Congress passed several laws in December of 2019 that impact several retirement savings aspects. This bundle of changes is referred to as the SECURE Act à “Setting Every Community Up for Retirement Enhancement”. Some of these changes will create some tax and estate planning challenges for non-spouse beneficiaries. Therefore, we are sharing some examples of how just a few of these changes will impact our clients and how adjusting their plans may help to pass their legacy as efficiently as possible. Please check back here on our blog to learn of other changes related to the SECURE Act.
The Death of the Stretch
Outside of some uncommon exceptions for chronically ill and disabled individuals, non-spouse beneficiaries of people dying after January 1st, 2020 will no longer be able to stretch distributions over their life expectancy. Under the new rules, the whole amount would need to be distributed within 10 years of the year following the year of death. This can create some significant tax consequences and may justify revisiting one’s retirement cashflow strategy as well as other ways to help manage the distribution of retirement assets in a more tax efficient way.
For example, if a 40-year-old were to inherit a $1 million IRA account from a parent, the first-year distribution under the old rules would be $18,762. In this example and under the new rules, the beneficiary would need to take $100,000 per year to deplete the inherited assets in the 10-year time frame. These distributions are all taxed as ordinary income to the beneficiary. If you consider a beneficiary blessed with this windfall while in their “peak earning years”, you begin to grasp how significant the tax consequences can be.
In general, it was often advisable to have retirees deplete their taxable assets before their tax deferred retirement assets (i.e. using brokerage accounts first, then retirement accounts). Given these changes, we expect some of our clients to begin living off their tax deferred assets sooner, while enjoying a lower income tax situation and working to reduce how much they will want to transfer to their heirs in retirement assets given the “death of the stretch” reality.
*Note: Spousal beneficiaries will continue to have the ability to inherit assets and treat them as their own.
Required Minimum Distributions (RMDs) were pushed back
Most of our clients go through highs and lows with respect to income taxes over their lifetimes (think of peaks and valleys). Many of our clients enjoy a lower income tax bracket at retirement, up until they are forced to take income from traditional retirement accounts. Historically, the age at which someone has been forced to start taking distributions on tax deferred retirement accounts has been 70 ½ years old. Under these new changes, this age has been moved back to age 72 (anyone born on July 1, 1949 or later).
Imagine you go to the store to buy coffee every week. You typically pay $8 for the coffee you love, but this week, it’s on sale for $4 a bag. Unless you’re short on money, you’ll likely stock up while it’s on sale for far less. Tax “valleys” (when you’re in a lower tax bracket) afford you the same opportunity to pay taxes on “sale”. Converting tax deferred assets in an IRA to a Roth IRA allows you to move money from a pre-tax position to an after-tax account, recognizing that income in the lower, tax “valley” year. Those assets will grow tax-deferred and qualified distributions are tax free. There are no required minimum distributions for the owner and the money can pass tax-free to the beneficiaries.
Removal of age restriction for traditional IRA contributions
The SECURE Act repeals the age restriction on contributions to traditional IRA accounts. Under previous rules, individuals who reached 70 ½ couldn’t contribute to a traditional IRA for the year in which they turned 70 ½ or any later year. There’s never been an age restriction on Roth IRA contributions. *Note: This new provision reduces the amount a tax payer may deduct for qualified charitable distributions from an IRA if post-age 70 ½ deductible IRA contributions are made.
Bringing it all together
The tax ramifications discussed here are powerful and provide a glimpse of the motivations of the legislation’s designers: More tax revenue for Uncle Sam. These changes will keep us busy in the months and years ahead as we review how it may impact each of our client’s financial plans. Evaluating the strategies that can be most beneficial to each of our clients’ estate, tax and cash-flow planning is where we shine. The SECURE Act appears to be a solid reason to dust off that old will or estate plan from long ago.
Photo from Anukrati Omar https://unsplash.com/@anuomar on unsplash.com