tax-deferral opportunities for most inherited IRA beneficiaries, this Act, the proposed regulations issued under it and the related SECURE 2.0 Act of 2022 broadened tax deferral avenues for one particular group: disabled or chronically ill beneficiaries.
Prior to the SECURE Act’s enactment, individual beneficiaries were able to “stretch” distributions from an inherited IRA over their lifetimes. However, disabled and chronically ill beneficiaries frequently struggled to capture this benefit without disrupting their eligibility for public and private assistance. With the SECURE Act eliminating stretch treatment for all inherited IRAs other than those held by an eligible designated beneficiary (EDB)–the definition of which includes a disabled or chronically ill beneficiary–the tables have turned.
Who is Considered Disabled or Chronically Ill?
Let’s begin by defining which beneficiaries are considered disabled or chronically ill.
Disability. An individual beneficiary is considered disabled for purposes of qualifying as an EDB if, as of the date of the participant’s death, the individual: (1) cannot engage in substantial gainful activity; or (2) already has been deemed disabled for purposes of Social Security disability benefits. As it may be hard to determine the long-term capability of a minor beneficiary, the proposed regulations apply a less exacting standard for those under age 18. In this case, the beneficiary must demonstrate a medically determinable physical or mental impairment that results in marked and severe functional limitations and that can be expected to result in death or be of long, continued and indefinite duration.
Chronically Ill. An individual beneficiary is considered chronically ill for purposes of qualifying as an EDB if the individual has been certified by a licensed health care practitioner as being unable to perform -without substantial assistance from another individual- at least two activities of daily living for an indefinite period which is reasonably lengthy in nature.
Under either definition, the proposed regulations require that the disabled or chronically ill beneficiary provide any necessary documentation -including the health care practitioner’s certification, if applicable, to the plan administrator no later than October 31 of the calendar year following the calendar year of the participant’s death.
Why Did Disabled or Chronically Ill Beneficiaries Struggle to Achieve Stretch Treatment Before the SECURE Act?
Programs that provide public and private assistance to disabled or chronically ill individuals may base eligibility for this assistance on the individual’s resources, sometimes referred to as means testing. Indeed, one of the primary public assistance programs, Supplemental Security Income, applies a $2,000 ceiling on the recipient’s currently owned assets –subject to certain exceptions– and other income limitations for participation. For this reason, family members of a disabled or chronically ill individual may leave inherited funds to a special needs trust, rather than to the individual outright.
A special needs trust typically grants the administering trustee total discretion over trust distributions and may include varying levels of restriction on distributions that would supplant, rather than supplement, outside assistance. Notwithstanding this protective language, the trustee may use trust assets to pay the providers of goods and services to the beneficiary. A special needs trust can also facilitate fiscal management and provide the beneficiary with asset protection. Most importantly, however, the terms of a properly drafted special needs trust will exclude such trust’s assets from the beneficiary’s resources for purposes of a means-tested assistance program.
Despite their benefits, special needs trusts have historically created certain tax-related hurdles for disabled or chronically ill beneficiaries when funded with inherited IRAs. Most notably, the prior stretch treatment allowed for individuals only applies to certain “see-through trusts” that either (i) distribute all IRA withdrawals to the trust’s beneficiary (that is, a “conduit trust”), or (ii) allow the retention of such withdrawals but (x) include only individual beneficiaries as potential recipients of the trust’s interest in the IRA funds and (y) key the IRA’s required minimum distributions to the oldest of these beneficiaries (that is, an “accumulation trust”). In each case, the IRS “sees through” the trust to any beneficiaries who may receive the trust’s IRA funds to determine whether stretch treatment is permissible. However, as discussed above, a conduit trust is unlikely to meet the needs of a disabled or chronically ill beneficiary, as the required outright distributions would disqualify the beneficiary from some forms of public or private assistance. Additionally, concerns over the ability to name older individuals or charities as remainder beneficiaries without lessening or losing stretch treatment made the accumulation trust structure unappealing for others.
What Has Changed Under the SECURE Act and Its Progeny?
The proposed regulations issued under the original SECURE Act and the recently enacted SECURE 2.0 Act now make it easier than ever before to fund a special needs trust with an inherited IRA and retain stretch treatment over a disabled or chronically ill beneficiary’s lifetime, thereby reducing income taxes on these assets. While the risk posed by a conduit trust to the beneficiary’s eligibility for public or private assistance remains, this change in law removed two major roadblocks to the use of an accumulation trust.
Multi-Beneficiary Trusts. Instead of adjusting or eliminating stretch treatment depending on the identities of all of an accumulation trust’s potential beneficiaries, the proposed regulations provide an exception for trusts that benefit at least one disabled or chronically ill EDB but have more than one beneficiary (known as an “applicable multi-beneficiary trust”). In that case, provided that the trust restricts access to the trust’s IRA funds to disabled or chronically ill EDBs while any such disabled or chronically ill EDB is living and that the trust’s beneficiaries during this period are all individuals, all non-disabled-or-chronically-ill trust beneficiaries will be ignored for purposes of determining stretch treatment. Thus, the IRA’s required minimum distributions may be stretched throughout the oldest disabled or chronically ill EDB’s lifetime despite the trust’s inclusion of non-EDB beneficiaries.
Charitable Remaindermen. Additionally, the SECURE 2.0 Act of 2022 expressly allows an applicable multi-beneficiary trust to include a charitable organization as a remainder beneficiary after the death of all disabled or chronically ill EDBs. Many families with disabled or chronically ill members welcomed this change, as such impacted individuals frequently receive significant support from charitable organizations. As a result, it is common for such families to include a charitable organization as a special needs trust’s remainder beneficiary. Now, the loved ones of a disabled or chronically ill EDB may use a special needs trust to give back to their favorite charity or charities without impacting the income tax treatment of the trust in question.
The adoption of the SECURE Act and the regulations and additional law that followed significantly altered the estate planning landscape for retirement account owners; particularly for families that include disabled or chronically ill individuals, who now have greater flexibility to preserve an IRA’s tax-deferral properties while benefitting both their loved ones with special needs and the other individuals and organizations they hold dear.
Robert Dietz is National Director of Tax Research, and Jennifer Goode is a Director in the Wealth Strategies Group, both at Bernstein Private Wealth Management.