At the end of last year, Congress passed a bipartisan spending bill. Included in this bill is the Setting Every Community Up for Retirement Enhancement Act, also known as the SECURE Act. The provisions of the SECURE Act are effective 1/1/2020 and will have real-world implications for your retirement and legacy planning. In this article, we will provide an overview of the SECURE Act, review its positive and negative attributes, outline their implications, and discuss ways to manage the repercussions of the Act.
Beneficial Changes in the SECURE Act
Let’s start with the positive aspects of the SECURE Act. The most beneficial impact is the change to Required Minimum Distributions (RMDs). Before 2020, RMDs began at age 70 ½, but in 2020 the new beginning age is 72 for both IRAs and 401(k) accounts. This change will provide additional flexibility in retirement income planning by delaying the required minimum distribution. The Act also removes the age limit for traditional IRA contributions. This means that if you work and meet the income requirements, you will be able to contribute to a traditional IRA.
The SECURE Act will allow more 401(k) participants to convert some or all their account balance to annuities, allowing for a pension-like payout at retirement. Only about 9% of 401(k) plans currently offer annuities. This low number is a result of plan sponsors’ fiduciary concerns. However, the Act provides for a “safe harbor” provision for plan sponsors that will likely allow sponsors to add more annuity options in the future. This change should be a good thing because of increased flexibility, but it will depend on the type of annuities offered and their cost structure. To be clear, the addition of annuities will be plan-specific, and you may not see this change in your 401(k).
Other positive aspects of the bill include the ability to withdraw up to $5,000 from a retirement account to cover certain expenses related to a newborn or an adoption. These withdrawals will be taxed but will avoid the 10% early withdrawal penalty. Finally, a 529 plan is now able to pay off student loan debt up to a maximum of $10,000 in total (this is not an annual cap).
Elimination of the Stretch IRA
The above are all great things about the SECURE Act. Still, there is a significant potential downside to the SECURE Act, and that is the elimination of the so-called “stretch IRA” for non-spouse beneficiaries.
A stretch IRA allows a non-spouse beneficiary, most likely children of the deceased, to inherit an IRA and distribute the IRA based on the child’s life expectancy. The nice thing about the stretch IRA is the child of the deceased can smooth out or “stretch” their distributions based on the child’s life expectancy, and this allows for tax-efficient withdrawals. The SECURE Act, however, changes this and instead will force the payout of the IRA over ten years. This “ten-year rule” will mean that the distributions could very well be taxed at higher rates. In fact, the Treasury expects about $16 billion in revenue because of this change.
There are exceptions to this 10-year rule. If you are disabled or chronically ill, you can continue to take out distributions under the old “stretch” rule paradigm. Also, if you are under the age of majority, usually 21 for most states, you can take the distributions based on your life expectancy. However, once you are no longer a minor, then the 10-year rule kicks in. Finally, the surviving spouse is not subject to the 10-year rule and can stretch out the distributions based on their life expectancy.
Example of the Impact
To explain the full impact of eliminating stretch IRAs, below is an example to illustrate the changes.
Mary is single and dies at age 75. Her son, Bob, is the primary beneficiary of her IRA account worth $1,000,000. Bob is 45-years old and has a taxable income of $138,850 per year from other sources.
Under the old law, Bob would inherit the IRA and would be required to take out distributions based on his life expectancy, which would be $24,450 in year one. In this case, 100% of that IRA distribution would be taxed in the 24% tax bracket. However, under the SECURE Act, Bob is forced to take about $128K per year from his inherited IRA to make sure the account is depleted in 10 years. This is an increase of $103,727 per year. This change will push Bob up into a higher tax bracket over the ten-year period. In this case, some of that nearly $104K of IRA income would be taxed at 24%, some at 32% and some at 35%, with an average tax rate of 31.87%. The result of this change is that Bob will lose out on about $141K on an after-tax basis in 10 years.
To be clear, Bob is not required to take yearly distributions, so he could elect to take all the money out at once. However, if he did a 100% distribution in a single year, it would likely be at dramatically higher tax rates.
Here is the example illustrated:
|Taxable Income Before IRA Distributions||$138,850|
|Tax Rate with 10 Year Distribution||31.87%|
|Tax Rate with Stretch||24.00%|
|Tax Filing Status||Single|
Stretch IRA versus the 10-year Rule:
|Distribution Plan||1st Year Distribution||Remaining Value After 10 Years in IRA||Remaining Value in Reinvestment Account Year 10 (1)||Total After Tax Balance|
|Secure Act-10 Year Distribution (amortized over 10 years)||$128,177||$0||$1,220,105||$1,220,105|
|Stretch IRA-RMD based on Life Expectancy||$24,450||$1,352,988||$332,774||$1,361,044|
Strategies to Address the Elimination of the Stretch IRA
So, how does one manage the elimination of the stretch IRA? Before getting into the strategies, remember the following:
- The IRA was intended as a retirement vehicle in the first place, and not a legacy planning strategy.
- The IRA is an excellent savings vehicle for retirement, but it does have some legacy planning drawbacks compared to a taxable account. Chief among these drawbacks is the IRA does not receive a step-up in tax cost basis at death as a taxable account does.
- You need to determine how important legacy planning is compared to meeting your own retirement income goals. There are trade-offs.
- The stretch IRA is NOT eliminated for a spousal beneficiary.
With the above said, there are few strategies to consider that will mitigate the elimination of the Stretch IRA:
- Spend the IRA versus other assets to maximize the step-up in your taxable accounts
- Change the tax character of the IRA through Roth conversions
- Leverage the IRA for your charitable giving
The above strategies are not mutually exclusive and can be combined into an overall strategy.
Let’s look at each of these strategies:
IRA Depletion Strategy
Perhaps, the most straightforward approach to minimize the impact of the 10-year rule is to consume the IRA versus other available assets, notably your taxable accounts. The benefit is it avoids (because the IRA is spent) potentially higher tax brackets when the second generation inherits the IRA. And, your taxable account assets will receive a step-up in basis at your death. This means your children will receive the taxable assets without a tax liability. The drawback is this approach adds taxable income at your top marginal tax bracket during retirement.
A note of caution is that there is always tension between the tax benefit of the IRA depletion strategy and an optimal portfolio allocation. Because you may avoid selling your “winners” in the taxable account with this strategy, your portfolio may become out of balance. You must monitor your overall portfolio diversification when pursuing this strategy.
The IRA depletion strategy is not new, but with the SECURE Act, it becomes more attractive. You will need to run both an estate and income tax projection and know your children’s tax situation to determine the best course of action.
Roth Conversions and the Stretch IRA
A Roth conversion allows for the transfer of assets from a traditional IRA or a 401(k) account to a Roth IRA. Ordinary income tax is owed on the amount of the conversion, but the converted assets will be tax-exempt, for both you and your heirs. This strategy works well when your tax rates are higher in the future. Because of the ten-year rule, it is more likely now that your children’s tax rates will be higher in the future. This change makes a Roth conversion potentially more attractive now than before the SECURE Act, but you’ll need to run the analysis.
There are two general ways to embark on a Roth conversion strategy:
The first way is to convert funds to a Roth IRA in a series of “tactical” Roth conversions over several years. Each year an amount is converted that allows you to stay within a certain marginal tax bracket. This strategy requires yearly tax projections to make sure you do not push your income into a higher tax bracket.
If your estate is subject to federal estate tax and you and your children will always be in the higher income tax brackets, then you may want to consider a strategic Roth conversion. In contrast to a tactical conversion, a strategic Roth conversion converts a large amount, even at higher tax brackets. In a case like this, the tax payment itself will lower the estate value subject to estate tax. In a sense, you could consider this tax payment a gift to your children, not subject to gift tax.
Charitable Planning and 10-Year Payout Period
Another way to manage the disadvantages of the SECURE Act’s 10-year rule is to use your IRA more aggressively to meet your charitable planning goals.
The first charitable strategy to consider is the Qualified Charitable Distribution or QCD. In this approach, individuals who are over 70 ½ can distribute to a charity up to $100,000 without tax impact. This means that the $100,000 avoids ordinary income tax, and by doing this, you reduce the value of the IRA that may be subject to the 10-year rule when the IRA is inherited. You are also able to satisfy your Required Minimum Distributions (RMDs) up to $100,000 by using this strategy when you turn 72.
The second strategy is to name a charity as your beneficiary. At your death, the charitable contribution can be used to offset estate taxes, assuming your estate is above the $11,580,000 per individual estate and gift tax exemption. A more complicated strategy is to name a Charitable Remainder Trust (CRT) as the beneficiary. The CRT will be able to pay out an income stream (about 5% of principal) to your beneficiary. The beneficiary is taxed on the distribution, but the trust can smooth out or “stretch” these payments for a more extended period than ten years. This may make sense when a reliable stream of income is needed for a beneficiary as opposed to providing too much money to manage in 10 year period.
Key Takeaways and Action Items
There is a lot to think about with the SECURE Act. Here are the key takeaways for now:
- Become familiar with the critical aspects of the Act, especially the stretch IRA provisions.
- Review your current beneficiary designations on your IRA. If you named a trust as your IRA beneficiary, it is also essential to review the terms of the trust. You may have a “Conduit” trust, where the IRA RMDs are distributed to the beneficiaries based on the life expectancy of the oldest beneficiary.
- Finally, to determine the best approach to manage the ten-year rule, you must crunch the numbers to compare what will happen under various scenarios.
Our recommendation is that the ten-year rule analysis should be completed in the first half of 2020. Think of this as one of your New Year’s resolutions! For McLean Asset Management, it is undoubtedly a top resolution for 2020!
In summary, the SECURE Act is a pretty big deal because it significantly changes the retirement and legacy planning landscape. Please feel free to reach out to our team with any questions you may have.
As a follow-up to this article, we plan to conduct a webinar on January 23, 2020 at 1 PM, to address any questions you may have about the SECURE Act. Click here to register for your spot!!
(1) The reinvestment account is the account where distributions are invested and we assume a 6% return.
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