As 2019 drew to a close both the House and Senate passed the SECURE Act. The President signed it into law, and it is effective as of January 1. I break this new law down in more detail in my January client newsletter “The You May Not Know Report” but will give you an overview of this week’s post. (If you’d like a complimentary copy of the newsletter, just give the office a call at 1-866-921-3613.)
Here’s the overview and a quick planning idea.
The SECURE Act allows required minimum distributions to be postponed until you are 72. Prior to the passage of the SECURE Act, required minimum distributions had to start at age 70 ½.
But, if you turn age 70 ½ after December 31, 2019, you can now postpone your first distribution until age 72.
The SECURE Act also changes the rules regarding IRA contributions. Now as long as you are working, you can contribute to a traditional IRA regardless of your age. Previously, you could not contribute to a traditional IRA once you attained age 70 ½.
The SECURE Act also expands access to Multiple Employer Plans (MEP’s). A MEP is a plan that allows employers to band together and pool resources to give employees access to retirement plans. The SECURE Act incentivizes the establishment of these plans by smaller employers by offering tax credits.
The SECURE Act also allows employers to auto-enroll employees in a plan at a savings rate of 6% of pay. Workers can opt out at any time.
The SECURE Act also allows plans to add annuities as investment options in employer sponsored retirement accounts. This is a big legislative victory for insurance companies that openly lobbied heavily for the bill.
529 plans were also revised under the SECURE Act. A 529 plan is a tax advantaged plan that allows for educational savings. 529 plan assets can now be used to pay for registered apprenticeships, homeschooling, up to $10,000 of qualified student loan repayments (including for siblings) and private elementary, secondary or religious schools.
The student loan provision allows for student loans to be repaid for a 529 plan beneficiary up to $10,000. An additional $10,000 can be used from the 529 plan to pay off student debt for each of the 529 plan beneficiary’s siblings.
The SECURE Act would also allow investors to have early access to IRA funds for any ‘qualified birth or adoption’ without paying the 10% early withdrawal penalty. This change allows each parent to take a penalty-free withdrawal of up to $5,000. The withdrawal will be taxable but would not be subject to the 10% penalty.
But the SECURE Act is not all good news in my view. The new law eliminates the stretch-out IRA that has been used as a cornerstone of estate planning for many IRA and 401(k) owners.
A non-spouse beneficiary (often a child) of an IRA or 401(k) had the ability to inherit the retirement plan and spread the taxes on the inherited account over his or her lifetime prior to the passage of the SECURE Act. For example’s sake, a 50-year-old child inheriting an IRA from a parent could take minimum distributions based on his or her life expectancy, pay tax on the distribution but allow the remaining IRA balance to continue to grow on a tax-deferred basis.
According to the IRS’ life expectancy table, a 50-year-old has a life expectancy of another 34.2 years. That means that prior to the SECURE Act becoming law, that 50-year-old would have to take the inherited retirement account balance at the end of the year and divide that total by 34.2 to determine the required distribution from the inherited IRA.
The next year, the IRA beneficiary would adjust the divisor by subtracting 1 from it. In this example, the 34.2 would be adjusted to 33.2 (34.2 – 1 = 33.2). The prior year-end balance would be divided by 33.2 to get the new required distribution for the current year.
In this way, should the beneficiary elect, the inherited IRA could be maintained for their life expectancy. In this example, to age 84.
That stretch out option is no longer available under the new law. The SECURE Act mandates that inherited IRA’s, 401(k)’s and Roth IRA’s be totally distributed within 10 years of inheriting them.
The SECURE Act makes leaving an heir money in a retirement account far less desirable. And, it makes Roth conversions that much more attractive for some IRA owners, especially those who plan to pass most of their retirement savings on to a non-spouse beneficiary.
Alternatively, there is another strategy that may make sense for some IRA owners to consider. One way to potentially establish a stretch-out like outcome under the new rules would be to establish a Charitable Remainder Trust that would be the beneficiary of the IRA or 401(k) account. The income beneficiary of the Charitable Remainder Trust would be the IRA beneficiary, typically a child.
Since distributions from a Charitable Remainder Trust are calculated based on the life expectancy of the beneficiary, the equivalent of a stretch out may be able to be established. This strategy could be combined with a life insurance trust to replace the portion of the IRA going to charity.
Here is a hypothetical example to make the possible outcome clearer:
A 72-year-old female has $1,000,000 in her IRA. She plans on taking only required minimum distributions and leaving her IRA balance to her only daughter at her death. Her daughter is presently 47 years old.
Currently, her required minimum distribution will be just under $40,000 and then increases from this point on. Assuming a 5% growth rate and taking only required minimum distributions, at her death (assuming death at age 90), her IRA balance will be about $834,000. Under the new law, her daughter will have to distribute and pay taxes on the entire IRA balance within 10 years. (Note: If returns other than 5% are realized, the outcome illustrated here could be significantly different.)
What if this 72-year old client decided to establish a charitable remainder trust and name her daughter the income beneficiary?
The daughter, in this hypothetical example would be 65 years of age. Assuming the charitable remainder trust was established with a 5% payout to the daughter and the assets continued to earn 5% annually, the daughter would receive income of $41,700 annually for as long as she lived. At her passing, a charity would receive the $834,000 in the trust.
There is no tax on the IRA transfer to the charitable trust on the death of the original IRA owner and no tax on the ultimate distribution to charity. Only the distributions to the daughter of $41,700 per year would be taxable.
The original 72-year old client could opt to combine this strategy with a life insurance trust in which she purchases a life insurance policy on her life in the amount of $1,000,000. The annual premium is $25,000. She pays this using her IRA assets. This strategy will reduce the ultimate benefit to charity but increase the net benefit to her daughter.
Let’s compare potential outcomes:
Nice potential outcome isn’t it. The client takes the same income. Daughter gets a net benefit of nearly double. And a charity wins that wouldn’t have otherwise received anything. It’s important to note that the IRA balance at the client’s death is lower using the CRT because the IRA is funding life insurance premiums. If you’re likely leaving retirement account assets to children, you might want to take a look at this Salvage Your Stretch TM strategy.