The recently passed Setting Every Community Up for Retirement Enhancement Act (SECURE Act) is the first major retirement reform in more than a decade. The Act hopes to address a shortfall in retirement savings for many Americans. According to Employee Benefit Research Institute, 41% of households are expected to run out of money in their lifetime. This bill will also affect estate and retirement planning.
To help individuals continue to save for retirement, the Act will eliminate the 70 ½ cutoff for contributing to retirement accounts. Golden-agers who are still working will be able to continue funding both their own and their spouse’s retirement accounts as long as they have enough earned income. Previously those over 70 ½ could not contribute to their IRA.
The required age to begin taking required mandatory distributions (RMDs) from IRAs is also being increased from 70 ½ to 72 beginning in 2020, which could have a significant impact on the growth potential of an account. A report by CNBC shows that “A theoretical $500,000 portfolio, earning 5% annually, would have $33,500 more at age 89 if the RMDs started at 72.”
The Act also gives some more flexibility for penalty-free withdrawals from both IRAs and 529 education funds. IRA holders now can withdraw up to $5,000 to help pay for the costs of having a baby or adopting. Withdrawals of up to $100,000 are also allowed for disaster relief in federally declared disaster zones. In these cases, the amount taken from the IRA will still be taxed as income, but the historical 10% penalty for pre-59 ½ withdrawals will be avoided. The related tax liability created can also be spread over a three-year period. The use of 529 plans has been extended to include repayment of student loans up to $10,000 and payment for apprenticeship programs.
But it is not all good news. The bill ends the Estate Planning strategy of the “stretch IRA.” In the past, when a beneficiary inherited an IRA they were, in most cases, able to use their own life expectancy to calculate distributions and stretch out RMDs. Now, the SECURE Act will require that non-spouse beneficiaries empty the contents of inherited IRAs within 10 years of the original account holder’s death. These beneficiaries can take their distributions annually or in a lump sum, whichever is better for their tax situation, just so long as they take it out within 10 years.
Inherited IRA accounts where the original account holder died prior to 2020 can continue to use the “stretch” method. There are some other exceptions but it is complicated so check with us, your lawyer or accountant.
The chart below illustrates how heavy taxation on inherited retirement accounts will impinge on parents’ plans to leave their children a long-lasting income stream. But as the Director of Policy Research at Morningstar, Aron Szapiro, stated, “These accounts were not designed to be large intergenerational tax avoidance vehicles.”
Most inherited IRA beneficiaries will now face a condensed distibution period, so managing the timing of those distributions will be important. Strategies like Roth conversions and charitable gifting could be attractive methods to reduce the future tax liability for heirs.