The SECURE (Setting Every Community Up for Retirement Enhancement) Act had been working its way through Congress for much of 2019 and was passed into law just before Christmas. As with any tax law, there are opportunities to embrace and obstacles to navigate. Your goals and financial circumstances will dictate how your personal financial planning may "pivot" with the changing landscape.
First, let’s begin with the largest obstacle created by the SECURE Act. The law had to pay for a number of changes, and it did so by limiting what was called the "stretch" IRA. Any qualified retirement account (IRA, Roth IRA, 401k, etc.) can be passed on at death to a beneficiary. Prior to the law change, any non-spousal beneficiary had a lifetime to slowly distribute the funds from the retirement account through annual Required Minimum Distributions (RMDs). The annual distributions were based on the beneficiary’s age relative to their life expectancy (mid-80’s) and typically required distributions of 3 to 4% the first year. As the beneficiary grew older, so did the percentage they were required to distribute each year. But since these accounts tend to grow over time, it could take decades for heirs to dip into the original dollars they inherited. At the extreme, a toddler would have 80 years to withdraw the last dollar from a retirement account (and that would not occur until the year 2100). More commonly, adult children inherit their parent’s wealth when they are in their 50’s or 60’s. Thus, they would have 20 to 30 years to slowly draw down the accounts.
Now, the rules are different, and it is a big deal. Going forward, all retirement accounts passed to a non-spouse (and a few other rare exceptions) must be liquidated within 10 years. Below are a number of key considerations.
Key Point #1
There is only an RMD in the tenth year - A beneficiary can choose to draw nothing in years 1-9. Human nature is to minimize taxes and defer, defer, defer. Waiting until the clock runs to zero will be an extremely costly strategy as all income would be taxed in one year. Generally, beneficiaries tend to be in their highest earning years when they receive their inheritance. If they inherit a sizeable IRA, tax bracket management (managing income below "expensive" tax brackets and deliberately filling the "cheap" tax brackets) will be critical. If no significant changes in income create a "tax gap," an effective strategy would be to distribute out the account as smoothly as possible over ten years (10% in year one, 11% in year two, 12% in year three, 14% in year four, 17% in year five, 20% in year six, etc.). Smoothing distributions can reduce the tax bill by half or more.
It will be important to have "cheap cash" to pay taxes (such as cash in a checking account or Roth IRA) to avoid the phenomenon of paying taxes on top of taxes. For instance, at top tax rates, if someone wanted to withdraw $100,000 to spend, they would then need to withdraw $50,000 to pay the tax on the first $100,000 distribution…and then withdraw $25,000 to pay the tax on the second distribution and so forth. Ultimately, a dollar needs to be withdrawn to pay taxes for every dollar that is withdrawn to be spent.
Key Point #2
Lifetime Roth conversions are even more critical – A Roth conversion is a strategy to transfer money in a pre-tax account (such as an IRA or 401k) into a forever tax-free account (a Roth IRA). Roths will be subject to the 10-year rule too upon the transfer to heirs, but all distributions are tax-free. Thus, there is no harm in delaying the liquidation until the last year nor any harm in using the Roth dollars for tax bracket management alongside an inherited IRA. Going forward, planning between parents and children will be extremely important.
Key Point #3
Trusts do not work well with the new rules – Many "conduit" trusts have been created to transfer out small RMDs to children, but protect the underlying wealth within the IRA from their children and creditors. The trusts were fairly tax-efficient, but now may be anything but. For instance, since there is no RMD until year ten, the Trusts would not allow for any distributions in year 1-9 and then be required to fully distribute out all the funds in the final year. It will be important for those with a trust named as beneficiary of their retirement accounts to review their estate plan with an attorney.
Key Point #4
Life insurance and charitable trusts may become more popular – There is already talk of using funds in IRAs to buy life insurance and to even fund charitable remainder trusts to recreate a stretch IRA of sorts (transfer an IRA to a trust that pays the heirs an annual distribution for many years and then pays the remaining dollars to a charity at the end of the term).
Key Point #5
IRAs for charity – In many cases, lifetime qualified charitable distributions (distributions from an IRA after age 70½ that are given directly to a charity) and listing charities as direct beneficiaries of IRAs can be extremely tax efficient. For those who may have a Federally taxable estate (wealth above $23 million for a married couple) and the majority of their wealth in an IRA, the tax benefit can exceed 100% (i.e. approximate Federal and Minnesota estate taxes of 55%; if all paid from an IRA could create another 50% tax on the income; thus gifting IRA to charity can save 105% in taxes... meaning the family is financially better off giving their wealth to charity than transferring it to the next generation).
Key Point #6
Non-qualified accounts – Unaffected by the SECURE Act – Non-qualified accounts were not impacted by the law, only "qualified" retirement accounts were. What is a non-qualified account? They are accounts which receive much, but not all, of the preferential tax treatment of IRAs and 401(k)s. The most common type of non-qualified account is an annuity. Certain types of annuities exist exclusively for tax and legacy planning purposes. They are called Investment Only Variable Annuities (IOVAs) and the lifetime stretch feature is alive and well. IOVA’s may become very popular in the years to come.
Opportunities Within the New Law
- RMD age is now 72 – Anyone who previously was not required to take a distribution from an IRA or 401(k) can delay distributions until age 72. If someone turned 70½ prior to the last day of 2019, they will need to keep taking their RMD. This will help defer taxes within pre-tax accounts and will create some additional "ebbs" within one’s "tax gap" planning.
- IRA Contributions – Can now make at any age (previously had to stop once RMDs began). As long as someone (or their spouse) has earned income, they can contribute up to $7,000 per year to their IRA.
- Qualified Charitable Distributions – Still age 70½ – Distributions from an IRA directly to charity can still be made at the "old" RMD age from an IRA.
- 401(k)s – Small plans now can receive tax credits to cover start-up costs; it should be easier to have companies band together to spread costs of administration under a multiple employer plan; and employers can set higher ceilings for automated savings for employees.
- 529 college savings plans – Now allow $10,000 of student loans to be paid from the account. Two years ago, 529 plans were allowed to pay for expenses even before a child attended college. Now, most any educational expense can be withdrawn tax-free from "Kindergarten – PHD."
- Kiddie Tax – Now reverting back to the "old" system – Once again, the parent’s income will be referenced to calculate the tax on investment income for their kids (under 24 years old if in college, under 18 if not) instead of using the trust tax tables. In some cases, this could reduce the tax to the family as trusts reach top tax rates at modest levels of income. This rule goes into effect in 2020, but folks can elect to make the switch for their 2018 and 2019 tax returns.
We are here to "help you get there" and to build and preserve your wealth. If you have questions on how the SECURE Act may impact your planning, contact us at 952.893.9320 or email@example.com.
The information provided has been derived from sources believed to be reliable, but is not guaranteed as to accuracy and does not purport to be complete analysis of the material discussed. Any tax advice contained herein is of a general nature. Further, you should seek specific tax advice from your tax professional before pursuing any idea contemplated herein. This advice is being provided solely as an incidental service to our business as (insurance professionals, financial planner, investment advisor, securities broker).
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