On December 20, 2019, new tax legislation was enacted, the Setting Every Community Up for Retirement Enhancement Act of 2019, known by its acronym “SECURE.”
This new legislation, which is part of a broad appropriations bill for fiscal year 2020, makes several changes to tax laws that could have a significant effect on retirement planning. More broadly, SECURE is aimed at providing retirement plan access for small business employees by making it easier for small business employers to offer plans and by providing enhanced, initial and annual, tax credits to certain employers starting new plans.
Increase in Age for Required Minimum Distributions
Participants in a qualified plan (e.g., a 401(k)) and owners of traditional IRAs are generally required to begin taking distributions at age 70½, though they may defer the distribution for the year in which they reach age 70½ until April 1 of the following year. There is an exception for an employee participating in a qualified plan like a 401(k) who is not a 5% owner of the company. In that case, the employee may defer withdrawals until retirement from the company.
The SECURE Act increases the required minimum distribution age from 70½ to 72. This change would be effective for required minimum distributions for individuals who attain age 70½ after December 31, 2019. For those turning age 70½ in 2019 or earlier, this new provision would not apply and they must continue to take their annual required minimum distributions under the pre-SECURE rules.
More on Provisions Affecting Retirement Planning
The End of “Stretch” Distributions from IRAs and Qualified Plans
Upon the death of an IRA owner or qualified plan participant, it is common planning to leave the retirement assets to one’s spouse. If there is no spouse, it is common planning to leave the retirement assets to one’s child(ren) or grandchild(ren). If structured properly, the retirement assets can then be distributed over the child’s or grandchild’s lifetime, often referred to as a “stretch” provision. This ability to stretch the retirement asset distributions allows undistributed amounts inside the retirement accounts to continue to grow on a tax-deferred basis until distributed. Moreover, the younger the beneficiary, the longer the life expectancy. The longer the life expectancy, the smaller the annual required distributions and the greater potential for deferring income taxes and growing the retirement account.
The SECURE Act changes this rule and severely limits the ability to stretch distributions from retirement assets in IRAs and qualified plans like 401(k)s. The new legislation generally requires non-spouse beneficiaries to take complete distribution of the benefits by the end of the tenth calendar year following the account owner’s death. This rule would apply regardless of whether the account owner died before or after his or her required beginning date.
There are exceptions to this new 10-year rule for a designated beneficiary who is (i) the spouse, (ii) a minor child, (iii) a disabled or chronically ill person, or (iv) a person not more than 10 years younger than the account owner. However, in the case of a minor child, the benefits would have to be distributed within 10 years from when the child attains majority. The age of majority is 18 in most, but not all, states. Hopefully there will be regulatory guidance from the IRS to clarify the age of majority.
This change would generally become effective for account owners dying after December 31, 2019.
Withum’s Private Client Services Group.
IRA Planning– Following are some suggestions to address the new 10-year rule that will end stretch distributions. These suggestions apply for IRA owners and are not as suitable for participants in qualified plans such as 401(k)s.
- Trust as IRA Designated Beneficiary For IRA owners, if you currently name a trust as the beneficiary of your IRA2 , this new tax provision might significantly alter your distribution plan. Depending on the terms of your trust and your intended planning, an IRA that you expected to be paid into a trust over the beneficiary’s lifetime might be fully distributed within 10 years, producing a very different result. Because of that, it would be prudent to review your IRA beneficiary designation(s) and understand the impact of the new SECURE legislation.
- Charitable Remainder Trusts (CRTs) Consider naming a CRT as a beneficiary of a retirement plan. A CRT is exempt from income tax and therefore could receive IRA benefits in a lump sum without any tax consequences. This could allow for payouts over the lifetime of a child or children who are beneficiaries of the charitable trust (or, alternatively, for a fixed period of up to 20 years). At the end of the CRT term, any remaining property passes to charity. The CRT payout would not necessarily increase over time, but could provide for a fixed percentage payout each year to the beneficiaries. Such a trust could restore a prolonged payout period, provide for a longer period of tax-free growth and defer income taxes. However, using a CRT to implement a deferred payout that can stretch well beyond 10 years comes at a cost: the charity’s interest in the CRT must be at least 10% of the value of the trust, calculated at the inception of the CRT.
- Life Insurance You may also consider withdrawing funds from your IRA, which could then be used to purchase insurance. If properly structured, the insurance could be owned by a trust and any insurance proceeds paid to it could be free from income and estate tax. The insurance proceeds would be payable to the trust and available to distribute to the beneficiary over an extended period of time.
- Roth Conversions Converting a traditional IRA to a Roth could become more popular due to a combination of two factors: (1) the 10 year payout rule will lessen the importance of deferral, and (2) the lower income tax rates enacted at the end of 2017, which are scheduled to last through 2025, offer a temporary opportunity to convert a traditional IRA to a Roth at a lower income tax cost. While a Roth conversion triggers an upfront income tax, a Roth does not have any mandatory distribution during the owner’s lifetime and distributions are tax-free. After the owner’s death, beneficiaries would be subject to the 10-year payout limit but would receive distributions tax-free. Deciding whether to convert to a Roth needs to be carefully examined.
Penalty-free Withdrawals from Retirement Plans for Individuals in Case of Birth or Adoption
With certain exceptions, there is a 10% penalty on distributions from qualified plans and IRAs before age 59½. The SECURE Act adds an additional exception under which 401(k) participants and IRA owners could withdraw up to $5,000 for expenses for each qualified birth or adoption, without penalty. (Interestingly, adopting the child of one’s spouse does not qualify for this provision.) The withdrawn amounts would still be taxable as income; this new provision only removes the penalty. In addition, amounts withdrawn could later be recontributed and treated as a rollover.
The new provision is effective for distributions made after December 31, 2019. However, in order to qualify for this exception, the distribution must be made during the 1-year period beginning on the date on which the child is born or the adoption is finalized.
Other Provisions Not Involving Retirement Planning