David Peartree, BridgeTower Media Newswires
At the close of 2019, Congress quietly passed legislation known as the "SECURE Act" that makes significant changes in the rules for IRAs and other retirement plans. One effect of the legislation will be to subject some IRA distributions to taxation sooner and possibly at higher rates than under the prior law.
Congress often chooses an acronym for legislation that is designed to mask any politically unpopular consequences with Pollyannaish promises if not outright mendacious claims. Think of the "Affordable Care Act" or various iterations of "Tax Simplification" legislation. The SECURE Act is no different. It stands for "Setting Every Community Up for Retirement Enhancement," but one commentator, Forbes writer James Lange, has already suggested that the legislation would be better named as the "Extreme Death-Tax for IRA and Retirement Plan Owners Act."
To be fair, the SECURE Act is a mixed bag with some good news for retirement account owners and some bad news for their beneficiaries. First, some of the good news.
-Required distributions start later. Previously, IRA owners were required to start taking distributions at age 70½. Effective this year, required distributions don't start until age 72, giving a little extra time for growth before starting the decumulation process. However, anyone who turned 70 ½ before December 31, 2019 is still subject to required distributions, even if they are not yet 72.
-IRA contributions at any age. Previously, IRA contributions were not permitted past the age of 70½, subject to a few exceptions. Now, there is no longer an age limit on making IRA contributions. An account owner can continue to make IRA contributions at any age as long as he or she has earned income for the year. The ability to make contributions at any age and to defer withdrawals until age 72 allow for greater tax deferred growth.
-Withdrawals for birth or adoption. One family friendly feature of the SECURE Act is to allow penalty-free withdrawals for the birth of a child or an adoption. Each parent can withdraw up to $5,000 within one year of the birth or adoption. The withdrawal is penalty free (no 10% penalty) but will still be subject to income tax. Even better, the withdrawal can be repaid later and will be treated as if it were a rollover.
These changes are all net positives for IRA account owners. However, other changes made by the SECURE Act are unfavorable for the beneficiaries of these accounts. Most notably, the "stretch IRA" is gone.
-No more "stretch IRAs." Before the SECURE Act, the beneficiary of an IRA was often able to take the required annual withdrawals over his or her life expectancy. IRA beneficiaries, other than a surviving spouse who does a rollover, were required to take distributions starting the year after the death of the account owner. However, by "stretching" those distributions over their life expectancy, they could minimize their tax liability and maximize the tax deferred growth of the inherited account for decades in some cases. That option is now foreclosed. Under the SECURE Act, distributions from an inherited IRA will come out faster, will be taxed sooner and, often, will be at a higher rate.
Under the SECURE Act, a designated beneficiary can no longer defer payouts over a life expectancy and must, instead, withdraw the entire account by no later than 10 years after the original IRA owner died. The difference can be dramatic. For example, assuming a $1 million IRA, the difference between distributions over a life-time versus distributions over 10 years could represent several hundred thousand dollars of lost value to the beneficiary who is forced to withdraw over the shorter period. Specific outcomes depend on several variables such as age, rate of growth, and taxes, but the shorter distribution period is an undeniable loss of value to the beneficiary. Forcing distributions out over a shorter period will, in many cases, force more income to be taxed at higher rates. Beneficiaries of IRAs will get less than before.
Inherited IRAs are not "retirement" accounts. Another clear message for investors is that inherited IRAs are not "retirement" accounts and will not get the preferred treatment the law sometimes provides for retirement accounts. The U.S. Supreme Court had already established that inherited IRAs do not get the same protection from creditors as do employer sponsored retirement plan or traditional IRAs. With this new law, Congress is telling us that while it wants to encourage retirement savings, inherited IRAs are not part of this plan. In fact, Congress intends to drain inherited IRAs more rapidly than before. The SECURE Act has made IRAs much less valuable for most beneficiaries, other than a surviving spouse.
Here are a few things to consider that may soften the blow of the new law or at least avoid its most pernicious effects.
1) Do you have a "designated beneficiary?" The term "designated beneficiary" has a very specific meaning under the tax code. Just because you list a beneficiary on a form doesn't mean that you have a "designated beneficiary." The failure to have a proper designated beneficiary means that the account will have to be drained even faster over 5 years and that will likely mean even higher taxes. Check with your advisor and attorney to confirm that you have met the particular requirements of a "designated beneficiary."
2) Paying IRA assets to a trust can be problematic. Any estate plan that includes paying retirement assets to a trust should be reviewed to see whether the plan still works as intended or whether the projected tax burden is too much. In cases involving a minor or disabled child, a properly designed trust can still use the child's life expectancy (at least for a while) to minimize withdrawals and the tax burden. In other cases, the tax burden of paying an inherited IRA distribution through a trust may be so onerous that the plan is impractical. Seek advice of counsel.
3) Other possible solutions. Other solutions you can expect to hear about include conversions to Roth IRAs, charitable trusts, and life insurance. The merits of these are beyond the scope of this brief discussion. In the right situation, one or more may be a viable solution to mitigate the accelerated tax burden on inherited IRA funds. But vet them carefully, especially any recommendation involving the purchase of life insurance, because an option poorly chosen can be a costly mistake.
Congress has decided that inherited retirement accounts are not part of its plan for enhancing the retirement security of its constituents. If you disagree if you would like for your retirement assets to contribute to the retirement security of your loved ones then it will be up to you to plan accordingly. Congress has other priorities.
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David Peartree JD, CFP is a registered investment advisor offering fee-only investment and financial planning advice. The information in this article is provided for educational purposes and does not constitute legal or investment advice.
Published: Fri, Mar 06, 2020
