There is a saying that the road to clarity begins with confusion. For your advisor’s sake, we hope that is true.
The IRS issued Proposed Regulations on February 23, 2022 and they are quite extensive. The Proposed Regulations interpret many provisions of the SECURE Act relating to See-Through Trusts. Specifically, the proposed regulations help us to better understand the definitions and rules regarding Designated Beneficiaries, Eligible Designated Beneficiaries, and “Disregarded Beneficiaries”.
I thank Brandon Ketron for his assistance with this article. Please join us Tuesday, March 22nd at 3:00 pm EST for a free 30 minute webinar discussing the Proposed Regulations (Click here to register).
By way of brief review, the SECURE Act, which became law effective January 1, 2020, eliminated the “stretch” IRA by requiring that all benefits must be paid out of the IRA/Plan on or before December 31st of the tenth calendar year following the death of the Plan Participant unless the IRA/Plan was left to an Eligible Designated Beneficiary.
The five categories of Eligible Designated Beneficiaries that remain eligible for the “stretch” under the SECURE Act are as follows:
(1) The Surviving Spouse;
(2) A minor child;
(3) A disabled beneficiary;
(4) A chronically ill beneficiary; or
(5) An individual not more than ten years younger than the deceased Plan Participant.
A trust for the exclusive benefit of one or more Eligible Designated Beneficiaries can withdraw monies from an IRA or pension over the life expectancy of the oldest Eligible Designated Beneficiary. In a trust for only Designated Beneficiaries who are not Eligible Designated Beneficiaries (“Non-Eligible Designated Beneficiaries”) the 10 year rule will apply. A trust that benefits creditors, charities, or other “non persons” may be required to use the five year rule if the Plan Participant had not yet started taking required minimum distributions, or continue to take distributions over the life expectancy of the deceased Plan Participant if the Plan Participant had begun taking required minimum distributions.
The Proposed Regulations also address the identifiability requirement, liberalize the use of powers of appointment, and allow for modifications or decanting of trusts post death to rectify any issues that would prevent the trust from qualifying as a see-through trust or allow for distributions to be paid over the life expectancy of an Eligible Designated Beneficiary of the trust.
The Proposed Regulations also continue to allow a special rule for surviving spouses who are the sole beneficiaries of an IRA to delay required minimum distributions until the deceased spouse would have been required to begin taking his or her required minimum distributions. In other words if a Plan Participant died before reaching his or her required beginning date (generally April 1st of the calendar year following the calendar year in which the Plan Participant reaches the age of 72) then the spouse who inherited the IRA would not be required to pull anything out of the IRA until the year in which the deceased Plan Participant would have reached the age of 72. This is discussed in more detail below in the Section titled Special Surviving Spouse Delay Rule.
A See-Through Trust is a trust that has become irrevocable on or before the death of an owner of a retirement account which can be the beneficiary of the account and hold assets for one or more individuals after the account older’s death. There are two types of See-Through Trusts: Conduit Trusts and Accumulation Trusts.
A Conduit Trust is a trust which provides that “[a]ll distributions [from the plan] will, upon receipt by the Trustee, be paid directly to, or for the benefit of, specified beneficiaries.” An Accumulation Trust “is any See-Through Trust that is not a conduit trust.” The trustee of an Accumulation Trust can receive distributions and “accumulate” them in the trust.
The Ten Year Rule
While the proposed regulations largely are favorable to taxpayers, the biggest and most unpleasant surprise relates to required minimum distributions following the death of Plan Participant who dies after reaching age 72.
Specifically, the proposed regulations state that a beneficiary who inherits an IRA or Retirement Plan from such a deceased over 72 Plan Participant will be required to take distributions beginning on the first calendar year following the year of the decedent’s death, each year until the 10th year following the calendar year of the decedent’s death when all assets in the IRA or Retirement Plan would have to be distributed outright to such beneficiary.
This is a departure from the “10-Year Rule” under the statute as understood by many practitioners and commentators, where the beneficiaries of the deceased Plan Participant’s Retirement Plan who are subject to the 10-Year Rule would not be required to take any distributions following the death of the decedent until December 31 of the tenth year following the calendar year of the decedent’s death (regardless of the decedent’s age at death).
Many practitioners and commentators find this IRS interpretation to be shocking, as a parallel “5-Year Rule” has been in effect under the Internal Revenue Code and Treasury Regulations regarding Retirement Plans for nearly 40 years, and such 5-Year Rule has never been interpreted or construed to require distributions to be made from the Retirement Plan before December 31 of the fifth year following the deceased Plan Participant’s death.
Nevertheless, authorities in this area have expressed concern that taxpayers and trusts may be severally penalized for failure to take distributions under rules that are very difficult to understand. Given this situation, trustees of trusts may wish to err on the side of caution and take minimum distributions during the initial ten years if this will not have a significant tax impact.
Designated and Disregarded Beneficiaries
The Proposed Regulations identify two tiers of Designated Beneficiaries.[1] Tier I includes “any beneficiaries of the trust whose benefits are neither contingent upon, nor delayed until, the death of another trust beneficiary who did not predecease the Plan Participant. Tier II includes “any beneficiaries of the trust who could receive amounts in the trust … that were not distributed to the [Tier I] beneficiaries, [but only if they cannot benefit until after the death of the Tier I beneficiary or beneficiaries].” If the beneficiary of the See-Through Trust is another trust, the beneficiaries of the second trust are treated as being beneficiaries of the first trust and thus they are considered Designated Beneficiaries.
There are multiple situations under the Proposed Regulations in which a beneficiary can be disregarded for purposes of determining which payout method applies:
1. If one of the following events occur prior to September 30th of the calendar year following the year of the Plan Participant’s death:
A. A beneficiary who predeceases the Plan Participant is disregarded.
B. A beneficiary who is treated as having predeceased the Plan Participant by reason of a simultaneous death provision under applicable state law or via a qualified disclaimer is disregarded.
C. A beneficiary who receives the entire benefit that the beneficiary is entitled to is disregarded.
D. If a power of appointment is exercised in favor of one or more beneficiaries, then the other permissible appointees are disregarded.
There are also situations under the Proposed Regulations that allow trust beneficiaries to be disregarded even if their interest is not eliminated prior to the September 30th Designation Date:
1. For Accumulation Trusts only, when entitlement of such beneficiary is conditioned upon the death of any and all Tier I beneficiaries and at least one Tier II beneficiary.
The Preamble to the Proposed Regulations contains the following example to illustrate this rule:
[A]ssume that an IRA names a see-through accumulation trust that requires the trustee to pay specified amounts from the trust to the employee’s surviving spouse. Upon the spouse’s death, the see-through trust is to terminate and the amounts remaining in the trust are to be paid to the employee’s brother (who is not more than 10 years younger than the employee, and thus is an Eligible Designated Beneficiary). Further if the employee’s brother survives the employee but predeceases the surviving spouse, then the amounts remaining in the trust after the death of the surviving spouse are to be paid to a charity.
In that case, the charity is disregarded as a beneficiary of the employee because the charity could receive only amounts in the trust that are contingent upon the death of the employee’s brother, whose only interest was a residual interest (that is, an interest in the amounts remaining in the trust after the death of the surviving spouse).
In contrast, the charity would be treated as a beneficiary of the employee if the brother could receive amounts in the trust not subject to any contingencies or contingent upon an event other than the death of the surviving spouse (such as the surviving spouse’s remarriage).
2. A beneficiary of a see-through trust may also be disregarded when entitlement is conditioned upon the death of an individual who has not reached the age of majority (21) if the terms of the trust requires full distribution to such individual by the later of (1) the 10th calendar year following the calendar year of the Plan Participant’s death, or (2) the end of the 10th calendar year following the calendar year in which that individual attains the age of majority.[2]
The following example from the Preamble illustrates this rule:
Assume an employee names an [Accumulation] trust as the sole beneficiary, the trust permits specified amounts to be paid to the employee’s niece until the niece reaches age 31 (age of majority plus 10 years). The trust is scheduled to terminate with a full distribution of all trust assets to the niece when the niece reaches age 31, but if the niece dies before this scheduled termination, then the amounts remaining in the trust will be paid to the employee’s sibling. In that case, the only beneficiary designated under the plan for purposes of section 401(a)(9) and these regulations is the employee’s niece because the employee’s sibling is disregarded under the exception described in the preceding paragraph.
However, if the see-through trust terms do not require a full distribution of amounts in the trust representing the employee’s interest in the plan until the niece reaches age 35, then this exception does not apply, and both the employee’s niece and sibling are treated as beneficiaries designated under the plan for purposes of section 401(a)(9) and these regulations.
3. Remainder beneficiaries of conduit trusts continue to be disregarded. In other words, only beneficiaries that could receive amounts in trust that are neither contingent upon, nor delayed until, the death of another trust beneficiary (Tier I Beneficiaries) must be taken into account.
The following example derived from the Proposed Regulations illustrate this rule:
Cathy dies at the age of 30 leaving his retirement plan payable to a trust for the benefit of her 35 year old sibling Doug. If and when Doug dies, the trust will pass to Edward, who is 50.
Doug is an Eligible Designated Beneficiary because he is not less than ten years younger than Cathy. Since the Trust is a conduit trust, Edward’s interest can be disregarded and distributions can be paid out over Doug’s life expectancy as an Eligible Designated Beneficiary; however if the Trust was a conduit Trust, Edward’s would be considered a designated beneficiary and since all trust beneficiaries are not Eligible Designated Beneficiaries the ten year rule would apply.
If the Accumulation Trust instead provided that it was for the benefit of Doug, and that after the death of Doug the trust would be held for the sole benefit of Cathy’s 36 year old half-sibling Frank, and then would only benefit Edward if both Doug and Frank were deceased, then Edward would be disregarded and the lifetime payment rules could apply since all beneficiaries are Eligible Designated Beneficiaries.
Minor Child Exception for Accumulation
Trusts As a general rule, if an accumulation trust has a designated beneficiary that is not an Eligible Designated Beneficiary, then the Plan Participant is treated as NOT having an Eligible Designated Beneficiary, and thus the IRA must be distributed no later than the end of the tenth year following the calendar year of the Plan Participant’s death.
The Proposed Regulations introduce a new exception to this rule if there is a designated beneficiary who is the child under age of majority of the Plan Participant. In this case, the Plan Participant is treated as having an Eligible Designated Beneficiary allowing life expectancy payments to be made until ten years after the child reaches the age of majority.
The following examples from the Preamble illustrate this rule[3]:
A Plan Participant names a see-through trust as the sole beneficiary of the employee’s interest in the plan, and the trust beneficiaries are the employee’s surviving spouse and the employee’s adult child who is not disabled or chronically ill, then the employee is treated as not having an eligible designated beneficiary. As a result, the employee’s entire interest must be distributed no later than 10 years after the employee’s death.
However, if there is another designated beneficiary who is the employee’s child and who, as of the date of the employee’s death, has not yet reached the age of majority, then, under the exception described in the preceding paragraph, the employee is treated as having an eligible designated beneficiary. In the situation described in the preceding sentence, if the trust is receiving annual distributions using the life expectancy rule, then a full distribution from the plan would not be required until ten years after the minor child reaches the age of majority.
Better Rules for Multi-Beneficiary Trusts for Disabled and Chronically Ill Beneficiaries
To summarize briefly, a beneficiary is considered to be disable or chronically ill if they satisfy the applicable definition as of the Plan Participant’s date of death and meet certain documentation requirements no later than October 31 of the calendar year following the calendar year of the employee’s death.
The Proposed Regulations do not provide new guidance with respect to defining “chronically ill”, and also do not change the definition of “disabled” for beneficiaries who are 18 years of age or older. The Proposed Regulations do provide a new definition of “disabled” for beneficiaries under the age of 18, and also provide a safe harbor that if a beneficiary is considered to be disabled as of the date of death by the Commissioner of Social Security under the definition of 42 U.S.C. 1382c (a)(3), then such beneficiary will be considered disabled for purposes of the required minimum distribution rules regardless of age.
A disabled beneficiary is defined as follows:
Age 18 or older – Aan individual who, as of the date of the employee’s death, is age 18 or older is disabled if, as of that date, the individual is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death or to be of long continued and indefinite duration.
Younger than Age 18 – An individual who, as of the date of the employee’s death, is not age 18 or older is disabled if, as of that date, that individual has a medically determinable physical or mental impairment that results in marked and severe functional limitations and that can be expected to result in death or to be of long continued and indefinite duration.
An “applicable multi-beneficiary trust” is a see-through trust with more than one beneficiary and with respect to which [the following apply]:
(1) all of the trust beneficiaries are designated beneficiaries; and
(2) at least one of the trust beneficiaries is an eligible beneficiary who is disabled or chronically ill[4].”
There are two types of Applicable Multi-Beneficiary Trusts, Type I and Type II.
A Type I Multi-Beneficiary Trust is a trust which provides that the amounts in trust are to be divided immediately upon the death of the Plan Participant into separate trusts for each beneficiary.[5]
A Type II Multi-Beneficiary Trust is a trust that both:
(1) identifies one or more individuals who are disabled or chronically ill and entitled to benefits during his/her lifetime, and
(2) provides that no individual who is not disabled, chronically ill, or entitled to benefits during their lifetime “has any right to … interest in the plan until the death of all of the Eligible Designated Beneficiaries who are disabled, chronically ill, and entitled to receive benefits during their lifetime[6].”
One of the separate trusts under a Type I Multi-Beneficiary Trust to which the amounts are divided can be a Type II Multi-Beneficiary Trust. The beneficiaries of the receiving Type II Multi-Beneficiary Trust who are not disabled or chronically ill will be disregarded for purposes of these regulations, thus allowing for payments to be made from the IRA over the life expectancy fo the disabled or chronically ill beneficiary. However, if the terms of the trust fail to comply with the requirements of a Type II Multi-Beneficiary Trust then all of the beneficiaries are treated as beneficiaries[7].
Identifiability Requirement – Power of Appointment
A See-Through Trust requires that the beneficiaries of the trust be identifiable by September 30th of the calendar year following the calendar year of the plan participant’s death (“Determination Date”). A trust satisfies the identifiability requirement “if it is possible to identify each person eligible to receive a portion of … the plan through the trust.” Previously, the presence of a power of appointment was considered to frustrate such requirement because the failure of the person who holds the power of appointment ( the “Powerholder”) to exercise or restrict such power results in the inability to determine who the beneficiaries are. The Proposed Regulations provide a safe harbor with respect to the exercise or restriction of a power of appointment, which is separate and apart from the ability to reform or modify a trust, which is further discussed below.
Power of Appointment Safe Harbor
The safe harbor provides that a See-Through Trust will not fail the identifiability requirement due to the presence of an unexercised power of appointment or an exercised power of appointment after the date of death of the Plan Participant. The provision ensures identifiability by clarifying who is deemed a beneficiary in the following scenarios:
1. If the powerholder exercises his/her power of appointment on or before the Determination Date then the parties appointed are considered to be beneficiaries of the trust.
2. If the powerholder exercises or limits their power of appointment after the Determination Date, the Takers in Default and the added individual(s) are considered the beneficiaries of the trust.
3. If the powerholder fails to exercise or limit their power of appointment on or before the Determination Date then the Takers in Default of the power are considered to be the beneficiaries.[8]
The following example derived from the Proposed Regulations illustrate this rule:
Dad died in 2022 at the age of 60. Dad named a see through trust as a beneficiary of his IRA. Under the terms of the trust, all trust income is payable to Dad’s surviving spouse, Mom, and Mom has a power of appointment to redirect the trust assets upon her death. The power of appointment provides that, if Mom does not exercise the power, then upon Mom’s death, Dad’s descendants are entitled to the remainder interest, per stirpes. As of the date of Dad’s death, Dad has two adult children, Child 1 and Child 2.
Before September 30 of the calendar year following the calendar year in which Dad died, Mom irrevocably restricts Mom’s power of appointment so that Mom may only exercise the power to appoint in favor of Mom’s siblings (who all are less than 10 years younger than Dad and thus, are Eligible Designated Beneficiaries).
Because Mom timely restricted the power of appointment so that Mom may exercise the power only in favor of Mom’s siblings, the only designated beneficiaries are Mom and Mom’s siblings, even though Child 1 and Child 2 are the takers in default of exercise of the power. Because all of the designated beneficiaries are Eligible Designated Beneficiaries, payments may be made over Mom’s life expectancy.
If Mom did not timely restrict the power of appointment, then Mom, Child 1 and Child 2 would all be considered designated beneficiaries and the ten year rule would apply since not all designated beneficiaries are Eligible Designated Beneficiaries.
Modification and Reformation
The Proposed Regulations are taxpayer friendly with respect to providing that amendments, modifications, and reformations of trust can be made on or before September 30th of the calendar year following the calendar year of the Plan Participant’s death so that trust beneficiaries, creditors, charities, and other entities can be add or removed.[9]
If a trust beneficiary is added after the applicable September 30th date, however, the addition of the new beneficiary will affect the life expectancy calculation. Additionally, if a beneficiary is added in a calendar year in which a full distribution is not required, and after the addition of such beneficiary full distribution would have been required, the full distribution shall not be required until the end of the calendar year following the calendar year in which the beneficiary was added.
Special Surviving Spouse Delay Rule
An often forgotten benefit that is provided to a surviving spouse is the ability of a surviving spouses to delay the commencement of distributions if the surviving spouse is the sole beneficiary, and the Plan Participant did not begin making distributions during their lifetime. As discussed above, in this scenario, the surviving spouse is permitted to delay distributions until the end of the calendar year in which the Plan Participant would have attained the age of 72.
If the surviving spouse dies prior to the Required Beginning Date (age 72), the applicable distribution rules (5 Year, 10 Year, Stretch) are to be applied as if the surviving spouse was the Plan Participant. For this purpose, the date of death of the surviving spouse is substituted for that of the Plan Participant.
If the surviving spouse remarries and dies prior to the commencement of distributions, the surviving spouse’s new spouse cannot utilize the delay exception.
This does not apply to spousal rollovers, but the surviving spouse may rollover the IRA into his or her own IRA and delay distribution until the surviving spouse reaches their own Required Beginning Date.