December 26, 2019
New legislation was recently passed which contains a laundry list of measures designed to expand and modernize the retirement plan system in America. The Setting Every Community Up for Retirement Enhancement, or SECURE act, brings a host of changes for retirees, particularly those with significant tax-deferred savings. What follows is a brief overview of the highlights of the bill and how we believe it may impact many of you going forward.
The ‘Stretch’ IRA is going away
Arguably the most significant provision of the bill is the elimination of the ‘stretch’ IRA, which previously allowed a non-spouse beneficiary to stretch required minimum distributions over their lifetime. It has been replaced with the ’10-year rule’ and it works exactly how it sounds. Non-spouse beneficiaries will have ten years to withdraw all funds from the IRA. However there are no annual distribution requirements under the 10-year rule as there are with the current stretch rules, meaning that a beneficiary can lump large distributions together in certain years, take no distributions in other years, or defer it all for a decade and withdraw everything in year ten!
Despite the flexibility of withdrawals over a ten-year period, we view this change as a net negative. The law will cut short what could be decades of additional tax-deferred compounding available under current rules. Moreover, the shorter distribution period means larger average withdrawals. This is a double whammy for heirs already in high income brackets and/or high tax states.
This presents a new planning paradigm. If your pre-tax (i.e. non-Roth and non-basis) retirement plan assets are likely to be high enough that withdrawing one tenth each year for a decade would place your heirs into a higher tax bracket than you are currently in, then Roth conversions for their benefit may be a suitable course of action.
The new rules do not apply retroactively, and there are certain limited exceptions where the current stretch rules will still apply. Notably, governmental plans such as 403(b), 457, and TSP were specifically carved out from the 2020 effective date for the new 10-year rule and will instead be impacted beginning Jan 1, 2022.
Challenges for Trust Account Beneficiaries
The new rules could unfavorably impact retirement accounts that have named a trust as the designated beneficiary. IRA trusts come in two flavors: conduit and discretionary (also called accumulation). With conduit trusts, the IRA looks directly through the trust to the end beneficiary and disburses the required minimum distribution to them each and every year. There is now only one required minimum distribution with the changes brought about by the SECURE act, and it comes in year ten. (Because technically prior to the 10th year the distribution isn’t required, just optional). It’s possible that some conduit trusts may be interpreted so that the trustee can only distribute in year ten, the year of the RMD, thereby potentially impoverishing a surviving spouse in need of the income.
Accumulation trusts may not fare any better. These trusts frequently state that all or a large part of the income created by the IRA be retained by the trust (as opposed to distributed to the beneficiary). Trust tax brackets are very compressed, with the highest 37% bracket starting at just $12,750 of income in 2019! With a shortened 10-year distribution period, and therefore higher average withdrawal rate, large amounts of wealth could be eviscerated in just a few short years due to taxes.
Perhaps most confusing of all, the law is entirely silent on how to treat trust beneficiaries that are exempted from the new ten-year rule. For example, disabled individuals are exempted and will still be eligible for a stretch IRA in 2020 and beyond. If the IRA is left to a special needs trust, as opposed to the specifically exempted beneficiary, is the trust also exempted from the 10-year rule as the beneficiary would be? We expect this ambiguity to be resolved soon through a Private Letter Ruling or perhaps a court case, but for the time being it leaves certain beneficiaries in the dark.
Required Minimum Distributions (RMDs) to begin at age 72
RMDs will now begin at age 72! Moreover, the SECURE act keeps in place the existing provision allowing individuals to take their first RMD no later than April 1st of the year following the year in which they turn 72 The change only applies to those who turn 70.5 in the year 2020 or later.
This bill does not change the life expectancy tables used to calculate RMDs. However, a separate rule change unrelated to this bill does update the tables beginning in 2021. The IRS is extending the tables to reflect the upward trend in longevity. The impact of this won’t be dramatic, but most everyone should experience a slight decrease in their required minimum distributions.
We view these changes as positive. Extra years of tax-deferred compounding can potentially extend the life of a portfolio before it is depleted, as well as allow additional time for Roth IRA conversions.
No change for Qualified Charitable Distributions (QCDs)
QCDs can still be made at age 70.5 or later despite the fact that RMDs have been pushed back to age 72. This allows individuals to reduce their RMDs by making QCDs early, thereby lowering the overall value of their accounts.
Traditional IRA contributions now allowed after age 70.5
The SECURE Act removed the previous restriction that prevented savers from contributing to an IRA after age 70.5. With that restriction gone, anyone with earned income (or a spouse with earned income) can contribute to an IRA. For the charitably inclined, the amount of QCDs that can be claimed as a tax deduction will be reduced dollar for dollar by the total amount of post-70.5 IRA contributions.
For example, say Bill contributes $5,000/yr to his IRA from age 71-73 ($15,000 in total) with income from his part time job. He fully retires at 74 and decides to donate $20,000 to charity through QCDs. He will only get credit for $20,000 QCD less the $15,000 post 70.5 contributions equals $5,000 total charitable contribution.
Annuities are going to proliferate
The rules governing employer-sponsored retirement plans are getting an update. Currently, employers can offer “lifetime income contracts” (annuities) as an option in retirement plans. This effectively allows participants to convert their workplace retirement plan, such as a 401k, into a good old-fashioned pension. Many employers shy away from this as they can be held liable if the annuity company goes belly up in the future and can’t make good on the contracts.
The new rules change this. The SECURE act will allow employers who follow certain criteria to be absolved of almost any liability resulting from a bankrupt insurance company. With practically no risk to the plan sponsor, we expect new annuity products to come to market and thrive inside of retirement plans.
This change in and of itself isn’t necessarily bad. What gives us pause is the specific clause within the SECURE act stating that there is no requirement to select the lowest cost option. Legislation rarely specifically mentions cost and annuities have long been derided for high fees. It’s too soon to tell where retirement plans are headed with this change, but we’re watching the developments with a healthy dose of skepticism.
Non-retirement related changes
- 529 plans will now allow up to $10,000 of qualified, non-taxable withdrawals to repay student loans.
- 401(k) credit cards will cease (yes, this was an actual thing and it’s not allowed anymore)
- $5,000 can now be disbursed from a qualified plan or IRA without the 10% early distribution penalty if used for a “qualified birth or adoption”.