The Setting Every Community Up for Retirement Enhancement (SECURE) Act1 will have a significant impact on a large part of the population and will cause people to rethink and replan their retirement and estate planning strategies. The main takeaway is that proper financial planning has to be done in advance, and failing to plan properly can cause people inheriting money to be met with some very large tax burdens. There are some notable changes that may have an immediate effect on some of you. We strongly urge you take some time to understand the changes that will impact your money and the money you leave behind to your beneficiaries. I've outlined some of the major changes and how they work, along with some practical techniques that we will be working on with our clients in order to plan properly and reduce the impact of this new law on their finances.
Contributing to IRAs past age 70½
The SECURE Act repeals the prohibition on contributions to a traditional IRA by an individual who is 70½.
Increased Required Minimum Distribution (RMD) ages
Currently, the age at which you are required to take distributions from your retirement accounts like IRA, TSP, 401K, etc., is when you are 70½ (with a couple exceptions, for another article). The SECURE Act changes this age to 72 for individuals who turn 70½ after 2019. If you turned 70½ in 2019 and took an RMD, you fall under the old rules and are still required to continue taking the distributions. Here's an image2 for clarity:
Ten-Year rule for Inherited IRAs or 401(k)s
If you have inherited an IRA from someone other than your spouse, you probably know that you need to take a yearly Required Minimum Distribution (RMD) to satisfy the IRS. This number, however, was likely calculated based off of your own age, and not the age of the person from whiom you inherited the IRA. The younger you were, the longer you were allowed to "stretch" this IRA before being required to deplete the account via RMDs. This is no longer the case if you inherit an IRA from someone other than your spouse in 2020 or beyond. You are now required to fully deplete the account within ten years of receiving it.
This presents major challenges for people who are on the cusp of reaching a higher tax bracket. Remember, any money distributed from an IRA, whether you were required to take it or not, causes a taxable event in the form of income tax to you. If you inherit an IRA and are subject to the new rules, you might have a significant RMD, and that distribution might be big enough to FORCE you into a higher tax bracket, effectively forcing you to pay more taxes than you would have if you had the ability to keep "stretching" the IRA over your full lifetime.
There are a few exceptions to this rule: spouses can still roll an inherited IRA into their own or leave it as inherited and take the RMDs in their own lifetime. Minor children may also commence the payout using their own life expectancy, however once the age of majority is reached (as determined by state law), the rule requires them to have fully liquidated by December 31st of the tenth year following the age of majority. If you are "disabled" within the definition provided in IRC Sec 72(m)(7) then you're allowed to use your own life expectancy too. Being "Chronically Ill" as defined by IRC Sec 7702B(c)(2) also allows someone to use their own life expectancy in the RMD calculation.
Wealth transfer opportunities and new financial planning techniques
The SECURE Act has also created some interesting financial planning opportunities for families. Effective long-term planning requires people to think about both their lifetime income needs in retirement and also what they want to leave behind to their heirs. The SECURE Act offers provisions that allow a handful of wealth planning techniques to be utilized in order to maximize your wealth transfer success and reduce your tax liabilities. One of the most notable changes going forward as mentioned earlier, is the reduction in the amount of time that a person will have to fully liquidate an inherited IRA. Inheritors will no longer have the same level of efficiency with their inheritance and will have less flexibility.
Historically, one of the wealth planning techniques for a family looking for tax efficiency and wealth building, was to limit distributions from an IRA in order to maximize the use of compound interest (which, if you remember, Albert Einstein said is the greatest force of all time), in order to keep growing the IRA tax-deferred. The acceleration of the payout time frame under the SECURE Act makes it so that different strategies will have to be utilized for IRA owners and their families to maximize how much money they can protect from taxes and keep growing their wealth. Here are some of those techniques3:
- Intra-family tax rate arbitrage
In this technique, the idea is that the IRA owner increases their withdrawals from their IRAs if the owner is in a lower tax bracket than their children, or whomever will be inheriting the IRA. Is this a common thing? Sure it is. Mom and dad might be retired and their annual income is much lower than their children, who may be at their peak earning years in their careers. This will allow the owner to lower the tax rate that the RMDs will fall under, thus reducing the total tax liability and allowing for more money to be passed on.
For example, if a father takes $100,000 as an RMD and is in the 22% tax bracket, $78,000 after taxes will be inherited by the beneficiary. If the father dies before taking that RMD, the full $100,000 will be passed on to the beneficiary. But once the beneficiary (who is still working, so thus likely in a higher tax bracket, let's say 37%) takes the $100,000 out of the account, they will only receive $63,000 after taxes. Remember, if money comes OUT of an IRA, it gets taxed at the income tax rate of whoever is receiving the money. If a parent is in a lower tax bracket, it may be more beneficial for them to pay the taxes so that the NET AFTER TAX amount inherited will be higher. Depending on how much money is inherited from an IRA, you may be able to save yourself over $100,000 in taxes.
- Using life insurance as a replacement of wealth
The idea here is that an IRA owner would utilize the after-tax dollars of their annual RMD to purchase life insurance. This can replace the wealth that is lost due to the accelerated income tax under the new ten-year payout rule or lost wealth building opportunity with the elimination of the life expectancy. Life insurance proceeds are also received as a tax-free benefit for the beneficiary of the policy, further helping offset the changes.
- Increasing income tax efficiency of IRA distributions through Qualified Charitable Distributions (QCDs)
Qualified Charitable Distributions (QCDs) have been a tried and tested technique of satisfying RMDs and protecting yourself from the additional income tax that the RMDs would create for you. In addition to the tax benefit, it allows a more tax-efficient way of being charitable while having an impact on a cause that is dear to you. These are allowed for traditional IRAs but not SIMPLE IRAs, SEP IRAs, or qualified plan owner. An individual who is currently over the age of 70½ can do a QCD of up to $100,000 a year directly to a charity.
It's important that the individual never takes possession of those funds, and that the money goes straight from the IRA to the charity. If you make the check payable to you, or have your IRA deposit the money into your bank account and THEN you write a charitable check, it does not count as a QCD and you will be responsible for income tax on the entire distributed amount. When done correctly, QCDs will satisfy your RMDs, essentially making your RMDs tax-free, all the while helping a charitable cause. I should also note that QCDs are only available to public charities, meaning that private foundations or donor advised funds are not eligible to receive QCDs. The last note on this is that the $100,000 limit is per IRA owner, so a husband and wife can both utilize this strategy, each having their own $100,000 limit, even if they file their taxes as married filing jointly.
- "Roth" Planning to create tax-free distributions for yourself and beneficiaries
When it comes to proper Roth planning for the purposes of estate and wealth transfer planning (not all Roth planning is created equally), the basic premise is that the tax rates for the owners are likely to be higher in the future than they are today, or that their current tax rate is lower than that of their beneficiaries.
One way to utilize a Roth would be to undertake small Roth Conversions each year, up to the amount of their current tax bracket. We generally partner with our clients' accountant on this, as careful planning needs to be done when doing a conversion. This will move the monies from the traditional IRA into a Roth IRA for your beneficiaries, effectively reducing the beneficiary's RMD and therefore reducing their chances of being pushed into a higher tax bracket. Under the SECURE Act, Inherited Roth IRAs are still subject to the same ten-year payout rule, just like traditional IRAs, however the distributions of gain from the inherited Roth IRA can be tax-free to the beneficiary if the Roth IRA is at least five years old. This is likely a better tax treatment than distributions from the regular IRA since those are fully taxable to the beneficiary.
Another Roth strategy is to utilize the Back-door Roth IRA conversion. This is where an owner of a traditional IRA makes an after-tax, non-deductible contribution to that IRA and then converts that Traditional IRA to a Roth IRA. This undertakes a tax-free conversion, since you made the contribution with after-tax dollars. This strategy can be used by IRA owners to create a Roth IRA for their beneficiaries so they can enjoy tax-free money upon inheritance.
There are some considerations to be aware of when implementing this strategy and it's one that requires careful planning so that you do not get yourself in trouble with the IRS. The pro-rata rule that requires that the amount of the Roth conversion be the same ratio of the pre-tax and after-tax amount that are within all of the owner's traditional IRAs. The rule assumes that for tax purposes, an IRA owner only has one pre-tax IRA, even if that's not the case. The second major consideration is that this ratio is applied to the conversion amount without regard to what has been contributed to the account being converted. This prevents people from exploiting the IRS code that allows this type of conversion.
The SECURE Act brings many changes and many opportunities for families to save properly for retirement and to transfer their wealth to their beneficiaries. There are methods of reducing the tax burden that people may face, but they involve planning early enough in advance to have enough time to make the necessary changes. There are many mechanisms that need to be taken into simultaneous consideration to ensure you stay out of hot water with the IRS. Retirement planning has gotten more complicated, and estate planning must be front of mind in order to minimize the taxes that beneficiaries of your accounts will be liable for. Make sure to ask the right questions as you plan your estate and your finances, and remember that the IRS code contains many other layers of laws that impact and build on the ones I mentioned in this article. Take some time in 2020 and be proactive for yourself and for your family – after all, it's not just your money, it's your future.
1 - www.irs.gov
2 - www.kitces.com
3 - This content does not constitute as advice and should not be taken as the sole information needed to make financial decisions. There are other unmentioned factors that need to be discussed individually. There are risks involved with investing, including possible loss of principal. Investments will fluctuate and may be worth more or less than when original purchased.