Passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act,1 effective Jan. 1, 2020, launched many headlines to the tune of “The Stretch is Dead.” This catchphrase tacitly refers to Internal Revenue Code Section 401(a)(9) and its accompanying regulations extending substantial income tax deferral of an individual retirement account over a beneficiary’s life expectancy. With some exceptions, the SECURE Act amended IRC Section 401(a)(9) to eliminate the life expectancy method for paying out annual required minimum distributions (RMDs) and substituted a 10-year period following the owner’s death over which to withdraw the entire IRA balance.2
Elimination of annual RMDs for targeted beneficiaries applies to defined contribution accounts, including IRAs.3 During the non-required distribution period, Year 1 to Year 9, a beneficiary may refrain from making any withdrawals.4
This upheaval to the withdrawal rules also brought a hidden headline, reaching well beyond income tax consequences. For a trust named as beneficiary, the newly created non-required distribution period may negatively impact a trust’s current income beneficiary’s entitlement to all the trust’s net income. Under the SECURE Act, the trustee has inherent discretion to accumulate an IRA’s internal income (the income earned by account assets) rather than withdrawing and, with appropriate authority, treating it as income of the trust.
Most vulnerable are trusts drafted before the SECURE Act’s effective date, and the IRA owner dies thereafter. While not required, the trust’s language expressly refers to what’s sometimes called the “applicable distribution period” (ADP) for withdrawing the account’s balance under Section 401(a)(9).5 Language defining the ADP tracks compliance with the RMD rules under the IRC. The trust is silent on discretionary withdrawals exceeding an RMD, although the plan document permits them. Equally noteworthy, the trust’s terms omit a method allocating IRA payments between principal and income, shifting the decision to state law.
Substantially similar language appeared in many governing instruments I reviewed as a risk manager for two different trust departments.
Framing the Issue
A hypothetical further frames the issues.
The IRA owner’s revocable trust agreement on death creates separate trusts for surviving children. An IRA beneficiary designation form expressly names these trusts as beneficiaries of separate IRAs established after the IRA owner’s death. The terms of each trust direct payment of RMDs in accordance with Section 401(a)(9) and its Treasury regulations. After receipt, the trustee must look to the state’s principal and income act to allocate the payment. The relevant section characterizes 10% as trust income. Non-required payments are entirely principal.
The trust’s dispositive terms mandate distribution of net income to a child. On this child’s death, the trust terminates with full distribution to the child’s lineal descendants in equal shares, per stirpes. If there are no lineal descendants, the child’s heirs at law split the trust share.
The IRA owner, 78, died in January 2021. As of the date of death, a traditional IRA held assets worth $2 million with income of $60,000 annually. Other trust assets include $800,000 in stocks and bonds. The annual income on these assets is $20,000.
Two adult children survive the IRA owner; each child has two children. Per the governing instrument, the trustee establishes separate trusts for each child funded with $400,000 in stocks and bonds, annual income of $10,000 and a 50% allocation ($1 million) of the IRA’s date of death value. The allocated share’s annual income is $30,000.
Within days of the IRA owner’s death, the trustee of the post-mortem trusts receives troubling news. The SECURE Act has made the IRA withdrawal provisions obsolete. Contemplated annual RMDs disappear as none of the exceptions to the 10-year rule apply.
The trustee, now afforded discretion under the SECURE Act, comes to a fork in the road: Retain or withdraw some or all the IRA’s internal income during the non-required distribution period. The decision impacts income tax and fiduciary accounting issues. Taking installment payments, particularly from a traditional IRA, would proportionately tax the withdrawn amounts. Conversely, complete retention will end in a lump sum payment followed by the trust paying potentially significant income tax.
For fiduciary accounting purposes, retention of the IRA’s internal income will preclude treating it as income of the trust, effectively reducing the current income beneficiary’s share of the trust’s net income. In Year 10, the plan sponsor pays out the entire account balance, including the IRA’s accumulated income. As the terms of the trust don’t allocate this payment between principal and income, the current income beneficiary will only receive an amount allocable to trust income under state law.
This scenario may or may not reflect the IRA owner’s intent. Was the expectation that the current income beneficiary entitled to net income always receives at least a portion of an IRA payment allocable to income? If so, the terms of the trust following passage of the SECURE Act frustrates this intent. Without further direction, a discretionary withdrawal may not include any allocation to trust income. Silence during the non-required distribution period should move a trustee to create a strategy addressing withdrawal and allocation of an IRA’s internal income.
Remedies for the Sounds of Silence
Several options exist to address the dual objectives of withdrawing and allocating an IRA’s internal income during the non-required distribution period:
1. Trust modification during IRA owner’s life. If the IRA owner is still alive and competent, the most effective and simplest remedy involves updating the terms of the putative post-mortem trusts. Any mention of Section 401(a)(9), as amended, should be general in nature and avoid referencing “RMDs” or the “required minimum distribution rules.” More specifically, the revised terms should focus on the timing of discretionary withdrawals during the non-required distribution period. The next step states the method to determine the IRA’s internal income earned to date of withdrawal. Possible methods include:
- Authorizing trustee discretion based on what’s fair and reasonable to the beneficiaries.
- Treating the IRA as a trust to determine the IRA’s internal income under traditional fiduciary accounting rules for receipts and expenses.
- Using the unitrust approach to establish the IRA’s internal income as a percentage of the account’s fair market value (FMV).6
- The last two methods reflect uniform rules created by prominent professors and attorneys and will be discussed later. After selecting a method to determine the IRA’s internal income, the trustee implements a direction to allocate an amount to trust income. The final step addresses any internal income earned but not withdrawn during the trust’s accounting period. Should the trustee retain or withdraw it?
2. Trust modification if IRA owner deceased. What if the IRA owner survives the SECURE Act’s effective date, but then dies without changing the trust’s terms? A constructive cure may lie in a state that’s adopted the Uniform Trust Code (UTC) approved by the National Conference of Commissioners on Uniform State Laws (Uniform Law Commission).7
The UTC allows modification of the trust’s governing instrument. Among its goals, modification seeks to bring clarity regarding the trust creator’s intent. A cautionary note: A particular state may not have adopted the UTC, but still permit modification.8 Regardless of jurisdiction, the trustee should only proceed after thoroughly reviewing the nuances of applicable authority. Below are brief descriptions of the UTC formats.
Judicial modification.Judicial modification falls into two categories. The first, under UTC Section 411(b), requires consent of all trust beneficiaries.9 A court must “conclude that [the proposed] modification is not inconsistent with the terms of the trust.” The second option, UTC Section 412, turns on “circumstances not anticipated by the settlor [to] further the purposes of the trust” or the trust’s terms would “impair” administration. If practicable, the modification should comply with the trust creator’s “probable intention.”
Under either method, a court-ordered modification would first address the timing and scope of discretionary payments from the IRA. Additional language would speak to the method for determining the IRA’s internal income and allocation between income and principal.
Non-judicial modification. Although not labeled as such, the UTC authorizes use of a non-judicial settlement agreement to effectively accomplish a modification. UTC Section 111 enables “interested persons” to resolve issues through a non-judicial settlement agreement that includes “grant[ing] a trustee any necessary or desirable power.” This authority suggests that with beneficiary consent, a trustee may gain the power to make discretionary withdrawals from an IRA and characterize its internal income as income of the trust.
A proposed modification in theory sounds like the road to resolution, but it could soon become an impassable one. Conflict may erupt with some beneficiaries understanding and acknowledging the need for modification while others object. The objections range from cost (such as the legal fees the trustee and/or beneficiary will incur) to a much deeper reason (such as that the proposed modification expressly or implicitly favors one class of beneficiaries over the other). This latter reason heightens the trustee’s duty of impartiality to ensure the modification is fair to all parties unless the governing instrument favors one class of beneficiaries.
3. Default rules for allocating IRA payments. If modification isn’t a viable option, the Uniform Law Commission again steps up to the plate. Currently, two uniform acts provide default rules for allocating IRA payments between income and principal. The first, and most familiar, is the Uniform Principal and Income Act (UPIA) adopted by most states. UPIA Section 409 contains the allocation provisions for deferred compensation payments, including IRAs.
UPIA Section 409 differentiates between trusts qualifying for the federal estate tax marital deduction (marital trusts) and those that don’t qualify (non-marital trusts). For the former, the relevant allocation rule treats the IRA’s internal income as income of the trust.10 The surviving spouse has the right to request payment of the internal income or an equivalent amount of principal.
For non-marital deduction trusts, UPIA Section 409 doesn’t focus on the IRA’s internal income prior to payment. Rather, allocation depends on the payment’s status as required versus non-required under UPIA Section 401(a)(9). A required payment is allocated 10% to income and 90% to principal; a non-required payment is 100% principal.11
This allocation scheme, as many will recognize, portends problems for a current income beneficiary receiving mandatory payments of the trust’s net income. The SECURE Act’s non-required distribution period means a discretionary withdrawal initially becomes principal. Without a further remedy, this beneficiary won’t receive any of the IRA’s internal income until Year 10.
Fortunately, the UPIA aids the trustee. Labeled the “power to adjust,” UPIA Section 104 authorizes discretion to convert trust principal into income. Exercising this power enables a trustee to increase the income component of an IRA payment, effectively making more of the IRA’s internal income available to the current trust beneficiary. Although an extended discussion of UPIA Section 104 is beyond the scope of this article, a trustee’s decision complying with the adjustment protocol “is presumed reasonable to all the trust’s beneficiaries.”12
The limitations on allocating the IRA’s internal income for non-marital trusts seem to have struck a chord with the Uniform Law Commission. The designated successor to the UPIA, the Uniform Fiduciary Income and Principal Act (UFIPA) approved in 2018, imposed one allocation standard for all trusts: income of the IRA, a “separate fund” under UFIPA Section 409(a)(4), is income of the trust. The trustee shall allocate a payment received during the trust’s accounting period to trust income “to the extent of the IRA’s internal income earned during [this time frame].”13
UFIPA Section 409, however, conveys a more dramatic message for non-marital trusts. All the IRA’s internal income effectively becomes income of the trust even if the trustee fails to withdraw it.14 The Uniform Law Commissioners guaranteed this result in UFIPA Section 409(e). The trustee must make up the unwithdrawn amount by transferring trust principal to income. The “Uniform Fiduciary Income and Principal Act,” p. 61, displaying UFIPA Section 409(e) and its commentary, confirms the mandatory transfer.
Before making it, the commentary advises caution. A trustee should consider exercising discretion to withdraw “greater amounts from the fund,” which in context, refers to the IRA’s internal income. This guidance from UFIPA Section 201(a), also included in the “Uniform Fiduciary Income and Principal Act,” p. 61, serves as a guardrail to applying UFIPA Section 409(e). The duty to “act in good faith based upon what is fair and reasonable to allbeneficiaries” broadens the scope of the trustee’s discretion. It looks to the trustee’s reliance on the IRA’s payout provisions rather than to the UFIPA. Consistent with its mandatory transfer requirement, the commentary to UFIPA Section 409(e) doesn’t mention the UFIPA’s discretionary power to adjust in Section 203.
Created before passage of the SECURE Act, UFIPA Section 409(e) may have assumed that the IRA’s internal income would periodically exceed the amount of a required payment. The trustee retains the tax-deferred “excess” internal income. This result undercuts the core value in UFIPA Section 409 entitling the current income beneficiary to all the IRA’s internal income.
In this regard, the drafters of the UFIPA were extraordinarily clairvoyant and seemingly anticipated passage of the SECURE Act’s non-required distribution period. They responded by arming a trustee with authority to force a withdrawal of principal and consider it equivalent to the IRA’s internal income.
Ultimate Antidote or Poison Pill?
UFIPA Section 409(e) seems like the perfect remedy to overcome the challenge posed by the SECURE Act. While effectively guaranteeing a current income beneficiary’s entitlement to the IRA’s internal income, invoking it may open a Pandora’s box of issues. At first blush, everyone seems pleased. The current income beneficiary now receives tax-free principal to compensate for the IRA’s retained internal income. Retention permits further deferral of income tax.
Relying on UFIPA Section 409(e), however, comes with strings. The trust’s remainder beneficiaries witness an annual depletion of principal following a required transfer to income. To some extent, the accumulated tax-deferred income (income in respect of a decedent) may offset the principal depletion. But the offset isn’t permanent. With a traditional IRA, the tax on accumulated income comes when the non-required distribution period ends. The trust’s remainder beneficiaries will likely bear the lion’s share of the income tax, reducing the balance left to them.
Two more subtle obstacles face the trustee. First, what if no withdrawals occur during the non-required distribution period, eliminating any need to determine the IRA’s internal income? As written, UFIPA Section 409(e) implicitly requires the trustee to make this determination prior to transferring principal to income. The trustee finds the answer within UFIPA Section 409.
UFIPA Section 409(b) determines the internal income of a separate fund like an IRA under two different methods.15 Method 1 follows the traditional fiduciary accounting rules. The trustee applies the receipt and expense allocation rules within the UFIPA. Method 2 follows the unitrust approach: The internal income “is deemed” to reflect an amount calculated by multiplying the IRA’s FMV on a prescribed date by a fixed percentage of between 3% and 5%. Use of the unitrust method under UFIPA Section 409(b) is conditional. Only if the IRA’s internal income can’t be determined under traditional fiduciary accounting rules does the unitrust method become operable.
The second obstacle implicates selection of principal assets comprising the transfer. While cash sounds like the most reasonable choice, UFIPA Section 409(e) has no defined hierarchy other than perhaps the trustee’s duty to act in good faith.16
Let’s examine how UFIPA Section 409(e) applies to the facts in the example. The SECURE Act’s non-required distribution period allows accumulation of the IRA’s internal income. Our well-informed trustee has memorized UFIPA Section 409(e) and the commentary to it. It must now ponder whether to retain or withdraw all or a portion of the IRA’s internal income.
If the trustee retains the IRA’s internal income determined under traditional fiduciary accounting rules, it must transfer $30,000 from trust principal to income and distribute this amount to the child of each separate trust. The distribution, which may consist of cash or other trust assets (the stocks and bonds), will over nine years deplete roughly 70% of the non-IRA assets.
On a related note, if the trustee in good faith can’t use Method 1 to determine the IRA’s internal income, Method 2, the unitrust approach, calculates the transfer from principal to income. A unitrust rate of 4% to 5% noticeably accelerates the depletion.
The remainder beneficiaries learn about the principal transfer in a periodic trust statement and absorb, perhaps painfully, the potential depletion rate over the non-required distribution period. But they also know that an equivalent amount, the accumulated IRA’s internal income, remains tax deferred. Their joy may be temporary as they’ll bear most of the tax on the income accumulated during the non-required distribution period and then withdrawn in Year 10.
If the trustee believes discretionary withdrawals of the IRA’s internal income provide a more satisfactory result for all beneficiaries, the fallout from UFIPA Section 409(e) dissipates. Withdrawal preserves trust assets and passes the IRA’s internal income to the current income beneficiary. Depending on the facts and circumstances, the optimal solution may be compromise. For some years, the trustee withdraws a portion or all the internal income and, if not fully withdrawn, transfers principal to income to make up the difference.
Going Forward
The SECURE Act’s creation of the non-required distribution period for making IRA payments to many post-mortem trusts warrants further discussion, preferably with the IRA owner while alive, but if necessary, with the trustee following death. The topic is the unintended consequence of retaining an IRA’s internal income rather than distributing it to a beneficiary entitled to all the trust’s net income. A conversation with the IRA owner should cover revising the trust’s language to include discretionary withdrawals during the non-required distribution period, allocation between principal and income and disposition of any unwithdrawn internal income.
If the IRA owner before death failed to deal with these issues, the trustee and beneficiaries may agree that modifying the trust will ease administration and reach a mutually acceptable solution. The final remedy involves applying state default allocation rules by consulting the relevant principal and income act.
Trustees in states currently following the UPIA’s version of Section 409 realize that for non-marital trusts, its terms limit or deny allocation of an IRA’s internal income as income of the trust. Another provision, UPIA Section 104, offers the trustee discretion to change the initial allocation following payment.
In the not-too-distant future, some states will adopt the UFIPA and its version of Section 409.17 UFIPA Section 409(e) challenges the trustee to analyze the potential effect of retaining an IRA’s internal income. Retention requires the trustee to transfer principal (cash or other trust assets) to replace the IRA’s unwithdrawn internal income. If an IRA owner wishes to avoid this result, prudence strongly suggests drafting language to override UFIPA Section 409(e) and expressly address retained internal income. Like its predecessor, the UFIPA subordinates its terms to those in the trust.18
If the terms of the trust are silent, the commentary’s guidance to relying on UFIPA Section 409(e) becomes especially important. UFIPA Section 201(a) conveys a subtle warning. Acting in good faith remains paramount in deciding whether to withdraw the IRA’s internal income or retain it, triggering a subsequent transfer of principal to income.
Endnotes
1. As enacted, SECURE stands for “Setting Every Community Up for Retirement Enhancement,” Division O of the Further Consolidated Appropriations Act 2020, Pub. L. No. 116-94, 133 Stat. 3176.
2. The SECURE Act added Subparagraph “H” to Internal Revenue Code Section 401(a)(9) to create the 10-year distribution rule; the exceptions to the rule are shown in Subparagraph “E(ii).”
3. IRC Section 401(a)(9)(H)(vi).
4. Natalie B. Choate, “Planning for Retirement Benefits After the SECURE Act,” 54th Annual Heckerling Institute on Estate Planning, University of Miami School of Law (January 2020), at p. 13 (“[i]n the interim no distributions are required, as long as the funds are out of the plan by the [10-year] deadline”).
5. Treasury Regulations Section 1.401(a)(9)-1, A-2 (plan must include required provisions; optional provisions permissible if they don’t conflict with Section 401(a) and its regulations).
6. For an enlightened review of drafting ideas, see Natalie B. Choate, Life and Death Planning for Retirement Benefits (8th ed. 2018), at pp. 399-402.
7. Uniform Trust Code (UTC) (Uniform Law Commission, 2000, last amended 2010), www.uniformlaws.org/acts.
8. See, forexample, CA Prob Code Section 15409.
9. See UTC Section 411(b).
10. See Uniform Principal and Income Act (UPIA) (Uniform Law Commission 1997, last amended 2008), Section 409 subsections “d” through “g” (Uniform Law Commission), www.uniformlaws.org/acts.
11. UPIA Section 409(c).
12. UPIA Section 103(b).
13. Uniform Fiduciary Income and Principal Act (UFIPA) (Uniform Law Commission 2018), Section 409(c); the full text of UFIPA Section 409 is available at www.uniformlaws.org/acts.
14. See David S. Sennett, “The Death of Percentage Allocation Rules For IRA Payments to a Non-Marital Trust,” Trusts & Estates (September 2019); UFIPA Section 409(d)(2) allows the surviving spouse to request transfer of principal to income in the event the trustee doesn’t, at this individual’s request, withdraw all the IRA’s internal income.
15. UFIPA Section 409(b).
16. UFIPA Section 201(b) (exercise of discretion is “presumed to be fair and reasonable to all beneficiaries”).
17. As of April 26, 2021, Kansas and Utah have adopted the UFIPA; several state legislatures are considering enactment. Seewww.uniformlaws.org/acts for updates.
18. UFIPA Section 201(a)(4).