How the SECURE Act May Impact Your Financial Plan
Key Points:
The Setting Every Community Up for Retirement Enhancement (SECURE) Act is a significant retirement-related legislation that expands opportunities for individuals to increase their savings and improve retirement security.
The SECURE Act includes sweeping changes that will impact a wide range of financial considerations, including repercussions to retirement, tax, and estate planning.
With proper review and planning, the negative impacts of the SECURE Act can be minimized, while taking advantage of new financial planning opportunities.
On December 20, 2019, the President signed into law the Setting Every Community Up for Retirement Enhancement Act of 2019 (the “SECURE Act”) as part of a larger spending package. The SECURE Act was enacted with the purpose of expanding opportunities for individuals to increase their savings and improve retirement security throughout the country.
Significant Effects on Existing Tax, Retirement, and Estate Plans
Many of the provisions of the SECURE Act may have significant effects on existing tax, retirement, and estate plans. The following are some of the more substantive modifications, with most being effective as of January 1st of 2020:
The Act allows contributions to traditional IRAs after age 70 ½ , assuming the individual has earned income. Prior law did not allow contributions to a tax-deductible traditional IRA after reaching this age limit.
The Act raises the Required Minimum Distribution (RMD) age to 72. Prior law required that most individuals take RMDs from their retirement account once reaching age 70 ½. This modification only applies to those who did not already reach age 70 ½ by the end of 2019.
The Act limits the distribution period of non-spouse inherited IRAs and retirement plans for certain designated beneficiaries to 10 years. In the past, many beneficiaries could potentially spread required distributions of inherited IRAs or retirement plans over their own life expectancy. The new law provides exceptions for spouses, minor children, certain disabled individuals, and those not more than 10 years younger than the deceased.
The Act allows penalty-free withdrawals from retirement plans for expenses related to the birth of a child or adoption, limited to an aggregate amount of $5,000. The $5,000 limit is per parent, per child. The distribution would need to occur within one year of the adoption becoming final, or the child being born, and applies to distributions made after December 31, 2019.
The Act expands the use of Section 529 Plans to allow up to $10,000 in distributions from a 529 Plan to be used to pay off student loans. This is a lifetime limit.
The new law included a repeal of the Tax Cuts and Jobs Act (TCJA) provisions on Kiddie Tax calculations, which had required the use of very compressed trust tax brackets on children with certain levels of unearned income.
The new law reinstates the use of the “old” Kiddie Tax rules, which utilizes the parent’s top marginal tax rate. The repeal is effective for 2018 tax returns as well.
Repeal of the “Stretch” IRA
The repeal of the “stretch” provisions for retirement accounts is one of the more notable changes that will impact many people. While the new rule does not apply to spouses inheriting a deceased spouse’s account, it does apply to most other beneficiaries of account owners who pass away after December 31, 2019.
In the past, an account holder could name a beneficiary, who (at the account owner’s death), could take distributions from the account based on that beneficiary’s life expectancy. For example, if a grandparent were to name a grandchild as a beneficiary of their IRA, that grandchild could then “stretch” the distributions from that account over a longer time period (the grandchild’s life).
From a tax perspective, this longer stretch of payments provided additional tax deferral, and also prevented larger annual distributions which could drive an individual into a higher overall tax bracket. The longer time period and smaller distributions also provided additional creditor and spendthrift protection for those younger beneficiaries who may not be equipped to handle large distributions of cash. Because of the repeal of this stretch allowance, beneficiary designations on retirement accounts should be examined closely.
The repeal of the stretch provision also creates a need for the review of existing trust and estate documents. In some situations, an account owner may have named a trust as beneficiary of their retirement account, which can provide additional controls to the account owner, even after death. Under prior law, certain trusts were provided the ability to receive distributions from an Inherited IRA, with the distribution period tied to the ultimate beneficiary of the trust, which again would allow for this “stretch” benefit. Although there is still some uncertainty on the treatment of various trusts under the new rules, the 10-year cap on the time period for withdrawals will most likely be applied.
The other modification to the withdrawal period under the new law is that the entire account must be withdrawn by the end of the 10th year. Under the old law, you were only required to distribute one-tenth of the account each year. While this does allow for some flexibility in tax planning, it also can cause some havoc in existing trust documents, and how distributions from those trusts are treated. In some cases, trusts do not make distributions out to beneficiaries unless in receipt of an RMD. The result of these trust provisions could then be interpreted to only allow the trustee to make a distribution of the entire balance in the 10th year. This could certainly run afoul with the original account holder’s intent.
In any event, review will be needed to ensure that the account owner’s wishes for the treatment of beneficiaries are met under the trust and account plan documents. This will be true not only from a tax planning perspective, but also considering creditor protection and spendthrift concerns in light of possible large distributions to beneficiaries.
Planning Opportunities Without the Stretch IRA
Even if trusts are not involved, beneficiary designations on retirement accounts will have to be further reviewed under the SECURE Act, as there are some modifications that can be made to alleviate the removal of this stretch period. For example, naming multiple beneficiaries on a retirement plan will result in lower overall distributions. In the previous example, a grandparent could name both their child and their grandchild as beneficiaries. This will cut down on the distributions to the grandchild while the parent is still alive. Then, at the death of the grandchild’s parent, they would “start over” with the remaining balance in the account, if any.
Also, with the compressed distribution period, there may be situations that warrant a charitable beneficiary in some form. An example of this would be the use of a charitable remainder trust (CRT), where the CRT is the beneficiary of the retirement account. The CRT could name another beneficiary to receive a lifetime income or annuity interest, with the remaining balance going to charity after the death of the CRT beneficiary. This could result in generating reduced but longer streams of income to the beneficiary.
Another planning option that may be appealing to some is to consider a Roth conversion of their traditional IRA account, either in a lump sum or over multiple years. The conversion of some or all of the balance will generate a current tax liability, but the funds in the Roth will grow tax-free. Also, while the Roth IRA is still subject to the 10-year withdrawal maximum under the new rules, no tax liability is due upon ultimate withdrawal. The beneficiary could leave the balance in the account for the full 10-year deferral, and then withdraw the entire balance in year 10 with no tax liability.
Age Change for Required Minimum Distributions
Another major change to retirement plan accounts under the SECURE Act is the age that RMDs must begin. The age modification, extending to age 72, provides an additional year and a half of tax deferral. It can also lend some simplicity to the calculations with the elimination of that half year. And although the new law modified the age for RMDs, it did not make any modifications to the Qualified Charitable Distribution (QCD) rules. A QCD allows an account owner to direct funds from their IRA to a charity in an amount up to $100,000 each year. By doing so, the distribution from the account is not included in the individual’s taxable income. The QCD is still allowed once an individual turns 70 ½ , even though no RMD is actually required.
If an individual is charitably inclined, the QCD is another way to provide a current tax benefit to the account owner, while also reducing the taxable plan balance for future beneficiaries.
Other Tax Planning Considerations
In addition to beneficiary and estate planning considerations, a thorough tax review will also be warranted under the SECURE Act. As mentioned above, with the additional time allowed for RMDs and QCDs, the tax planning in place prior to 2020 may now need to change if an individual is turning 70 in 2020 and beyond.
Tax reviews under the SECURE Act are not limited to those in their retirement years. Under the repeal of the Tax Cuts and Jobs Act provisions relating to the taxation of minor children or dependents, an analysis of 2018 and 2019 returns filed for those children should also be completed. If those children had significant unearned income during those years, and the parent’s tax rate was not at the highest marginal rate, a change may be beneficial. While the repeal under the SECURE Act is effective for the 2020 tax year, the law does give the option to file amended returns in order to elect to retroactively apply the “old” Kiddie Tax provisions.
Conclusion
The passing of the SECURE Act was intended to create additional opportunities for retirement savings. However, the Act also included provisions that create added complexity to tax and financial planning recommendations for many individuals. The repeal of the stretch provisions and modifications to RMDs can have repercussions to many existing account owners and their heirs. All of the modifications under the Act will require further review and discussion to ensure that an account owner’s wishes are met in their overall financial plan.