By Nirav Batavia, CFA
In December, the Setting Every Community Up for Retirement
Enhancement (SECURE) Act was passed into law. The SECURE Act includes a variety
of changes affecting how individuals will save for retirement going forward.
Some aspects of the SECURE Act are expected to have a major impact on retirement planning and savings, some are minor, and for some parts, we’ll just have to wait and see. What we want to do in this article is provide a primer and our thoughts on what we feel are the most significant portions of the Act.
Note that we did not include a section on changes to retirement plans for employers and employees as these changes will primarily impact small business owners. If you are a small business owner, we encourage you to speak with your financial advisor.
Elimination of Stretch IRAs
Stretching inherited IRA distributions over the life expectancy of a beneficiary has been an important financial planning technique used to reduce the impact of taxes on beneficiaries. The SECURE Act eliminates so-called “stretch” IRAs for the majority of non-spouse beneficiaries for any account owner who passes away after 12/31/2019.
However, it is still possible to stretch IRA distributions if the beneficiary falls into one of the following categories, known as eligible designated beneficiaries:
· Surviving spouses
· Minor children (until the age of majority)
· Beneficiaries who are no more than 10 years younger than the deceased account owner
· Individuals with disabilities and chronically ill individuals
Outside of these categories, beneficiaries will have 10 years to fully deplete an inherited IRA or Roth IRA. There will be no RMDs, so beneficiaries will have to manage the distributions themselves.
For inherited Roth IRAs, the math is simple. Since Roth IRAs compound tax-free and distribute tax-free, beneficiaries will generally be best served waiting until the 10th year to distribute the account unless they need access to the funds sooner.
For inherited traditional IRAs, there is a lot more to consider. Since the distributions will be taxed at ordinary income tax rates, the expected income of the beneficiary can play a large role. For example, if a beneficiary had planned to retire in Year 3, it may behoove the beneficiary to wait until Years 4–10 to start distributions from the IRA.
For account owners concerned about overall family taxation, it may be valuable to consider several strategic choices, especially after a spousal beneficiary is no longer in the picture. These options include:
· Roth conversions of IRA assets since retirement tax rates tend to be low for most individuals
· Naming multiple beneficiaries to spread out distribution tax effects
· Naming children and grandchildren as beneficiaries
For those who have a trust as a beneficiary of an IRA or 401(k), there could be an issue with the plan now that the SECURE Act has passed. For example, if the trust states that the beneficiary only has access to the RMD each year, under the new rules, there is no RMD until Year 10 after the year of death. This means the IRA money could be held up in the trust for 10 years and then all be distributed as a taxable event on Year 10.
Your advisor and estate planner can help you through these decisions and review whether a trust remains the right type of beneficiary and whether the language within the trust continues to work with the SECURE Act.
Increasing the Required Minimum Distribution Age to 72 From 70.5
For some people who are approaching 70.5 this may feel like a large change, but it’s long overdue given the increase in life expectancy over the past few decades. For individuals who turned 70.5 before 12/31/2019, nothing changes. For everyone else, RMDs don’t start until the age of 72. From our perspective, the potential of a new RMD table in 2021 that would take into account newer life expectancy data will probably have a much larger effect on clients than the 1.5-year delay on RMD commencement.
Removing the Contribution Age Cap for IRAs From 70.5
The contribution cap for IRAs frankly never made a lot of sense and given a larger population that is working until later in life this was much needed. Without a cap, anybody who has wage income in a given year could potentially contribute to an IRA (or Roth IRA) regardless of age. Right now, this change currently affects a small portion of individuals, but the population of older workers continues to grow every year.
Allow the Use of Tax-Advantaged 529 Accounts for Qualified Student Loan Repayments and for Apprenticeship Programs
While the change to use 529 assets for student loan repayments garnered all the headlines, the impact is relatively small. The lifetime limit of $10,000 per beneficiary is minor compared to the balance many graduates are carrying. We’ll have to wait to see the impact of allowing the 529 to be used for apprenticeship programs.
One Big Caveat: Both of these changes have similarities to the recent change that allowed 529s to be used for private K–12 education for up to $10,000 per year. While these changes are approved on the federal level, state law may not align with the federal law changes, so the distributions would be allowed at the federal level and could be penalized as nonqualified at the state level. We recommend that you speak with your financial advisor and accountant before proceeding.
Penalty-Free Withdrawals of $5,000 From 401(k) Accounts to Defray the Costs of
Having or Adopting a Child
Penalty-free doesn’t mean tax-free so individuals would still owe ordinary income tax on pre-tax 401(k) distributions. With that being the case, we would mostly advise clients to not use 401(k) funds toward these costs and instead use after-tax cash first. However, it’s nice to know that these funds are available in a pinch.
The SECURE Act entails some of the largest changes to retirement planning in the past few years, but the bulk of the effect is due to the elimination of “stretch” IRAs going forward for most non-spouse beneficiaries. The delay in RMDs by 1.5 years should be noted but this change is minor when viewing it in the context of an expectation of 20 years of RMDs for most households during their lifetime. Small business owners should speak to their financial advisor about some of the benefits of the new Act when setting up or maintaining retirement plans.
Even if the changes in the SECURE Act alter how and where we can save for retirement, there are still many planning strategies available to help you meet your long-term financial goals. If you have questions about which strategies would work for you, please contact your financial advisor.