On December 20th, President Trump signed into law the SECURE (Setting Every Community for Retirement Enhancement) Act as part of a spending bill. The SECURE Act was the result of a bipartisan effort to address the dismal state of American retirement savings and the fact that we are living and working longer.
While a major portion of the Act attempts to incentivize employers to sponsor 401(k) plans, there are three key provisions that will materially affect individual investors’ income tax and estate plans, in both positive and negative ways. Below we address the three changes that we believe have the most impact on our clients.
First, the positive changes:
Required Minimum Distribution (“RMD”) age is raised to 72
Effective January 1, 2020, the RMD age is raised from 70½ to 72. This change is long overdue considering the life expectancy of Americans has significantly increased since mandatory distributions were first added to the Internal Revenue Code in 1962. IRA owners reaching age 70½ in 2020 catch a break and will not have to take their first RMD next year now that the RMD age has been extended to age 72.
Age limitation on Traditional IRA contributions is removed
Under prior law, contributions to a traditional IRA were disallowed upon attaining age 70½. As a result of the SECURE Act, any individual with earned income may continue contributing to a traditional IRA throughout his or her lifetime with no age restriction.
Now for the bad, we believe much more consequential, change:
Lifetime stretch distribution for Inherited IRAs is now replaced with a ten-year rule
Beginning for deaths after December 31, 2019, the so-called “stretch IRA” will be replaced with a ten-year rule for the vast majority of beneficiaries. There will be no annual RMDs; however, the full account balance will have to be distributed and taxed by the end of the tenth year following the year of death. For beneficiaries who don’t need income from their inherited IRAs, this not only results in a loss of deferral, but also a potential increase in their marginal tax bracket because of the acceleration in distribution.
Let’s look at an example: Dave inherits his father’s $1 million IRA in 2020 when he is 50 years old. Under the prior law, the IRS table says Dave has 34.2 years to live, which means he could stretch the distribution of the $1 million, plus earnings, over the next 34 years and only needs to withdraw about $30,000 in the first year. Under the SECURE Act, Dave is now required to withdraw and pay tax on the $1 million over the next 10 years. If he divides the distribution equally among 10 years, he will need to withdraw $100,000/year, over 3 times more than what he would have been required to take out under prior law.
Furthermore, generationally speaking, a big percentage of taxpayers receive inheritance from their parents in their late 40’s and 50’s, which tends to also be the prime of their careers with their strongest earning power. As a result, most of the distributions will be taxed at a much higher tax bracket, instead of a big portion continues to be deferred until they retire and taxed at lower rate. If, for example, Dave and his wife Katherine currently make over $500,000 a year, the additional taxable income from Dave’s inherited IRA will be taxed at a 35% rate for federal and a 9.3% rate for state, assuming they live in California. In the other words, they likely would only receive a little more than half of the IRA balance, net after taxes. One can argue that it would be more tax-efficient if Dave’s parents had converted a portion of their IRA balance into a Roth, paid tax at their lower bracket and left Dave and Katherine tax-free income.
If you’ve had an inherited IRA, rest easy, this rule only applies to retirement accounts whose owners die after the end of 2019. Anyone who inherited an individual retirement account before the end of 2019 can still draw down the account over his or her lifetime.
The new rule also exempts five classes of “eligible designated beneficiaries,” who can still stretch the RMDs over their life expectancy. These include surviving spouses, minor children, disabled and chronically ill individuals and beneficiaries not more than ten years younger than the original IRA owner.
Given the drastic impact the SECURE Act has on the landscape of retirement and estate planning, we encourage you to review your current plan with your financial planner to determine the right strategies for your individual situation. Is the current beneficiary designation plan still appropriate? If you are retired but still have earned income, should you make a contribution to an IRA or Roth IRA now that there is no age limitation? How should Roth conversion be (or not be) incorporated in your overall plan, especially before the RMD kicks in? Should it be used in conjunction with charitable gift planning and/or tax-loss harvesting from your taxable portfolio? Where can you get cash flow to cover the tax liability from the conversion? There is not one right answer for these questions but your advisor can act as a sounding board and help devise an intentional, tax-efficient plan for you and your heirs.