On December 20, 2019, President Donald Trump signed into law a spending bill containing the SECURE act (Setting Every Community Up for Retirement Enhancement Act). The new legislation took effect on January 1st of 2020, giving only 11 days (minus holidays and weekends) for everyone to adjust. This has left many financial institutions and financial professionals affected and scrambling to prepare.
Everyone seems to be trying to get their arms around it all and determine how to answer the questions they are getting from their customers. New details seem to emerge weekly.
Some of the bigger positive takeaways from this new legislation are considered to be the following:
- Delayed Required Minimum Distributions (RMDs), Up until this point, RMDs were required to begin in the year when an IRA owner reaches age 70 ½. This will now begin at age 72. That is unless you had already begun taking RMDs. If an IRA owner was required to have started taking required minimum distributions in 2019 or prior, they will have to continue to take distributions. For those folks who are not yet required to take distributions beginning in 2019, they will not have to take any distributions until they reach age 72.
- The age restriction on IRA contributions has been repealed. In the past, unlike workplace retirement plans and Roth IRAs, even if you had earned income you could not contribute to an IRA if you were age 70 or older. By eliminating the age restriction for contributing to an IRA, it opens the door for those still working beyond age 70 to add to their retirement savings. The new change brings contribution rules for IRAs in line with those of 401Ks and other workplace qualified plans as well as Roth IRAs.
- The SECURE Act paves the way for annuities to be offered within employer-sponsored plans like 401(k)s by creating Safe Harbor rules to protect plan sponsors (your employers) against certain potential liability for doing so. It also requires that each year plan administrators provide you, as a participant in the plan, with a lifetime income disclosure statement demonstrating how much your account balance might generate as a lifetime income stream if you were to purchase an annuity with it.
- Multiple employers with unrelated business ownerships are now permitted to band together to offer employer sponsored retirement plans. Known as Multi-Employer Plans, or MEPs. MEPs would potentially reduce the cost to both plan sponsors (employers) and participants (you, the employee) by taking advantage of economies of scale through pooling expenses across multiple small employers. In theory, this would open the door for many more Americans to have access to a workplace retirement plan who currently do not have access because their employer finds the expense of starting an operating plan too burdensome.
- There’s also a measure that allows for 529 funds to be used to pay for registered apprenticeship programs, as well as a provision permitting up to $10,000 per year to be used to pay student loan debt.
Considering these positive outcomes, the SECURE Act is looking like a net win for many Americans. However, the good government giveth and the good government taketh away.
So, what are the tradeoffs for all of the positive implications? In other words, how does a deficit-ran federal government plan to pay for all these goodies?
Say Goodbye to Stretch (or Inherited) IRAs
Prior to the SECURE Act, Stretch IRAs provided a pathway for non-spouse beneficiaries (like your children and grandchildren) who inherit pre-tax dollars (like those in your IRA or 401k) to spread out the tax burden of their inheritance over their lifetime. This could mean they could have spread the tax burden potentially over 3 or 4 decades. However, all good things must come to an end.
Under the SECURE Act, beneficiaries who receive pre-tax dollars as an inheritance will be required to distribute the tax-deferred money over a period of 10 years or less. There’s no set schedule as to how much must be distributed each year, allowing for some flexibility, but by the 10th year all of the money must be distributed resulting in subsequent taxation.
Without the option of a Stretch IRA, non-spouse beneficiaries of IRA owners will have to distribute pre-tax dollars over a much-condensed period of time. With that being the case, there is an expectation of increased tax revenue for the federal government.
Stretch IRA’s Were Never a Birthright
I published an article on June 26, 2019, titled “Pending Legislation Could Affect Inherited IRAs in a Big Way” written specifically for my financial advisor friends around the country as a warning bell of likely things to come. In that article, I gave a short history of Stretch IRAs, and I do mean “short” because it wasn’t that long ago that the Stretch IRA rules as we know them, were passed into law. We also discussed the reasons why they were likely not to last.
The fact that Inherited IRAs have been under attack by many legislators over the last decade or two led us to believe that counting on Stretch IRAs as part of a larger long-term wealth transfer strategy was likely to come back to bite us. Therefore, the TWFG team has never relied on the use of Stretch IRAs as a primary wealth transfer strategy for our clients and their legacy planning.
For years leaders within the federal government have been slipping similar language into spending bills, but most of them were partisan with little chance of passing. The SECURE Act was the first piece of legislation containing language to dismantle Stretch IRAs that was bi-partisan, and more likely to be signed into law.
So, what will the fallout of this legislation look like and how will this change to Stretch IRAs potentially impact you and your beneficiaries?
Those of you who own sizable pre-tax accounts that you are likely not going to use in their entirety throughout your lifetime would likely be the most impacted.
In addition, your beneficiaries (often your children) should really understand what this may mean to their inheritance:
- How they will receive it
- How much they are likely going to get to keep
- How much they will likely pay in taxes
- How it can negatively impact their personal income tax rate
Successful beneficiaries, who will likely be in their primary earning years when your wealth passes from you to them may find it unappealing to inherit large sums of pre-tax money to which they’ll have to fork over a sizable percentage to the state and federal government. The impact it will have on their own taxable income and the effective tax rate they pay may be shocking as well.
Meet Mr. and Mrs. Did-a-lot:
A hypothetical couple who may be affected by the SECURE Act
Imagine for a moment you have neighbors who did a lot to save and prepare for retirement. We’ll call them the Did-a-lots. Mr. and Mrs. Did-a-lot are 65 years old and transitioning into retirement. They’ve been through the Triplett-Westendorf PT 5 retirement plan screening process and now enjoy a comprehensive written plan to guide them to and through retirement. Between retirement income sources like pension and Social Security, accompanied by supplemental distributions from their pre-tax savings like 401Ks and IRAs, they will be able to maintain their standard of living.
They are currently sitting in the 12% tax bracket, with a $15,000 cushion before hitting the next highest marginal tax bracket. They have about $250,000 in an IRA asset that we’ve identified as excess. Unless they decide to increase their lifestyle substantially, this is money that they will likely never need to use throughout their lifetime, and it will be passed to the next generation. Their distributions from the other pre-tax assets used to supplement their retirement income is enough to satisfying all the required minimum distributions beginning at age 72. Therefore, this money will grow undisturbed.
Mr. and Mrs. Did-a-lot have an average life expectancy as a couple according to the Society of Actuaries (SOA) of 92. At 6% rate of return net of fees, their $250,000 IRA will grow to over $1 million by age 90. Neither may be around by then, but it’s statistically plausible that one of them could be.
The couple has two daughters. Both are college educated, married, and earning sizable household incomes. Both daughter’s households are generating an annual taxable income that would put them at the top end of what today would be the 24% tax bracket. It won’t take much to push them over into the 32% bracket.
When Mr. and Mrs. Did-a-lot have both passed, each child is set to receive 50% of the IRA assets. If either Mr. or Mrs. Did-a-lot live to age 90 or beyond, the daughters are each likely to receive a little over $500,000 in pre-tax money.
Even if the children stuff it in a bank account (don’t invest it for growth) and distribute all of their inherited pre-tax money equally over 10 years, they will be adding $50,000 per year to their existing income pushing them into what would now be the 32% federal tax bracket. All of this increases their effective federal tax rate. Their inheritance from mom and dad has actually hurt their household income tax situation.
Would you say they’re being rewarded or penalized because mom and dad were good savers, and they have had successful careers and households?
Some might argue that they’re being penalized for being successful.
A More Likely Scenario
A likely scenario is that the daughters inherit the pre-tax money, and end up delaying making any distribution decisions immediately. Maybe they invest it for a rate of return or save it in an interest-bearing account. They may not know the new inherited IRA rules, what to do, and have a trusted financial professional (who knows the rules) to guide them.
Since there is no longer a required distribution schedule to follow, for several years they take little to no distributions before realizing that time is running out, and that they have to distribute everything before the end of the 10th year. It’s possible that they could end up bunching taxable distributions over an even shorter period of time thus potentially driving up their effective tax rate even higher.
So, Why Are We Even Having This Conversation?
What’s happening today is a consequence of long-term tax deferral promulgated over decades by tax and financial professionals, as well as financial institutions selling investment products. Many folks seem to think that they’re getting a tax savings by putting money in an IRA, for instance, when the reality is, they’re just kicking the can down the road to a later date. It’s not a tax savings, it’s a tax deferral, and at some point, the money must be distributed and taxed at whatever income tax rate the recipient is subject to.
Following the theoretical advice of “save tax now by contributing to a qualified plan” has resulted in a paradigm shift in retirement savings. Where past generations may have saved in after-accounts (like CDs or brokerage accounts) with little saved in pre-tax accounts (IRAs and 401Ks), today’s near retirees are the first generation to have the overwhelming majority of their wealth saved in pre-tax accounts.
What does that mean for you?
Opportunities for Potential Planning
There are often blatantly obvious and then not-so-obvious opportunities to take advantage of anytime legislation like this occurs. To make sure you take advantage of all opportunities, knowing the rules is a good first step. Get educated on the new Secure Act rules that effect you and your family, or work with financial professionals who are. Like any other game, knowing the rules will give you and your family a better chance of succeeding in the long run.
Next, take a step back and look for ways to apply the new rules to improve your life while simultaneously avoiding the unintended consequences created by the legislative changes. One way to more easily accomplish this is by simulating your actions using computer aided design programs, like Retirement Analyzer (RA). We use RA to simulate possible corrective actions that folks could take before committing to taking any real-world actions. Determine the likely impact of a decision and whether it will likely produce the desired outcome or not builds confidence and conviction.
When you’re willing to do the work and complete a comprehensive analysis, there is a possibility you can turn the counterproductive tax impact of the SECURE Act into a positive for you, your beneficiaries, and your legacy.
How Might the Did-a-lots Take Action?
What might the Did-a-lots do to take advantage of the SECURE Act legislation? We previously discussed the potential outcome if they take no action, and the likely impact to their daughter’s household tax situation. If they ask themselves, “How much of our IRA do we really want to go to pay federal income tax,” they may decide as little as possible! In that event what actions could they consider?
Perhaps they could begin taking strategic distributions from their IRA prior to the age at which the federal government requires that them to do so. Having a plan to strategically distribute pre-tax dollars, and minimize their taxable footprint by creating a tax equilibrium throughout their retirement years, might be a start.
Imagine for a moment that Mr. and Mrs. Did-a-lot make pre-tax distributions while controlling their next highest marginal tax bracket. Withdrawing just enough money to be used to pay the taxes due, yet have enough left over to fund a federal income tax free wealth transfer strategy using life insurance, and simultaneously create a pool of assets to be used by Mr. or Mrs. Did-a-lot if either of them experiences a long-term care event.
There are many tools available to you in the insurance industry today that did not exist a decade ago. You may be able to leverage them to offset the impact of the SECURE Act on your beneficiaries who are likely to inherit large sums of pre-tax money during their prime earning years.
How It Might Work for The Did-a-lots
Recalling from earlier, the Did-a-lots are currently in the 12% bracket, and they have a $15,000 cushion before they hit the next highest marginal tax bracket. It is likely they could make distributions each year, pay federal and state taxes, and still have about $12,000 annually to fund a strategy that will pass tax-free dollars while simultaneously creating a pool of assets that could be used for expenses associated with a long-term care event should either of them become chronically ill.
While they are alive Mr. and Mrs. Did-a-lot could potentially use the insurance death benefit to cover costs associated with a Long-Term Care event should either of them become chronically ill. When the last spouse passes, the federal income tax free death benefit is immediately available to be split between their daughters. The two daughters who are likely in a higher tax bracket during their prime earning years won’t be negatively impact because they won’t be saddled with the burden of making forced and unwanted taxable distributions from an inherited IRA account.
Change Can Be Scary, and Rewarding
Although change can be scary, it can also open our eyes to ways we can better align our financial resources with our long-term objectives. Often times when Washington acts for the good of the American people it creates disruption. However, opportunistic strategies seem to emerge that could actually be more beneficial. By understanding and applying the new rules for the benefit of you and your beneficiaries it’s possible to make incremental improvements in your plan.
If you’d like to learn more about:
- The SECURE Act
- Its potential impact on your wealth
- How it might affect your family’s legacy, or
- The Hypothetical strategy implemented by the fictional Did-a-lots
……contact our team to schedule time for a review.