Here’s How the Proposed Secure Act Regulations Are Tougher on Older Beneficiaries

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The IRS’ proposed regulations issued in February 2022 would totally restate the required minimum distribution rules for IRAs, 401(k) plans, and similar tax-favored retirement accounts. The purpose of the restatement is to incorporate changes made in the RMD rules by the Secure Act of 2019, but the restatement makes some changes above and beyond what Secure requires. One of those changes created (for no apparent reason) strangely harsh payout rules for older adult beneficiaries of older adult IRA owners.

The 3 Categories of Beneficiaries

The Secure Act recognizes three classes of beneficiaries. The highest category—the eligible designated beneficiary, or EDB—still gets some form of the life expectancy payout that was the norm for all designated beneficiaries prior to 2020. EDBs are the account owner’s surviving spouse or minor child, a disabled or chronically ill beneficiary, or any beneficiary who is not more than 10 years younger than the account owner.

The middle category is the plain-old designated beneficiary, or PODB. That is any individual or qualifying see-through trust that does not meet the definition of an EDB. Secure decreed that PODBs would be subject to a 10-year rule (modeled on the old “five-year rule”): All benefits are to be withdrawn within 10 years after the account owner’s death, regardless of whether death occurred before or after the account owner’s required beginning date, or RBD, which is April 1 of the age-73 year for IRA owners.

Finally, the bottom category is the nondesignated beneficiary, or non-DB): The account owner’s estate, or a trust that does not meet the requirements for a “designated beneficiary trust.” Secure did not change the rules for non-DBs: It’s the five-year rule if the owner died before the RBD, otherwise the beneficiary must take annual installments over what would have been the owner’s remaining life expectancy. The owner’s life expectancy has gained the colorful nickname “ghost life expectancy.”

The wording and legislative history of Secure make it clear that the act did not intend to change the existing RMD rules beyond these listed changes and intended for the IRS (as always) to create workable rules, through regulations, to smooth out the rough edges of Secure’s outline.

Well that seems clear enough. How could the proposed regulations mess up this seemingly clear, Secure-mandated set of payout rules? Part of the problem lies in Secure’s own muddled and complicated scheme: It creates seven different types of beneficiaries (the PODB, the non-DB, and five categories of EDBs), with (among them) six different sets of payout rules—times two (because rules differ depending on whether the owners died before or after their RBD). That means we’re up to 12 possible payout paths before we even start discussing multiple beneficiaries on the same account (for example, a trust for the surviving spouse and minor children). What could possibly go wrong?

One area where the IRS’ proposed regulations seem to veer off the track is the (seemingly unnecessary) harsh treatment of older individual beneficiaries.

The Longer-of/Shorter-of Rule for Older EDBs

Let’s take the example of Doris and Evelyn. Doris dies in 2022 at age 80, leaving her IRA to her older sister Evelyn, age 85. Evelyn is not disabled or chronically ill. Since Evelyn is older than Doris, she qualifies as an eligible designated beneficiary, entitled to the life expectancy payout. That’s good, right? Well, actually no. At age 85, Evelyn’s life expectancy is only 8.1 years. A plain-old designated beneficiary would have gotten a 10-year payout, but Evelyn (though she is a supposedly “superior” EDB) gets only 8.1 years.

Can’t Evelyn elect the 10-year rule? Can’t she elect to use the payout applicable to a “lower class” of beneficiary, that is, the PODB? Nope. Under the proposed regulations, an EDB can elect to use the 10-year rule instead of the life expectancy payout only if the account owner died before the RBD. Since Doris died after her RBD, Evelyn cannot elect to use the 10-year rule.

But wait, what about the “longer-of” rule? The proposed regulations contain (as the existing regulations also contain) a longer-of (or “greater-of”) rule to soften the situation for an older beneficiary: During Evelyn’s life, her RMDs will be calculated using the “greater of” her life expectancy or the “ghost life expectancy.” Since Doris’ life expectancy (at age 80) was 11.2 years, Evelyn’s RMDs will be calculated using the 11.2-year ghost life expectancy instead of her own 8.1-year life expectancy. So, Evelyn is protected, right?

No, she isn’t. She would have been protected by that rule under the existing regulations. The existing regulations apply the greater-of rule in this situation, period. So, the final payout year under the existing regulations is the later of the last year of the ghost life expectancy or the last year of the beneficiary’s life expectancy. Inexplicably, the proposed regulations take that benefit away from the older EDB and dictate that all benefits must be distributed from the account no later than the final year of the beneficiary’s life expectancy even if that is shorter than the ghost life expectancy. The proposed regulations actually make this EDB’s situation worse after Secure than it was before.

What could Doris have done to make things a little better for Evelyn? If Doris had left her IRA to her estate, of which Evelyn is the sole beneficiary, the payout period would have been the ghost life expectancy—with no “shorter of” rule coming into the picture. Doris could also consider leaving her IRA to a charitable remainder trust for Evelyn’s life benefit to provide Evelyn with a lifelong income and no worries about RMDs.

How a PODB Can Get Stuck With a Less-Than-10-Year Payout

This harsh effect on older adult beneficiaries is not limited to EDBs. It can also happen to a PODB. The PODB is supposedly entitled to the 10-year rule. The usual interpretation of the 10-year rule is that the beneficiary does not have to take any RMDs until the year that contains the 10th anniversary of the participant’s death (at which point 100% of the account becomes the RMD). But the IRS’ interpretation of the 10-year rule, as it applies in cases of death after the RBD, is that the PODB must take annual distributions over their life expectancy, beginning the year after the year of the account owner’s death, with 100% distribution no later than the year that contains the 10th anniversary of the account owner’s death.

Here’s another example: George dies in 2022 at age 94, leaving his IRA to his brother Wally, age 83. Wally is not disabled or chronically ill and is more than 10 years younger than George. As a PODB, Wally is subject to the 10-year rule. Most people assumed that, under Secure, Wally would be entitled to withdraw the account any time between 2022 and 2032, as long as he withdrew 100% by the end of 2032. Not so says the IRS. Under the proposed regulations, because George died after his RBD, Wally must withdraw annually over his life expectancy, with 100% payout no later than 2032. But by using Wally’s life expectancy, the account won’t make it to 2032. His life expectancy is only 9.3 years.

How could George have done better for Wally? Leaving his IRA to his estate (of which Wally is sole beneficiary) won’t help because the ghost life expectancy (George’s life expectancy) was only 4.3 years, so that would make things worse.

Maybe George could get a job with a big company and roll his IRA into the company’s plan and keep working, so his death would be “before the required beginning date” for the company plan? Then (because death was before the RBD) the 10-year rule would apply to Wally as his beneficiary without the override of annual life-expectancy payouts during years one to nine. But going to work for a big company is not normally a realistic planning choice for 94-year-olds.

The charitable remainder trust might be worth investigating if George has any charitable intent.

The best result would be for the IRS to eliminate the requirement of annual RMDs during the 10-year rule and give PODBs the benefit of the 10-year payout that Secure clearly mandated (and allowed) for designated beneficiaries “whether or not distributions of the employee’s interests have begun” (IRC § 401(a)(9)(H)(i)).

What’s an Older IRA Owner to Do?

Once the IRA owner passes their required beginning date, the planning options for the IRA (in terms of spreading out distributions over at least 10 years) are very limited. Using the example of an over-age-72 client who does not have any minor children, the client can either:

1. Leave the account to the surviving spouse outright, so he can roll it over to his own IRA and take payouts using the Uniform Lifetime Table instead of the Single Life Table or 10-year rule. But this may not help much if the surviving spouse is close in age to the decedent. An example: For an 89-year-old decedent leaving the IRA to her 89-year-old spouse, the annual payouts under the Uniform Lifetime Table will start with about a 12-year life expectancy. For the “leave account to spouse” strategy to produce significant income tax deferral, the surviving spouse would have to be much younger than the decedent.
2. If the group of beneficiaries the client hopes to benefit includes a younger individual who is disabled or chronically ill, consider directing the IRA to a trust for that individual and leaving other assets to other beneficiaries. A trust for a disabled or chronically ill individual can still qualify for the life expectancy payout.
3. Leave the account to a designated beneficiary trust for younger individuals (under, say, age 60). The payout over the life expectancy of a young beneficiary is obviously no longer an option—that choice was eliminated by Secure. But the long life expectancy of younger family members can still be exploited to allow a see-through trust to truly benefit from the 10-year rule. Since the proposed regulations interpret Secure to require annual distributions over the oldest beneficiary’s life expectancy even when the 10-year rule applies (in cases of death after the required beginning date), you get the most benefit from the 10-year rule if the “oldest beneficiary” is young: The life expectancy of a 40-year-old is 45.7 years, requiring only about a 2% annual distribution to start. One hundred percent distribution will still be required in the 10th year, of course.
4. Leave the account to a charitable remainder trust, or CRT. The IRA proceeds pass tax-free to the CRT, which then pays a life income to the decedent’s chosen human beneficiary (or beneficiaries). Obviously, the CRT has many technical requirements that are beyond the scope of this article, and it is not useful for someone with zero charitable intent. But it can be a very attractive option for an older individual trying to maximize the benefit of the IRA for their not-so-young beneficiaries if there is some charitable intent present.

Over 150 comments on the proposed regulations were submitted to the IRS by the May 25, 2022, deadline. Presumably, the IRS will make some adjustments to fix glitches noted in those comments, perhaps by including some changes to mitigate the harsh effects of its first edition of the regulations on older adult beneficiaries.