Major Changes in Ira and 401K Rules That May Impact Your Estate and Financial Planning

Congress passed the “Secure Act” which makes major changes in the rules as to distributions from 401k plans and IRAs, beginning January 1, 2020. If you have any questions, please contact us to see how these new rules may impact your estate planning. Set forth below is a Q/A to explain some of the changes. We will refer to IRAs only, but unless noted below these rules apply to 401k plans or profit-sharing plans. The new rules do not apply to pension plans.

1. Q. CAN I STILL LEAVE MY IRA OR 401K PLAN TO MY CHILDREN?

A. Yes, however, the stretch IRA (both for Roth IRAs and Traditional IRAs) is no longer available except in limited circumstances. Under the old law if a child or grandchild inherited your IRA, they could take the required minimum annual distributions based upon their life expectancy rather than yours. This allowed decades of income tax deferred (or income tax free if a Roth) distributions from the IRA. Unfortunately, under the new law, distributions have to pay out over a period no longer than the end of the calendar year containing the 10^th anniversary of the date of your death. The IRA distributions may be made over the 10-year period or it may be distributed all at once, even in the 10^th year. There are exceptions to the 10-year withdrawal rule for a spouse, minor children (not grandchildren), a disabled person, a chronically ill individual including possibly a special needs child, or a person who is no more than 10 years younger than you.

2. Q. WILL THIS CHANGE IN THE IRA LAW IMPACT MY ESTATE PLANNING?

A. It might. If your primary beneficiary is your spouse, there is no change since your spouse can roll the IRA over income tax free into his or her own IRA and take the funds out over his or her life expectancy or choose a few other available options. However, if you leave funds to a child or grandchild or a trust for their benefit, then the 10-year rule applies (with certain exceptions mentioned above). The problem is you might have already set up a trust for the benefit of a child or grandchild that was designed to take advantage of the long pay out rate over the life expectancy of the child or grandchild under the old rule. Under the old rule, you could protect the IRA from a financially immature child or grandchild and keep the funds in the family and protected from in-laws, what we call a Bloodline Trust. However, most trusts drafted under the old law direct that the required minimum distribution the trust receives each year from the IRA, must pay outright to the beneficiary. Thus, these trusts drafted under the old rule, will now end up paying the entire IRA outright to the beneficiary in 10 years, rather than protecting the money for decades. If your trust is setup to do this, now may be the time to revisit your estate plan.

3. Q. IF I HAVE A SPECIAL NEEDS CHILD ARE THERE CHANGES I SHOULD MAKE TO MY ESTATE PLAN?

A. Under the new law, certain disabled and chronically ill beneficiaries can use their life expectancy when inheriting an IRA. If you have a special needs child or beneficiary, please contact us to see if your plan should be updated to take advantage of this rule. See Q/A 7 and 8, below.

4. Q. WHEN MUST I TAKE MONEY OUT OF MY IRA OR 401K?

A. The old rule provided that in the year you turn 70 ½, you must begin taking your required minimum distributions from traditional IRA and/or 401k plan with certain exceptions. (This is the tax law, so of course there are always exceptions.) The new rule changes the date to age 72. If you turned 70 ½ in 2019 or earlier, you are covered by the old law not the new one. Going forward, as long as you did not turn age 70 ½ by 2019 or earlier, you are eligible for the age 72 rule. For example, if you turn 72 in 2021, you must take your first distribution for the traditional IRA by no later than April 1, 2022, plus one more in 2022, and then a minimum distribution in each year thereafter. Remember, under the old and new law, there are no required distributions that apply to your Roth IRA.

5. Q. HAVE THE RULES CHANGED ON HOW LONG I CAN CONTRIBUTE TO AN IRA?

A. The age restriction on deductible contributions to an IRA has changed. You can now continue to make deductible contributions to an IRA after age 70 ½, as long as you have wages or self-employment earnings.

6. Q. WHAT IF I LEAVE MY IRA TO A CHILD OR GRANDCHILD?

A. The rules are different for your child and grandchild. If your child is under the age of majority, they can use distribution rules based upon their age. However, when they reach the age of majority, the IRA must be liquidated within ten years. There is no such rule for a grandchild. So, an IRA paying to a grandchild must be paid out over no longer than 10 years. Unless the IRS states otherwise, the age of majority is probably 18 except for the few states that have different age of majority. Ohio’s age of majority is 18.

EXAMPLE. Let us say that on your death in the year 2025, your IRA is payable to your 10-year-old child (or probably a trust for the benefit of the child.) Under the IRS tables, the age of the child is determined the year after your death – 2026. Under the IRS tables, the child has a life expectancy of 71.8 years. If the balance of your IRA at the end of 2025 was $248,100, that amount is divided by 71.8, which equals approximately $3,455. The $3,455 is the required minimum distribution for the child that must be paid out to the child or trust by no later than the year after your death – 2026. This means you have only removed approximately 1.4% of the trust. Hopefully, your IRA will continue to grow tax free or deferred at a greater rate and keep growing. Let us say by the end of 2026, after the distribution, the IRA has grown to $258,000. Then in 2027, the minimum distribution will be $258,000 divided by 70.8 (the life expectancy is reduced by one each year) or approximately $3,644. When the child reaches the age of majority, the rest of the IRA must be distributed by the end of the 10^th year following the year the child reaches the age of majority.

7. Q. WHAT IF I LEAVE AN IRA TO SOMEONE WHO IS DISABLED OR CHRONICALLY ILL?

A. A payment to someone who is disabled or chronically ill can be paid out over their lifetime – a stretch out just like the old stretch out rules. This applies to payments to a child, grandchild or any other individual. The definition of disabled means the person is unable to engage in any substantial gainful activity because of a physical or mental impairment which is expected to last until death or for a long and indefinite duration. A chronically ill individual means someone who is unable to perform at least two activities of daily living for an indefinite period without assistance. The activities include eating, toileting, transferring, bathing, dressing and continence. A chronically ill individual also includes someone who requires substantial supervision to protect that individual from threats to health and safety due to severe cognitive impairment.

8. Q. DOES THE IRA HAVE TO LIQUIDATE UNDER THE NEW FAST PAYOUT RULES FOR A SPECIAL NEEDS CHILD?

A. Depending on how the IRS interprets the new law and the states interpret the Medicaid rules, it may be possible to provide that the IRA pays into a special needs trust for a disabled child and still have the IRA payout over the life expectancy of the disabled child allowing for more tax deferred growth. The trust would provide for the special needs child, but the child would still qualify for Medicaid and other needs-based government programs.

9. Q. ARE THERE ANY OTHER CHANGES THAT IMPACT MY IRAS?

A. Yes. The IRS has proposed new life expectancy tables which recognize that life expectancy has increased. If finalized, this would mean that the yearly required minimum distributions would decrease compared to the existing rules. If finalized, these rules will become effective for required distributions in 2021. For example, under existing rules in your first year when you have to take out your minimum distribution using the new age 72 required minimum distribution rule, if you had $250,000 in your IRA, you would be required to withdraw $9,766, or approximately 3.91% of your IRA. Under the new rules you would be required to take out $9,158, or approximately 3.66% of your assets. This means you would take out $608 less. Although this is a small number, it will allow more dollars to stay in the IRA, growing tax deferred. The rules are even more pronounced for older individuals. Under the existing rules, a 90-year-old retiree with $250,000 in his or her IRA would be required to withdraw $21,930 from the IRA, compared to $20,661 under the proposed rules, leaving $1,269 in the IRA to grow tax deferred.