Earlier this year I had the privilege to meet with lawmakers on Capitol Hill to provide industry feedback on the implications of the Setting Every Community Up for Retirement Enhancement Act (aka the SECURE Act). As expected the SECURE Act was included in the spending bill that Congress passed on December 19th. The spending bill funds the government through the 2020 election and now sits on the President’s desk waiting approval to become law.
The SECURE Act makes some major changes to the rules of retirement accounts and even includes some changes to 529 College Savings Plans. Below is an overview of the changes that will impact individuals personal financial planning, for a discussion of how this impacts businesses click here.
The Biggest Change
The SECURE Act limits the ability of retirement plan beneficiaries to “stretch” the account balance over their lifetime and requires most children who inherit retirement accounts to draw down the accounts within 10 years.
This is by far the most impactful provision of the SECURE Act. Currently, if you are the beneficiary of a retirement plan account (ie. 401k, IRA, etc.) you have the option to take the inherited fund in a lump-sum, over a period of 5 years or you can “stretch” the distributions over your lifetime. Remember that distributions from pre-tax retirement accounts are taxable to the recipient in the year they receive the money. Therefore, many people chose to “stretch” the inherited funds over the lifetime in order to spread out the taxes. Under the SECURE Act only spouses, minor children, disabled individuals and beneficiaries less than 10 years younger than the original account owner can “stretch” distributions – all others must receive the entire account balance within 10 years.
This has a huge impact for those expecting to receive an inheritance of a retirement account and potentially for current account owners. Consider that retirement accounts have swollen in value over the last 10 plus years thanks to a rocket fueled stock market and we are in the midst of the largest transfer of wealth in history.
If you are expecting to be on the receiving end of mom and dad’s retirement accounts when they pass, you will now be forced to receive and pay taxes on potentially a large amount of additional income over the 10 years after they pass. If mom and dad were 30 when you were born and live to be 85 you will likely be inheriting this additional income while you are in your prime earning years and thus already in a high tax bracket. Regardless of your income levels it may throw you into a higher tax bracket further eroding what you ultimately inherit.
From mom and dad’s or perhaps grandma and grandpa’s perspective there may be concerns about a beneficiary’s ability to responsibly manage this greater amount of income or perhaps they had planned on the beneficiary stretching the balance out over their lifetime and having enough left over to pass to future generations.
We will likely write more about this and will certainly be discussing these strategies with clients. I see these changes putting more of an emphasis on the strategic use of ROTH IRAs and perhaps Trusts that are specifically designed to inherit and protect IRAs after death. Distributions from inherited ROTH IRAs are not taxable. Therefore, mom and dad may want to consider converting some of their traditional IRAs to a ROTH IRA while they are living so that the kids don’t inherit a big tax burden. Sure, they will have to pay taxes when they make the conversion but the tax rate would likely be lower than what the beneficiaries tax rate is projected to be. Perhaps the kids would also be willing to chip in or fully pay for the tax on the conversion.
So why was this change made – it’s all about the revenue. The government knows that the amount of money in motion is significant – with these changes they get to receive the tax revenue on the inherited IRA’s sooner which is sorely needed to help reduce the bulging deficit and helps to offset additional spending measures or further tax cuts.
Other Retirement Changes
Increases the age for required minimum distributions to 72.
Currently you are required to start taking distributions from your retirement accounts once you reach age 70.5. The SECURE Act pushes the age to begin distributions to age 72. If you already receiving your RMDs you will not be impacted. This would be effective for distributions required to start after December 31, 2019.
Allows individuals over age 70½ to make non-rollover contributions to an IRA.
Currently, you are not able to make contributions to a Traditional IRA after age 70½ however with the passage of the SECURE Act you will now be able to. However, the rule that you may only make IRA contributions if you have earned income remains. Therefore, this applies to those over 70 ½ who are still working in some capacity but might not have access to a corporate retirement plan.
Allows participants to take a penalty-free withdrawal from retirement accounts of up to $5,000 upon the birth or adoption of a child. These distributions could be repaid to the plan.
Having a child is expensive, adopting a child is even more expensive. Now you will be able to take a withdrawal, up to $5,000 from your retirement accounts and avoid the early withdrawal penalty normally incurred for distributions prior to age 59 ½.
Part-time workers will now have access to company retirement savings plans.
Part-time workers who complete three consecutive years with at least 500 hours of service will be required to have the opportunity to save to the company retirement plan. Under current law, companies can exclude all employees who don’t work 1,000 hours.
I see this being the biggest opportunity for couples where one spouse might be a high earner and the other works part-time. This would allow the part-time worker to save up to $19,500 (the 2020 401k contribution limit) vs the $6,000 IRA limit. Further, if the married couple earns too much to be eligible for a ROTH IRA the part-time worker could likely make ROTH contributions to the company retirement plan which are not subject to the income limitations.
Withdrawals for 529 college savings arrangements could be used to pay for apprenticeship programs and to repay student loans (limited to $10,000 total repayment).
Included in the 2017 tax law changes 529 plans can now be used to pay for private grade school tuition (up to $10,000 per year). The SECURE Act expands on this by now allowing 529 funds to be used for apprenticeship programs and to repay student loans. This can provide some relief for grandparents or parents who are concerned that their kids might not attend a traditional college or university. Further, if you believe that having kids take out loans so that they have “skin-in-the-game” for their own college tuition then you may use 529 savings to help repay those student loans.
We look forward to working with clients to adjust their current plans in this new environment. In the meantime, do not hesitate to reach out to us with questions.
Written by – Chris Thomas, CFP®, AIF®, CPFA