The SECURE Act was signed into law on December 20, 2019 to be effective ten days later. It was swept into the massive budget bill enacted by Congress and signed into law by President Trump. The budget bill calls for over $1.7 trillion in spending some of which will be paid for by accelerating the distribution of your tax-deferred retirement plans.
First the good news: SECURE eliminated the age limit to contributing to an IRA. Previously anyone over 70 ½ could not contribute. However, the contribution after age 70 ½ may or may not be tax deductible. SECURE also delayed the age when a participant must begin taking required minimum distributions (“RMDs”) from the IRA. The new age is 72, up from 70 ½ previously. SECURE also allows you to set up a 401(k) or other qualified retirement plan for your business after the end of the tax year and be retroactive to the prior tax year.
Now the bad news: SECURE radically changed planning with retirement benefits. SECURE applies to any Traditional or Roth IRA, 401K, and 403(b) plan (collectively and for simplicity referred to as “IRA” in this paper) inherited after January 1, 2020.
Ten Year Payout is the Rule: For all but a few categories of beneficiaries, the “stretch IRA” or life expectancy payout from an inherited IRA is gone! The life expectancy payout is replaced by a ten year payout rule. Rather than taking RMDs over the beneficiary’s lifetime and thereby stretching the time for tax deferred growth over that lifetime, the SECURE Act requires the entire account be distributed by December 31 of the year containing the 10th anniversary of the plan participant’s date of death. No RMDs are required as long as the entire account is distributed by the 10 year payout.
Exceptions to the Rule: There are five eligible beneficiaries who are exceptions to the 10-year payout rule. These are the Eligible Designated Beneficiaries (“EDBs”):
1. Surviving spouse of the plan participant
2. Minor child of the plan participant until the child attains the age of majority – then the 10-year payout rule applies
3. Disabled beneficiary
4. Chronically ill individual
5. Individual who is less than ten years younger than the decedent
Why does any of this matter? Think of your IRA as a big piggy bank full of taxable income. As you pull money from your piggy bank, the amount you pull out is treated as ordinary income. You must pay Uncle Sam a share of that ordinary income. So, if you have a million dollars in your piggy bank, it is not really worth a million dollars. It is worth a million minus the share you must give Uncle Sam. The longer you defer pulling money out, the longer you defer paying Uncle Sam.
Pre SECURE Strategy – Before SECURE, often you would select a younger person to be beneficiary or contingent beneficiary of our IRA to allow longer tax deferred growth, e.g. children, grandchildren, great grandchildren, and so on. After SECURE these strategies must change.
New Strategy – You may want to select your spouse, or another EDB as beneficiary to allow EDB to withdraw IRA funds over EDBs life expectancy in RMDs. All other beneficiaries, must withdraw within ten years regardless of life expectancy. By leaving your IRA to your spouse or other EDB first, the tax deferral continues for the EDBs lifetime with RMDs at age 72 [except minor child as noted above]. Then at EDBs death, the successor beneficiaries have 10 years to withdraw and pay the income tax.
New Strategy – If your tax bracket is lower than the tax bracket of your expected beneficiaries, you may want to consider converting to a Roth IRA. The SECURE Act also requires Roth IRAs to be distributed to non-spousal beneficiaries within ten years of the account owner’s date of death but distributions from Roth IRAs are not considered taxable income. BUT, who wants to pay taxes now when they can be deferred until later, especially when we don’t know what the tax rates or the Roth distribution rules will be in the future. None-the-less, you may want to run the numbers to see if a conversion makes sense and does not jeopardize your own retirement plans.
New Strategy – If you have a charitable component to your estate plan, you may consider leaving your IRA to a charitable remainder trust. Doing so essentially eliminates the income tax on the IRA because the charity is the ultimate beneficiary. The lifetime payout to the human beneficiaries can replace the life expectancy payout. However, if you have no charitable intent, this approach may not provide a greater benefit to the human beneficiaries because of the substantial amount that must be left to the charity for the charitable remainder trust to qualify as tax exempt.
New Strategy – Long ago before the unified gift and estate tax credit exempted more than 99% of the population, an IRA strategy known as wealth replacement was popular. The wealth replacement strategy went like this: For people who did not need all of their RMD to consume maintaining their lifestyle, the excess RMD would be used to pay the income taxes on the distribution and the premiums for a life insurance policy on their own life or a second to die policy on the participant and the participant’s spouse. The life insurance would be purchased by a properly structured irrevocable life insurance trust (“ILIT”) that would be free of estate tax at the death of the insured. The proceeds of the life insurance would replace the value of the IRA that was taxable and left for rollover to the successor beneficiary. That wealth replacement strategy can be used again to eliminate the painful effects of the 10-year rule or in combination with the charitable remainder trust strategy described above. By using the combined strategy, the human beneficiary receives both the lifetime payout of the IRA and the value of the life insurance policy. To achieve even greater value, the life insurance can be purchased on the life of the human beneficiary of the charitable remainder trust through an ILIT and distributed to the next generation of beneficiaries.
What Now? To see if SECURE impacts your retirement planning, wealth building, or generational distribution of your estate, schedule an appointment to discuss your plan. Together we can develop an efficient strategy that meets your needs.