The Secure Act
International tax and estate planning attorney, Misbah Farid, explore the intricacies of Section 401(a)(9) of the Internal Revenue Code.
Transcript:
MISBAH FARID
Good afternoon. My name is Misbah Farid, and I’m one of the attorneys here at Bilzin Sumberg in its private client group. I’m here with Stephanie Diaz, who is also a fellow attorney in the private client group.
STEPHANIE DIAZ
Thanks, Misbah. So I hear we’re talking about the Secure Act. Well, it apparently has nothing to do with security. Well, what is the Secure Act, and how did we get here?
MISBAH FARID
So, on December 19, 2019, Congress approved an appropriations bill; it’s H.R. 1865. It involves changes to Section 401(a)(9) of the Internal Revenue Code. It became effective on January 1 of 2020, and much of the Secure Act relates to the administration of qualified plans and individual retirement accounts. For individuals who die after December 31, 2019, the applicable distribution period for inherited benefits paid to “designated beneficiaries” has been changed. Before, designated beneficiaries were permitted to take distributions from the inherited benefits over the designated beneficiary’s life expectancy. The Secure Act now creates a new category of a beneficiary called an Eligible Designated Beneficiary, and these are the only persons who may receive inherited benefits over their life expectancy. They are the following persons: a surviving spouse, disabled individuals, chronically ill individuals, individuals less than ten years younger than the participant, which can be a friend or a family member, and a minor child to the participant but only until they reach the age of majority as defined in the new law at which point the ten-year rule becomes applicable. Note that upon the death of an eligible designated beneficiary, if the benefits have not been distributed in their entirety, remaining distributions can no longer be stretched over the beneficiary’s life expectancy, but must be distributed within ten years of the death of the death of the eligible designated beneficiary. Benefits payable to designated beneficiaries who are not eligible designated beneficiaries must be paid out no later than ten years after the death of the participant. As to the payout over a ten-year period, I wanted to point out that it need not be pro-rata, and everything can be couched in either earlier or in later years.
STEPHANIE DIAZ
That’s interesting, though. It doesn’t have to be pro-rata. If these rules are for eligible designated beneficiaries, how do we deal with non-designated beneficiaries?
MISBAH FARID
That’s a great question. A five-year rule applies to a beneficiary who is not a designated beneficiary. So the same rules apply to a non-designated beneficiary both before and after the Secure Act. Examples of non-designated beneficiaries are as follows: the plan participant’s estate, a charity, and a trust that does not qualify as a see-through trust. If a no designated beneficiary is named and a plan participant dies before their required beginning date, then the five-year rule applies. The five-year rule requires the plan participant’s account balance to be fully distributed within five years of the plan participant’s death. The exception: if a plan participant dies after his required beginning date, then the “at least as rapidly rule” can apply. The “at least as rapidly rule” uses the plan participant’s remaining life expectancy measured via the single life table to determine the number of years and distribution amount per year required to be distributed to the non-designated beneficiary. The Secure Act provisions do not contradict the “at least as rapidly rule” exception set forth in the Treasury Regulations. As such, the exception is presumed to still apply until further Treasury Regulations are introduced.
STEPHANIE DIAZ
Okay. So, it feels like there are four categories we have got to be thinking about. Are they eligible beneficiaries? Are they non-designated beneficiaries? And then are we in a ten-year rule or a five-year rule? When do those periods commence?
MISBAH FARID
That would be December 31 of the calendar year of the plan participant’s death.
STEPHANIE DIAZ
Okay. How do we deal with a situation where there’s no beneficiary designation?
MISBAH FARID
If there is no beneficiary designation, everything must come out within five years.
STEPHANIE DIAZ
Wow. Okay. So going back to eligible designated beneficiaries, is it difficult to meet the definition of "disabled"?
MISBAH FARID
So the term disabled is defined in Internal Revenue Code Section 72(m)(7). The definition states as follows: “For purposes of this section, an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long, continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and in manner as the Secretary may require.” So, Stephanie, based on that definition, I do think it is a difficult test to meet, and of course, you have to provide proof of the disability.
STEPHANIE DIAZ
Okay. Wow. So how do you deal with a chronically ill beneficiary? What’s that test like?
MISBAH FARID
Well, in general, the term “chronically ill individual” means any individual who has been certified by a licensed healthcare practitioner as (and this is going to be an "or" test): So the first "or", or the first possibility to meet the definition of the term “chronically ill” is being unable to perform without substantial assistance from another individual, at least two activities of daily living for a period of at least 90 days, due to a loss of functional capacity, or the second option, having a level of disability similar (as determined under regulations prescribed by the Secretary (in consultation with the Secretary of Health and Human Services) to the level of disability described in that first test that we previously mentioned, or the third test requiring substantial supervision to protect the individual from threats to health and safety due to severe cognitive impairment. This definition would not include an individual who would otherwise meet the requirements of this test unless, within the preceding 12-month period, a licensed healthcare practitioner has certified that such individual meets these requirements. And, I do want to point out that the activities of daily living are as follows: they are eating, toileting, transferring, bathing, dressing, and continence.
STEPHANIE DIAZ
So it’s another difficult test.
MISBAH FARID
Yes, that’s absolutely correct, Steph.
STEPHANIE DIAZ
Well now that we have these two difficult, complex situations covered, I wonder whether the third type of an eligible designated beneficiary, the minor child, has any curveballs. What’s a minor child?
MISBAH FARID
Well, it’s been limited to a child of the plan participant, so it cannot be a grandchild. And then here’s your curveball, Stephanie. A child may still be considered a minor for purposes of determining eligible designated beneficiary status through age 26 if enrolled in any “specified course of education.” The term “specified course of education” is referenced in the existing, and I mean pre-Secure Act, Treasury Regulation 1.401(a)(9)-6, Question and Answer 15 to explain eligibility of a surviving minor child under a defined benefit plan. However, it’s not actually defined.
STEPHANIE DIAZ
Okay. As if that wasn’t enough to digest, are there other aspects of the Secure Act we need to be aware of?
MISBAH FARID
Well, for one, there has been an increase in the age at which most individuals must begin taking required minimum distributions from 70½ to 72. There has also been an elimination of the maximum age for contributions to a traditional individual retirement account.
STEPHANIE DIAZ
Got it. Okay. So thinking back on plan distributions, I’ve heard it’s better to pay plan distributions to a trust rather than paying them outright. Why is that?
MISBAH FARID
Well, trusts are tools to protect against creditors, spendthrift beneficiaries, and divorce. They plan for special needs for financial planning and estate tax planning, and they give the plan participant control over his or her assets from the grave.
STEPHANIE DIAZ
Okay. What kind of trust should someone consider using?
MISBAH FARID
Well, you would want to use a designated beneficiary trust. To be a valid designated beneficiary trust, the trust must be a see-through trust. A see-through trust can be a conduit trust or an accumulation of trust. The requirements for a see-through trust are set forth in Treasury Regulation 1.401(a)(9)-4, and they are as follows: The trust is valid under state law. The trust is irrevocable upon the death of the plan participant. The beneficiaries of the trust are individuals who are identifiable from the trust instrument. Note that the deadline to identify the beneficiaries is September 30 of the year following the year of the plan participant’s death, and all beneficiaries must be individuals, but they do not need to be specified by name, and you have to produce the required documentation by October 31 of the year following the year of death. Note, issues do arise when a beneficiary of the trust is a non-individual, like an entity. A non-individual beneficiary, even a contingent non-individual beneficiary, disqualifies a see-through trust from being a receptacle for plan assets. However, a mere potential successor of interest of the plan assets is not considered a beneficiary for purposes of determining whether a trust qualifies. I would recommend you review Treasury Regulations 1.401(a)(9)-5, Question, and Answer 7 if you would like more information.
STEPHANIE DIAZ
So it sounds like there’s a couple of options: an accumulation of trust and a conduit trust. What are the differences?
MISBAH FARID
With a conduit trust, if the trust receives monies from the plan, it must distribute out the assets immediately. This type of trust helps a surviving spouse get a lifetime payout. If there is a minor beneficiary, you can use the lifetime of the minor beneficiary, but of course, as we discussed before, the stretch applies until the minor reaches a majority, which is determined by state law, then the ten-year rule kicks in. You can also use it when there’s a chronically ill beneficiary. With respect to an accumulation trust, the trustee can accumulate the plan distributions and does not have to distribute it out to the distributee of the trust; however, the ten-year rule will apply. Of course, for example, with a chronically ill beneficiary, you can use the lifetime of that beneficiary because they can stay on Medicaid or public support. And again, now we do not need to worry who the oldest beneficiary is or how old that beneficiary is under the new law.
STEPHANIE DIAZ
So is one type of trust better than the other?
MISBAH FARID
Well, before the Secure Act, the conduit trust was commonly named as the individual retirement account beneficiary because the trust requires the trustee to distribute the distribution to the trust beneficiary immediately upon receipt. This type of trust keeps spendthrift beneficiaries from taking any more than the required minimum distribution, and it also provides for creditor production. After the Secure Act, with respect to minor children, a minor child may use a conduit trust for life expectancy distributions until the child attains majority, then the ten-year rule applies. If the minor child cannot use an accumulation trust for life expectancy distributions, the ten-year rule applies regardless if the child is minor or has reached majority. A minor child is not considered the sole beneficiary of an accumulation trust even if he or she is the sole lifetime beneficiary pursuant to Regulations Section 1.401(a)(9)-5 and (a)(7)(c)(1). With respect to beneficiaries not more than ten years younger than the plan participant, you get life expectancy distributions for the beneficiary if you are using a conduit trust, and you’ve got the ten-year rule for the beneficiary if you’re using an accumulation trust. With respect to surviving spouses, surviving spouses are entitled to life expectancy distributions under a conduit trust, but not an accumulation trust or the ten-year rule would apply. So, in summary, an accumulation trust with significant discretion is preferable in the vast majority of cases. The trust can accumulate plan distributions within the mandatory payout period inside of the trust, and it would give the trustee discretion to control distributions against spendthrift beneficiaries and protect the beneficiary from creditors. If at the time of the client’s death the beneficiary is an eligible designated beneficiary, but not in the disabled or chronically ill category, it would be better to have a conduit trust for the beneficiary’s sole life benefit and accordingly, that would qualify for the life expectancy payout based upon the beneficiary’s life expectancy instead of being subject of the to the ten-year rule.
STEPHANIE DIAZ
Okay. That sounds like the way to go if you can. Not that we can control our beneficiary’s eligibility, but life expectancy hopefully is a lot longer than ten years.
MISBAH FARID
Hopefully.
STEPHANIE DIAZ
What are some drafting considerations for these trusts? Do practitioners, as a result, need to make changes due to the new law?
MISBAH FARID
Absolutely. In most cases, it may not be prudent to create a conduit trust for a beneficiary who is not an eligible designated beneficiary because the entire balance of the benefits must be paid out to the conduit beneficiary in 10 years. This could results in a faster distribution and in significantly larger sums than the client desires. In addition, even if the conduit beneficiary is a minor child of the participant (an eligible designated beneficiary), the benefits passing to the conduit trust must be paid out to the conduit beneficiary within ten years of that beneficiary attaining the age of majority. Again, this could result in a more accelerated distribution schedule and larger distributions than desired by the client. In drafting an accumulation trust, we should consider whether any or all of the beneficiaries of the trust are eligible designated beneficiaries. If any of the beneficiaries are eligible designated beneficiaries, we should consider whether the distribution of benefits paid to the trust should be limited to such eligible designated beneficiaries. If so limited, it may be possible to stretch the distribution of the benefits over the life expectancy of the oldest eligible designated beneficiary. However, all other beneficiaries of the trust will be prohibited from receiving any distribution composed with a qualified plan or the individual retirement account benefits. When drafting an accumulation trust for one or more minor children, consider that the applicable description period will change to 10 years once the child has reached (or the children reach) the age of majority. In addition, with respect to trust with multiple beneficiaries who are minor children, consider the fact that the applicable distribution period, likely will shift to 10 years once the oldest child reaches the age of majority.
STEPHANIE DIAZ
It’s a lot to consider. Thanks for your time, Misbah. I learned a lot about the Secure Act.
