When a Special Needs Trust is the Beneficiary of a Retirement Account

Posted by Haddad Nadworny on Sat, Feb 22, 2020 @ 06:00 AM

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stretching into the futureThe SECURE Act* eliminates the “stretch” IRA distribution option for non-exception beneficiaries. It requires all assets be distributed to beneficiaries by the end of 10 years however annual RMDs (Required Minimum Distributions) are no longer required from these accounts.

What was the “stretch” IRA anyway?  

Prior to the SECURE act, retirement account beneficiaries were able to “stretch” the distributions from inherited accounts over the course of their lifetime.  This practice was an especially great benefit to young heirs and heiresses, as RMDs from the inherited accounts were based upon the age of the beneficiary.  The younger the beneficiary, the smaller the RMD, allowing the bulk of the assets to grow tax-deferred over the course of their lifetime and to potentially be inherited by the next generation.  

What it means:

Non-exception beneficiaries inheriting 401(k)s and other defined contribution plans, traditional IRAs and Roth IRAs from individuals who died after 1/1/2020, are subject to the “10-year distribution rule”; they are required to receive a full distribution of all assets of an inherited retirement account by the end of 10 years.

Who is effected: 

Non-exception beneficiaries of people inheriting 401(k)s and other defined contribution plans, traditional IRAs and Roth IRAs from individuals who died after 1/1/2020, are subject to the “10-year distribution rule”. 

If you own an inherited IRA from a person who died before 12/31/2019, the 10-year rule does not apply to that IRA over your lifetime. At your death, beneficiaries of this IRA will be subject to the 10-year rule.

Exception beneficiaries are NOT subject to the 10-year rule. They may treat the inherited IRA as their own and take distributions over their lifetime.

  • Spouses
    • A designated beneficiary will inherit the account, and overrides any provisions in a will.
    • If there is no will or beneficiary designation, the spouse will generally inherit the IRA. 
    • There are some exceptions, specifically in community property states.  
  • Disabled or chronically ill individuals
  • Individuals who are not more than 10 years younger than the account owner
  • Minor children. But once the child reaches the age of majority, he or she has 10 years to withdraw the money from the account.

   (Source: Elder Law Answers) 

Impact on the retiree/ IRA owner's planning:

The elimination of the stretch provision impacts both the retirement account owner and the beneficiaries. Given the current demographics, many recipients of inherited IRAs will have to take distributions during their peak earning years, potentially bumping them into a higher marginal tax bracket. It may make sense for retirees to consider strategies to mitigate this effect. Individuals with sizable retirement accounts are advised to speak with their tax advisor to discuss the impact of this change on their estate planning 

When a Special Needs Trust (SNT) is the beneficiary of the IRA.

There are 2 types of trusts that are often set up as beneficiaries of a retirement account: (1) a conduit or pass-through trust and (2) an accumulation or complex trust. The diagram below depicts the treatment of distributions from the inherited IRA when a trust is the beneficiary.

IRA RMD

 

Special Needs Trusts (SNTs) are accumulation or complex trusts. The trustee will have the authority to use the funds on behalf of the beneficiary over their lifetime. The RMD will be calculated using this “stretch” formula.

Even though the stretch provision still applies for beneficiaries with special needs, the elimination of the stretch provision for beneficiaries who do not have special needs may necessitate a change in planning strategy. In the past, many estate planners recommended that non-qualified assets be designated for funding a SNT upon a parent’s death. Individuals who have pursued this strategy may want to revisit both their own and their beneficiaries’ situations to determine if this still makes sense given the eligibility of the family member with a disability for the “stretch’ provision of an inherited IRA.

New Strategy: The SNT, with the family member with a disability as an exception beneficiary of the SNT, will inherit the IRA and become the owner.

In addition to the inherited IRA, the SNT will also own a non-retirement account for the purposes of receiving distributions (annual RMDs) from the inherited IRA and will pay taxes on this distribution.  The trustee may utilize this money to pay for expenses for the individual while also protecting their eligibility for government benefits.

Upon the death of the beneficiary with special needs, proceeds of the IRA will flow to the contingent beneficiary and the 10-year rule will go into effect.

 

Stay tuned for Part 2 next week with further discussion of planning considerations and strategies in light of the SECURE Act.

* The Setting Every Community Up for Retirement Enhancement or SECURE act was signed into law on December 20, 2019, becoming effective January 1, 2020. The law provides important changes for individuals and small businesses to consider in their retirement, estate and tax planning.

 

This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.

Financial planning and investment advice offered through Affinia Financial Group, LLC, a registered investment advisor. Securities offered through LPL Financial, Member FINRA/SIPC. Affinia Financial Group and LPL Financial are separate entities.

 

 

Tags: Retirement Planning, Special Needs Trusts

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