Late in December Congress adopted its 2020 budget. The law goes by the poetic name the “Further Consolidated Appropriations Act, 2020“. We’ve already told you about the SECURE Act, part of the budget law. But there’s more in this complicated law. For our practices, it’s particularly important to know about the relationship between the budget act and special needs trusts.
There are two important considerations for special needs trust practitioners buried in the budget law. One is part of the SECURE Act; we alluded to it in our earlier article, but this time we’re going to focus on it more closely. The other deals with income taxation of children — many of whom are beneficiaries of special needs trusts.
The Secure Act and special needs trusts
As we explained two weeks ago, the budget law included a significant rewrite of the rules governing individual retirement accounts (IRAs), 401(k) accounts and other retirement funds. The most-discussed change: the new law all but eliminates the so-called “stretch IRA”.
Mandatory withdrawals from IRAs and most other retirement accounts are calculated to assure retirees will begin to remove funds. That means that the withdrawals will be subject to income taxation, and not accumulated indefinitely for post-death beneficiaries.
For years most beneficiaries who inherit IRAs have been able to withdraw funds based on their own life expectancy. The rules, of course, are very complicated — but the bottom line has been that a 40-year-old beneficiary might have more than 40 years of life expectancy. That could mean withdrawing just over 2% of the account balance in each of the first few years after the account owner’s death.
That all changes this year. Now most beneficiaries will have just 10 years to withdraw the entire account balance. Note that does not mean 10% of the account each year — the beneficiary could wait ten years and withdraw the whole account — and pay income tax in just that one year (but at very high rates).
Does that apply to everyone?
No, it does not. And that’s one way in which the new budget act and special needs trusts are interrelated.
There are five types of beneficiaries who have different rules about withdrawals. They are:
- The account owner’s spouse (who usually can roll over the inherited account into his or her own IRA).
- A minor child of the owner (who may be able to withdraw at a slower rate UNTIL they reach the age of majority).
- A disabled beneficiary (which might include a special needs trust or other trust for such a beneficiary).
- A “chronically ill” beneficiary (who may also be the beneficiary of a trust named as beneficiary of the IRA).
- A beneficiary who is less than ten years younger than the account owner (they may be able to use the very slightly slower withdrawal rates based on their own age and life expectancy).
How the disabled beneficiary exception works
If an IRA, say, names an individual who has special needs (and receives Supplemental Security Income or Social Security Disability Insurance benefits), that beneficiary might qualify to use their own age/life expectancy rather than the 10-year rule. That might also be true if the IRA beneficiary is a trust for the benefit of that disabled beneficiary. That’s the very definition of a special needs trust.
In other words, beneficiaries of special needs trusts are often the only people who can still get the “stretch-out” benefit of IRAs and other retirement accounts. And Congress made it much easier for such a trust to qualify.
For years special needs planners have talked about “see-through” trusts, conduit trusts and accumulation trusts. Those distinctions are largely (but not completely) irrelevant under the new rules. That makes it much easier to name a special needs trust as beneficiary of a retirement account.
Is that the whole story?
Of course not. That would be too easy. The relationship between the budget act and special needs trusts just had to be more complicated than that.
For one thing, there are special rules for a trust that names several beneficiaries, but separates into distinct trusts at the IRA owner’s death. So if you name your trust as beneficiary of your IRA, and it immediately divides into shares for each of your children, your daughter with a disability can still take advantage of the stretch-out rules (though the other beneficiaries can not unless they qualify on their own).
Also, the definition of a trust benefiting only a person with a disability is awkwardly worded. If you have included a so-called “poison pill” in your daughter’s special needs trust, you might have inadvertently compelled her to withdraw everything in ten years. What kind of provision might cause a problem? If your daughter’s trust says that if anyone challenges the validity of the trust it immediately terminates and gets distributed to her brothers, that might be enough.
What do you need to do?
Have you prepared a special needs trust for a family member? Do you ALSO have an IRA, 401(k), 403(b) or other contribution retirement account? Then make an appointment to discuss these issues with your estate planning attorney before the spring season ends. Even if your IRA doesn’t name the trust as beneficiary, it might suddenly be worth considering. If it does name the trust as beneficiary, it might be time to modify the trust — or modify the beneficiary designation.
Is this a disaster waiting for you? Not really. But it could mean a significant tax bite that could be avoided — or at least significantly reduced — if you get on to the planning process.
What about minor children with special needs trusts?
The change in law that affects some other trust beneficiaries is the so-called “Kiddie Tax.” That provision of income tax law has long meant that minor beneficiaries of special needs trusts (or some other kinds of unearned income) can pay income taxes at a higher rate.
In 2018, the tax law changed significantly for those subject to the Kiddie Tax. In a draconian move, the law changed to impose the highest available tax rate to those individuals. We wrote about how that had affected some of the special needs trusts we manage just after calculating and paying 2018 income taxes last April.
Now Congress seems to have recognized the fundamental unfairness of that 2018 law. The new budget act changes the calculation of the Kiddie Tax back to its pre-2018 rules. It also allows taxpayers adversely affected last year (or in the 2019 tax year for which returns are now being prepared) to amend their returns. That could mean thousands of dollars back in some cases.
Is there more?
Almost certainly. Those are the key provisions of the budget act and special needs trusts. We’re still looking through the 700+ page law to see what else is tucked away in there. We’ll keep you posted.