By: David Munn, CFP
In December 2019, Congress passed and the President subsequently signed into law the SECURE Act, arguably the most impactful legislation on retirement and estate planning that has happened in quite a while. While the law touched on quite a few different areas, including 401(k) and 529 plans, we believe the two most significant changes deal with Individual Retirement Accounts (IRAs).
1. Increase in starting age for Required Minimum Distributions (RMD) from 70.5 to 72
Prior to the Secure Act, individuals who reached the age of 70.5 were required to begin taking an annual minimum distribution from their Traditional IRA, an amount based on the age of the account owner as well as the account value. This is essentially the government’s way of forcing the taxation of the large amount of pre-tax money Americans have accumulated, primarily through company 401(k) plans.
For an individual turning 70.5 in 2019, the initial RMD was 3.65% of the value of the account as of December 31, 2018. This percentage then increases every year, rising to 5.35% at age 80, 6.45% at age 85, 8.77% at age 90, and so on. The subsequent impact (and intent of the RMD law) was the depletion of the retirement account, leaving less funds for a potential beneficiary to then stretch over their lifetime upon the death of the original account holder.
However, as life expectancies have continued to rise, the RMD increased the probability the retirement account would be depleted during the lifetime of the original account holder, a problem Congress was seeking to mitigate by raising the starting age to 72, though the percentages remain the same and an individual turning 72 will need to withdrawal 3.9% of the account value in their first RMD year.
This age change applies to those born on July 1, 1949 or later. Those born prior to this date still fall under the previous law and should have already commenced their RMDs.
Despite the change to RMD rules, individuals who are age 70.5 or older are still eligible to take advantage of Qualified Charitable Distributions (QCDs) up to $100,000/year, where funds are gifted directly from an IRA to a charitable organization, without incurring any taxable income or impact on the taxation of Social Security benefits or Medicare premiums. This is by far the most tax-effective way to conduct charitable giving for those who have reached age 70.5.
2. Removal of the “stretch” IRA option
Prior to the SECURE Act, a non-spouse beneficiary inheriting an IRA or 401(k) would be required to either distribute the entire balance of the Inherited IRA within 5 years, or stretch the distributions over their lifetime by fulfilling an annual Required Minimum Distribution (RMD), much like the RMD described above for those who are 70.5 or older, but utilizing a separate distribution schedule.
With the new legislation, beneficiaries inheriting an IRA from a decedent who dies on January 1, 2020 or later must distribute the entire Inherited IRA by the end of the 10th calendar year following the original account holder’s death.
There are multiple implications from this new law, but with limited space, I will solely address the tax impact. Consider the following scenario that we expect will play out many times moving forward.
Bruce, age 50 inherits a $250,000 from his mother. Not needing any additional income while still working, he waits to take any funds from the account and allows it to grow to $500,000 over the subsequent 10 years. However, in the 10th year, he is then forced to withdraw the entire balance, and must pay approximately $200,000 in income taxes (an estimate based on current tax rates and assumptions about Bruce’s personal income).
This scenario shows the significant impact even a moderate-sized IRA could have without any planning or mitigation efforts. Bruce may have been better off to stretch the distributions out over the 10 year period, but not necessarily depending on his income over that period.
The only definitive way to effectively mitigate the tax impact is for steps to be taken prior to the death of the account holder. While the options are more limited than they were prior to the SECURE Act, there are still avenues that can be considered, including, but not limited to:
● Roth Conversions or taxable distributions (assuming the account holder is in a lower tax bracket than the beneficiary) to remove the funds from the IRA and provide more flexibility to the beneficiary.
● Qualified Charitable Distributions (QCD) - If the intent of the account holder and/or the beneficiary is to give a portion or all of the money to charity, it should be done prior to the death of the account holder, as the beneficiary does not have the option of a QCD. Additionally, one or more charities could be made the direct beneficiary of a portion of the IRA.
● Charitable Remainder Trust (CRT) - A CRT allows for distributions to occur over the course of a beneficiary’s lifetime, with the remaining funds being donated to a charity. Even if there is not an intent to donate the IRA funds, a CRT may actually increase the after-tax proceeds that are distributed to the beneficiary as it maintains the ability to stretch distributions over the beneficiary’s lifetime.
So what should you do as a result of this law? First and foremost, you should assume that you are impacted by the law and, at a minimum, a conversation with your financial advisor and attorney is in order. Those with larger IRAs/401(k)s and/or revocable trusts named as beneficiary of an IRA are likely to be the most impacted. Even beneficiaries who anticipate inheriting an IRA in the future should consider encouraging appropriate planning conversations to take place as I have yet to meet a single person who does not value reducing payments to the IRS.
Discussing these changes will be a focus of our meetings with clients as we go through 2020, but we invite you to reach out with questions in the meantime.