Provisions Affecting Retirement and/or Estate Plans

This Tax Blast addresses two changes in the SECURE Act that might cause some investors to rethink their retirement and/or estate planning strategies. The first change significantly increases the pace at which an IRA account must be liquidated following the account owner’s death; this may have a negative impact on investors and IRA beneficiaries. On the other hand, the second change may have a more positive impact on investors: it repeals a recent modification to the “kiddie tax,” which drastically increased the tax rate on a child’s unearned income.

Limitations on Stretch IRAs

Before the SECURE Act, beneficiaries of an IRA had some flexibility in how much time they had to draw down the account of the deceased. Depending on the date of the IRA owner’s death, beneficiaries could either withdraw from the IRA account at the same pace as the deceased (if the owner had already begun taking distributions) or stretch the distributions over the beneficiary’s life expectancy. This latter rule is commonly known as the IRA “stretch” provision.

The SECURE Act modifies these rules and provides that, regardless of whether the IRA owner dies before or after distributions have started, the account balance must be distributed to beneficiaries within 10 years after the owner dies. Sec. 401(a)(9)(H).

However, this rule does not apply to certain eligible designated beneficiaries. Such persons include the surviving spouse, the IRA owner’s children who are under the age of majority (usually age 18), disabled or chronically ill persons, and any other individual who is less than 10 years younger than the owner. Secs. 401(a)(9)(E) and (H)(ii). In other words, distributions to these beneficiaries can still be made over their life expectancies (at least while they are alive).

When one of the beneficiaries listed above dies (or when a child beneficiary reaches the age of majority), the new rule kicks in and the account balance must be distributed within 10 years. Secs. 401(a)(9)(E)(iii) and (H)(iii).

These new rules only apply to IRA owners who die after December 31, 2019. However, there is a catch. If the owner dies on or before December 31, 2019, but the beneficiary dies after December 31, 2019, then the account balance must be fully paid out within 10 years of the beneficiary’s death.

As a result of these changes, IRA beneficiaries have only a decade (rather than a lifetime) to pay income tax on forced distributions from an inherited account. Thus, the IRA may now be a less attractive estate planning vehicle for passing wealth to family members. For example, IRA owners may want to consider naming a spouse (rather than a trust or a child) as the designated beneficiary. That way, the spouses can take advantage of the stretch provision for their lifetime, and then pass the balance (if any) to a child, who will have 10 years to empty the account.

Kiddie Tax Repealed

Before the enactment of the Tax Cuts and Jobs Act (“TCJA”), the net unearned income (i.e., capital gains, dividends, and interest) of a child was generally taxed at the parents’ tax rates. Beginning in 2018, the TCJA required that this income be taxed according to the brackets available to trusts and estates. Former Sec. 1(j)(4). Thus, under the TCJA, the amount of tax paid by the child was unaffected by the parents’ tax situation.

Generally, this so-called “kiddie tax” applies to any child who: (1) is either under age 19 or a full-time student under age 24; and (2) has unearned income of more than a few thousand dollars. The tax was enacted back in 1986 to prevent parents in high tax brackets from shifting income to children in lower tax brackets. However, the TCJA changes indirectly increased the tax on certain children, including survivors of deceased military personnel (“Gold Star children”), first responders, and emergency medical workers.

For example, in 2018, for amounts in excess of $12,500, the ordinary income tax rate for trusts and estates was 37%, while the parents’ rate for that same amount would only be 10% (if married filing jointly).

To address this concern, the SECURE Act repeals Sec. 1(j)(4), the kiddie tax provision that was added by the TCJA. As a result, the unearned income of a child is once again taxed at the parents’ tax rates and not at trust and estate rates.

This new provision applies beginning in 2020, but taxpayers can elect for it to apply retroactively to 2018, 2019, or both.

For more information on this Tax Blast, please contact any of the following individuals:

Name: Meghan Andersson, JD, LLM
Office: Irvine, CA
Phone: (949) 623-0542
Email: [email protected]

Name: Donna Sirois, CPA, JD, MBA, MST
Office: Irvine, CA
Phone: (949) 623-0546
Email: [email protected]

Name: Mark Cook, MBA, CPA, CGMA
Office: Irvine, CA
Phone: (949) 623-0478
Email: [email protected]