On Feb. 23, the Internal Revenue Service released proposed regulations under the Setting Every Community Up for Retirement Enhancement (SECURE) Act. Here’s a first look at some of the key changes in the proposed regs.
EDBs Get More Time to Take RMDs
The proposed regs benefit a new class of beneficiaries created under the SECURE Act: eligible designated beneficiaries (EDBs). EDBs consist of the individual retirement account owner’s spouse, a person not more than 10 years younger than the IRA owner, the IRA owner’s minor child, or a disabled or chronically ill beneficiary. (In the case of an IRA owner’s minor child, only during minority. The age of majority is set at 21.) While the SECURE Act requires other beneficiaries to take their required minimum distributions (RMDs) over a 10-year period, EDBs may continue to take their RMDs over the life expectancy of the “designated beneficiary” of the trust. This gives EDBs more time to take their RMDs (thus extending the tax benefits of the IRA).
If the IRA is a trust, you determine the designated beneficiary by looking at the trust beneficiaries. If the beneficiaries are all individuals, the oldest beneficiary is considered the designated beneficiary, so EDBs can stretch the RMDs over the oldest beneficiary’s life expectancy.
In an accumulation trust (one in which the trustees could accumulate some or all of the amounts they received from the IRA), the life expectancies of remainder beneficiaries are taken into account. If the remainder beneficiary is a charity, the IRA owner is treated as having no designated beneficiary, because IRA benefits could be accumulated during the previous beneficiary’s lifetime to be subsequently paid to the charity. This would usually result in a shorter time to take RMDs.
In a conduit trust (one in which all of the amounts the trustees received from the IRA must be paid out to the current beneficiary), all of the subsequent beneficiaries could be disregarded in calculating the lifetime of the designated beneficiary.
The proposed regs allow IRA owners to disregard some beneficiaries of accumulation trusts when determining the RMD period. A beneficiary whose interest is contingent on the death of a prior beneficiary who only has residual interest can be disregarded. For example, suppose a trust with an IRA provides income to A, then remainder to B if B survives A, but if B doesn’t survive A, then the remainder goes to charity. Under the proposed regs, if B survives the IRA owner and has no interest in the trust during A’s lifetime, then the charity is disregarded. This would usually result in the ability to take the RMD over a 10-year period.
To take advantage of this, the trust must have a remainder beneficiary who takes outright, as in the example in the previous paragraph. However, as in that example, if the remainder is payable to B outright on A’s death, B will lose the creditor protection and tax savings of having the assets in the trust. The trust assets will be thrown into B’s estate for estate tax purposes and will become subject to B’s creditors, spouses and Medicaid. Before naming a charity as a contingent remainder beneficiary, IRA owners should consider whether they’re willing to give up this protection by having the first named remainder beneficiary take outright rather than in further trust.
Similarly, if a beneficiary of a trust must receive all the trust assets by the later of the end of the year following the IRA owner’s death or the end of the year when they reach age 31, a subsequent beneficiary who only takes if the primary beneficiary dies before that point is disregarded. For example, suppose a trust mandates complete distribution to A by the later of the end of the year following the IRA owner’s death or the end of the year when A reaches age 31, but if A dies before that point, then to B. In that case, B is disregarded.
IRA owners may not want to set up a trust in this way because the trust protections would cease by the end of the year in which the primary beneficiary reaches age 31 or by the end of the year following the IRA owner’s death.
Broader Definition of Disabled
A disabled beneficiary is an EDB and may use the life expectancy stretch. A trust for the benefit of a disabled beneficiary may also use the life expectancy stretch if, during the disabled beneficiary’s lifetime, no distributions may go to anyone other than a disabled or chronically ill person.
The SECURE Act defines “disabled” the same way it’s defined for Social Security purposes. That is, an individual is considered disabled if they’re unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death or to be of long-continued and indefinite duration.
Because it may be difficult to apply that test to younger individuals, the proposed regs provide that an individual under age 18 is considered disabled if they have 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 to be of long-continued and indefinite duration.
The proposed reg also provide a safe harbor. If, as of the IRA owner’s death, the Social Security Administration has determined that an individual is disabled, they’ll be deemed to be disabled for this purpose.
Class Additions Don’t Affect Identifiability Requirements
The beneficiaries of a trust need to be identifiable. The proposed regs make clear that an addition to the class of beneficiaries, such as the birth of an additional grandchild in the case of a trust for the benefit of the IRA owner’s grandchildren, won’t cause the trust to fail the identifiability requirements. This will allow considerable flexibility in drafting.
Treatment of Appointees Under Power of Appointment
Under the original 1987 proposed regs under Internal Revenue Code Section 401(a)(9) regarding required distributions, there was some uncertainty as to how permissible appointees under a power of appointment (POA) would be treated. In 2002, the IRS allowed a POA that could be exercised in favor of anyone other than the beneficiary, their creditors, their estate, the creditors of their estate or anyone born in a calendar year prior to the year of birth of the IRA owner’s oldest living issue at the time of the IRA owner’s death. Since that ruling allowed a broad class of permissible appointees, planners generally followed it and limited their POAs in the same manner.
Under the proposed regs, if a POA is exercised by Sept. 30 of the year following the IRA owner’s death in favor of one or more identifiable beneficiaries, those individuals will be treated as designated.
Beneficiaries who are eliminated by Sept. 30 of the year following the IRA owner’s death are disregarded. The proposed regs allow the class of permissible appointees to be restricted to identifiable beneficiaries by that date. This will permit a beneficiary with a POA to narrow the class of permissible appointees to eliminate an unwanted beneficiary from the class of permissible appointees. The IRS previously allowed this in Private Letter Rulings 201203003 (Jan. 20, 2012) and 201840007 (Oct. 5, 2018).
Beneficiaries who are added after Sept. 30 of the year following the IRA owner’s death are counted. That suggests the possibility that permissible appointees might not be counted until the POA is exercised so as to make them beneficiaries.
Modifications Won’t Affect Identifiability Requirement
The proposed regs provide that a see-through trust won’t fail the identifiability requirement merely because state law permits the trust to be modified, such as by reformation or decanting. A beneficiary removed by Sept. 30 of the calendar year following the IRA owner’s death is disregarded, and one that’s added is considered. If the additional beneficiary is added after Sept. 30 of the calendar year following the IRA owner’s death, the rules governing beneficiaries added pursuant to a POA will apply.
More than half the states have decanting statutes. In addition, while the common law is sparse, a trustee with complete discretion to distribute principal may be able to decant a trust under common law in favor of one or more of the beneficiaries. It should also be possible to decant a trust to the extent authorized in the will or trust instrument.
While the trust instrument referred to the action as a disclaimer rather than a decanting, the IRS had allowed decanting pursuant to the terms of the instrument in PLR 200537004 (Sept. 16, 2005).
The IRS originally allowed reformations in PLRs 200620026 (May 19, 2006) and 200235038 through 200235041 (Aug. 30, 2002). However, subsequent to those rulings, the IRS didn’t allow reformations in PLRs 201628004 (July 8, 2016) and 201021038 (May 28, 2010). The proposed regs will provide additional flexibility in this regard.
Annual Distributions to Designated Beneficiaries
Under the SECURE Act, a designated beneficiary other than an EDB must take complete distribution by the end of the 10th calendar year following the IRA owner’s death.
Commentators had assumed that no distributions would be required until that year. However, the proposed regs require that, if the IRA owner dies on or after the required beginning date (April 1 of the year following the year the IRA owner attains age 72), the beneficiaries (other than the spouse) must take annual distributions in the interim based on the designated beneficiary’s life expectancy in the year following the IRA owner’s death, reduced by one for each subsequent year.
Similarly, the proposed regs require annual distributions during the 10-year period following the death of an EDB, as well as during the 10-year period following an IRA owner’s minor child reaching majority.
The basis for this is Internal Revenue Code Section 401(a)(9)(B)(i), which provides that, when the IRA owner reaches his required beginning date, distributions to the beneficiary must be made “at least as rapidly as under the method of distributions being used … as of the date of [the IRA owner’s] death.”
The IRS had previously included this in the draft of Publication 590-B but then removed it. Some people think this was included in error.
Beneficiaries of a traditional IRA may want to spread the distributions over multiple years in any event to avoid bunching the income. However, a beneficiary of a Roth IRA who didn’t need the money earlier would have waited until the final year before taking distributions so as to maximize the period when the Roth IRA could continue to grow tax-free. If this requirement remains in the final regulations, it will result in a greater burden on beneficiaries of Roth IRAs.
If this provision remains in the final regulations, the determination of the oldest beneficiary will have significance, because it will determine the amount of the RMDs during the 10-year period until complete distribution is required.
Subject to Change
Keep in mind that these are only proposed regs and may change when the IRS issues final regs. Also, the IRS will continue to issue PLRs, which while not binding on the IRS except with respect to the taxpayers to whom they are issued, may provide an indication of their thinking.