Table of Contents
Intro and Background
The SECURE Act 1.0, as of the writing of this article, is almost 4.5 years old. For those who knew, or at least felt comfortable with the prior distribution and trust look-through rules of IRC Section 401(a)(9), this Act created significant confusion.
Everyone anticipated that new Treasury Regulations would hopefully clear up these issues. But, we first needed new Treasury Regulations. A set of proposed Regulations were published for comment in early 2022 under Treasury Decision 2022-02522, but over two years later they still have not yet been finalized. For those with the stomach for it, you can read the proposed Regulations here: https://www.federalregister.gov/documents/2022/02/24/2022-02522/required-minimum-distributions
One of the significant items of content forthcoming in this newsletter is a video and written series on these new Regulations, if and when they are finalized (and perhaps before) – with a focus on what has changed between the old and new rules for distribution planning for individual and trust beneficiaries of a decedent. The problem is that we are now into the 3rd year of the IRS punting on one key issue that came as a surprise to many who compared these Regulations to the SECURE Act 1.0 changes. To start, let’s tee up that issue.
The 10-Year Rule
A defined contribution plan that failed to make a specified RMD (as defined in Section IV.C of this notice) will not be treated as having failed to satisfy section 401(a)(9) merely because it did not make that distribution.
IRS Notice 2022-53, Section IV.A
A defined contribution plan that failed to make a specified RMD (as defined in section V.C of this notice) will not be treated as having failed to satisfy § 401(a)(9) merely because it did not make that distribution.
IRS Notice 2023-54, Section V.A
A defined contribution plan that failed to make a specified RMD (as defined in section IV.C of this notice) will not be treated as having failed to satisfy § 401(a)(9) merely because it did not make that distribution.
IRS Notice 2024-35, Section IV.A
If you feel like you are having déjà vu reading these quotes, you are correct. Let’s look at what led to this mess to begin with.
Under IRC Section 401(a)(9)(B), both before and after the SECURE Act was implemented, certain default rules determined the distribution horizon (after an employee’s death) from a qualified retirement plan such as a 401(k), 403(b), or 457 plan. Since distributions are (income) tax-deferred, the IRS does not wish for this deferral to continue indefinitely. So, this Code Section contains required minimum distribution (RMD) rules to limit indefinite tax deferral. These rules generally provide three maximum distribution windows as follows:
1. If an employee dies after their required beginning date (RBD),[i] the balance of a qualified plan must be distributed over a time horizon no longer than an employee’s remaining actuarial life expectancy.
2. If an employee dies before their RBD, the balance of a qualified plan must be distributed no later than 5 years after the employee’s death.
3. As an alternative to the 5-year rule, if an employee dies before their RBD but leaves a “designated beneficiary” (usually an individual or oldest see-through individual beneficiary of a trust), the balance of a qualified plan may instead be distributed over a time horizon no longer than the remaining actuarial life expectancy of the designated beneficiary.
These distribution requirements were extended to individual retirement accounts (both traditional and Roth). However, SECURE Act 2.0 eliminated required minimum distributions to the owner of a Roth, but not to a nonspousal beneficiary of a Roth.
All of this factored into the tax planning discussion in estate planning, as the longer the payout period, the greater the tax deferral.
But, when the SECURE Act 1.0 came along, the life expectancy payout was changed. In order to receive a life expectancy payout, a beneficiary had to be an “eligible designated beneficiary” (a definition to later be discussed). If you were simply a run-of-the-mill “designated beneficiary,” there was a new 10-year rule that applied. Further, even if the employee died after their RBD (and had a longer life expectancy than 10 years), 10 years had to be used as the distribution horizon by a designated beneficiary (instead of the employee’s remaining actuarial life expectancy).
(There are two other 10-year rules applicable here, which will be explored as part of the broader then-and-now SECURE Act series – after the child reaches the age of majority, and after the death of an eligible designated beneficiary. The same annual distribution requirement, and relief discussed below, apply to these outcomes as well.)
Under prior Regulations, this caused some confusion. While options 1 and 3 above both require annual minimum distributions (with the difference being the controlling life expectancy), the 5-year payout under option 2 did not. If you were stuck with the 5-year rule, the solace was that you could wait and take one lump-sum distribution at the end of that 5-year period. So, it was assumed that the new 10-year payout would work the same since it was based on a fixed period.
However, there was somewhat of a flaw in reasoning. The 5-year rule forced a lump-sum distribution because there was no “controlling life” under the old rules from which to calculate annual minimum distributions. Often, this rule applied where there was a beneficiary other than an individual – often an estate, charity, or a trust that failed the see-through rules of the 401(a)(9) Treasury Regulations. But, the 10-year rule only applied when there was, indeed, an individual “designated beneficiary” whose life expectancy could be determined.
As a result, the new proposed Regulations required a hybrid outcome under the 10-year rule – minimum distributions based on a designated beneficiary’s life expectancy for years 2-9,[ii] and a final lump sum distribution for year 10.
There are some problems, however, with this approach.
The Pain of Delays, and Associated Relief
For those who inherited IRAs from individuals who died in 2020, RMDs were suspended due to COVID-19 relief. But, starting in 2021, the assumption for many designated beneficiaries inheriting IRAs is that the 10-year rule was to be applied as a lump-sum distribution without the need for annual distributions.
Thus, the proposed Regulations came as a surprise. It meant income tax deficiencies for those who failed to take RMDs in 2021. It also meant excise taxes for qualified plans and IRA custodians due to such failure. The problem, however, is that the Regulations were (and are still) not finalized. So, until there were final Regulations, there could be no certainty regarding retroactive tax liability.
The IRS Notices cited above – 2022-53, 2023-54, and 2024-35 – were all designed to shore up this uncertainty and avoid any retroactive tax liability. Collectively, they waive any required RMDs through 2024 for those designated beneficiaries who are subject to the 10-year rule (along with associated excise taxes on failures to make RMDs for plan administrators and custodians).
Also, in 2023, we saw a delay of the required beginning date by one year under SECURE 2.0. However, some systems and software were not coded to prevent forcing the first RMD for those reaching their RBD under the old rules in 2023. As a result, Notice 2023-54 created a limited window to return this (unrequired) minimum distribution.
What’s Next?
Each Notice claimed that the proposed Regulations should be finalized by the year following the Notice, with the latest promise being January 1, 2025. Whether this happens remains to be seen.
But, for now, the proposed Regulations have some other interesting changes. There is a firmer definition of a conduit trust versus an accumulation trust under the trust look-through rules. Also, the degree of look-through required has been limited to certain immediate or secondary tiers of remainder beneficiaries based on accumulation trusts, powers of appointment, and other factors. This changes the old way of applying trust look-throughs (especially for accumulation trusts), where one had to consider most if not all potential beneficiaries under the sun. There are other needed and interesting changes around trusts for eligible designated beneficiaries, trust modifications, and the payout of disqualifying beneficiaries before a determination date.
I will cover all of these changes in future videos and articles, so stay tuned for more.
[i] This date was April 1 of the year after reaching age 70½ before the SECURE Act. The SECURE Act 1.0 changed this starting age to age 72, and the SECURE Act 2.0 again changed this to age 73 starting in 2023 and age 75 starting in 2033.
[ii] For year 1 (the year of death), the required minimum distribution that would have been required to be taken by the employee or owner must be taken based on the employee’s or owner’s life expectancy.