By: Anne Sullivan, Esquire
Published: July 2021
When was the last time you checked your TSP or IRA beneficiary designations? If you haven’t lately, or even if you have, please go back and review them now against the Secure Act. Never heard of the Secure Act? Let me explain.
In December 2019, Congress enacted the Secure Act to encourage Americans to save more in their retirement accounts. While the law ushered in several changes to stimulate retirement savings, it also dramatically changed the distribution rules for TSPs, IRAs, and other income tax-deferred accounts. The law applied immediately to IRAs but delayed implementation for the TSP until December 30, 2021.
The Major Change
Before the Secure Act, a beneficiary of an inherited TSP or IRA could “stretch” the required minimum distributions (RMD) based on their age and life expectancy. Popularly known as the “stretch-IRA,” this was a simple strategy for estate planning attorneys to help clients pass along retirement savings to the next generation. With the lifetime stretch, heirs could withdraw smaller, incremental amounts over time, lowering their income tax burden and allowing inherited TSP and IRA investments to grow. Under the Secure Act, most beneficiaries of an IRA or TSP must withdraw the entire account balance and pay taxes within 10 years from the account owner’s death. Beneficiaries can withdraw funds in any amount over 10 years, so long as the entire account balance is depleted by the end of the 10thyear. Nevertheless, the 10-year rule means that many heirs will have to pay higher income taxes, and the accounts will have less time to grow.
Rethinking Your Distribution Plan
As an estate planning attorney, one of the top questions I receive from clients with significant account balances is whether there are any strategies to offset this change in the law. For clients with younger heirs, that question is often followed by asking how the funds can be protected for them and sometimes from heirs who may not make the best financial decisions.
Naming an Eligible Designated Beneficiary: Although the Act eliminated the stretch for most beneficiaries, it is still available for certain groups that are referred to as “Eligible Designated Beneficiaries.” The largest of this group are surviving spouses. The old rules still apply. A surviving spouse can retitle the account and defer RMDs until they turn 72. Other Eligible Designated Beneficiaries include:
- The Account Owner’s Minor Children: Can delay taking distributions until 18 or 21, depending on the state, and then the 10-year rule takes effect.
- Chronically Ill and Disabled Beneficiaries: Can stretch the TSP for a lifetime; and
- Beneficiaries fewer than 10 years younger than the Account Owner: Can stretch the TSP for a lifetime.
Consider Roth Opportunities: Another option to consider is a better use of the Roth TSP or potentially a Roth conversion. There are no intra-plan conversions for TSPs. This means you cannot “roll over” a TSP into the Roth TSP. However, you can elect to have distributions moving forward apply to the Roth TSP. The Secure Act and the 10-year rule apply to Roth IRAs, though the distribution from a Roth IRA is not taxable.
Another option is to convert a Traditional IRA to Roth IRA. You will pay income taxes on the market value of the amount converted from a traditional IRA to a Roth IRA in the year that it is converted. Federal employees separated from service or having attained age 59 ½ can make an in-service withdrawal or distribution from a TSP and transfer it into a Traditional IRA. Once the funds are transferred into Traditional IRA, they can be converted into a Roth IRA. Because of the immediate income tax implications, it is always important to discuss this option with a CPA and financial advisor to fully understand the tax ramifications of conversions and transfers.
Naming Charities and Charitable Remainder Trusts: If you have charitable intent, a great option is to name a charity or a charitable remainder trust as a beneficiary because charitable organizations are exempt from paying income taxes. For people with sizeable retirement accounts, a charitable remainder trust is an option for those who plan to leave their assets to a charity but also want to continue to provide an income stream to a beneficiary. This type of trust can generate an income stream for another beneficiary for years or for their lifetime and leaves the remaining balance to the charity.
Thorny Issue When Naming a Trust as Beneficiary
The Secure Act has complicated distribution plans for those who have designated a trust as the beneficiary of their TSP or IRA for the benefit of minor children or young adults. Many clients with minor or young adult children prefer to name a trust to help protect funds from mismanagement, creditor claims, and divorce. To maximize income tax deferral, though, a TSP or IRA must have a designated beneficiary. IRS does not consider a trust as an individual unless it has “see-through” provisions.
One common type of trust is set up to accumulate income over an extended period, known as an “accumulation trust.” Unless this trust has “see-through provisions,” the trustee must withdraw the entire amount within five years and pay taxes at the highest income tax bracket of 37%. However, the benefit of an accumulation trust is that the trustee can distribute the money to beneficiaries past 10 years. Despite the higher tax, an accumulation trust with no forced distributions is sometimes the preferred estate planning option for parents of young children or for adult beneficiaries with creditors, spendthrift tendencies, or other issues.
Another type of trust, one that has see-through provisions, is a conduit trust. Under the old law, the trustee of a conduit trust could stretch distributions over the oldest beneficiary’s lifetime. The Act changed this so that the inherited account must be emptied after 10 years. Some conduit trusts can still qualify for a stretch by requiring withdrawals to the designated beneficiary. It is important to remember that the entire balance must still be distributed to an individual beneficiary by the end of the 10 years (or the end of the term for Eligible Designated Beneficiaries). And the issue is that some conduit trusts will not qualify for a stretch because the trust language does not account for this change in the law. If you have a pre-Secure Act conduit trust, it is essential to have an estate planning attorney review the terms.
Review your TSP beneficiary designations to make sure they are aligned with your goals and consider distribution options. If a trust is named a designated beneficiary, it is important that you review the trust with an estate planning attorney. You may need to change the trust provisions or eliminate the trust altogether.
Anne H. Sullivan, Esq. has been a member of the Maryland State Bar since 1999 and is a member of the District of Columbia, and Virginia State Bar Associations. Anne has spent 14 years as a speaker in the area of trust and estate planning with the National Institute of Transition Planning. As an estate planning attorney, Anne is most passionate about helping people have the real and necessary conversations about death and disability, then leveraging her legal expertise to help put plans into action.
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