The Setting Every Community Up for Retirement Enhancement Act, or the SECURE Act, as it’s better known, was signed into law in late December 2019, after months of congressional squabbling and revisions. Among other things, it has resulted in some of the most significant changes to the retirement plan distributions rules in decades. Additionally, the SECURE Act created various new incentives to encourage employers to create—and employees to contribute to—employer-sponsored retirement plans. It also made some minor modifications to various income tax provisions.
This article focuses on the provisions of the SECURE Act that will impact individuals, in particular those who are approaching retirement and those who have material retirement accounts balances that must be considered in the estate planning process.
Repeal of age threshold for contributing to traditional IRAs.
Traditional Individual Retirement Accounts (IRAs) were created by the government to allow people who aren’t covered by an employer-sponsored retirement plan (such as a 401K) and those who are covered but with relatively low wages to save for retirement on a tax-deferred basis.
Additionally, all individuals wishing to save on an after-tax basis can generally make non-deductible contributions to an IRA to achieve tax-deferred growth of their investments. Historically, the caveat to being able to contribute to an IRA was that the individual must have not attained age 70 ½ and they (or their spouse) must have sufficient earned income to match the contribution amount.
WHAT CHANGES: Starting in 2020, the age 70 ½ cap has been eliminated, meaning an individual of any age can now make IRA contributions. However, the earned income requirement and the income thresholds for deductibility of contributions remain in place.
Extended required minimum distribution age.
To ensure that tax-deferred retirement accounts don’t go untaxed indefinitely, especially for wealthy taxpayers who have no financial need for the assets, the IRS put into place required minimum distribution (RMD) rules. Historically, these rules stated that account owners must begin withdrawing (and subjecting to income tax) a minimum amount out of the account each year starting at age 70 ½. Their first distribution could be delayed until April 1 of the year following the year that they turned 70 ½ if they wished, in order to achieve some income-tax efficiencies.
WHAT CHANGES: For individuals who attain age 70 ½ in 2020 and beyond, the age at which RMDs must be started has been extended to age 72. With people generally working later in life and living longer, this change will allow slightly longer tax-deferred growth of retirement savings and additional time to better manage the income tax aspects of their pre- and post-retirement income situation.
Partial elimination of stretch IRAs.
IRA and retirement account owners can designate the beneficiaries of any unused assets that remain in their accounts at the death of the owner. These designated beneficiaries can be spouses, children, other family members or individuals, and even trusts and charities. Historically, both spouse and non-spouse beneficiaries had the general freedom to take as much money out from the retirement account as they wanted or needed (albeit living with the income tax consequences of doing so). However, to maximize the tax-deferred growth of the inherited assets and to manage the tax impact of distributions, they were also permitted to take only a minimum amount of distributions over their remaining life expectancy, hence the “stretch.”
WHAT CHANGES: Retirement account beneficiaries, whose benefit comes when the original account owner’s death occurs after December 31, 2019, may now be limited in their ability to stretch distributions from their inherited accounts over their remaining life expectancy.
Many will be limited to a 10-year period at most. There are useful exceptions and aspects of the stretch elimination, however.
- Spouse beneficiaries will still be allowed to stretch distributions out over their remaining life expectancy, as will disabled and chronically ill beneficiaries and any individual beneficiary who is not more than 10 years older than the deceased account owner.
- Minor children of the deceased account owner also receive a reprieve from the stretch elimination rules. Throughout their remaining age of minority, they can take minimum distributions based on their remaining life expectancy. However, once they reach the age of majority, they are subject to the same 10-year distribution requirement.
- The 10-year distribution requirement, in general, is a bit of a change, as well. The provision does not require that the account be liquidated ratably over the 10-year period, only that the account be fully distributed by the end of the 10th year following the account owner’s death. This gives individual beneficiaries subject to these rules some discretion and planning opportunities in managing the income tax impact caused by the distributions.
The impact on estate planning decisions.
Retirement account assets can be a significant portion of an owner’s estate. When engaging in the estate planning process, people attempt to pass their remaining assets to heirs or charity in an income- and estate-tax-efficient manner, while protecting the assets from creditors, divorcing spouses, and from the spendthrift and poor investment choices of the account beneficiaries themselves. This is no different for retirement assets as it is for significant brokerage accounts.
Historically, where significant retirement account assets existed in an estate, planners often recommended the use of see-through trusts such as conduit trusts, or, less often, accumulation trusts. Generally speaking, a conduit trust would receive the retirement account assets at the death of the owner and the trustee would ensure that required minimum distributions were distributed to spouses and non-spouse beneficiaries, while preserving the corpus of the retirement account assets for instances of extraordinary need, all while keeping a keen eye on income tax consequences for both the beneficiaries and the trust itself.
Additionally, placing the IRA in trust enabled the original account owner to essentially posthumously control subsequent beneficiaries of the assets, rather than leaving control to surviving spouses and children.
WHAT CHANGES: With the elimination of the stretch provision for most non-spouse beneficiaries, conduit trusts and their trustees will now be faced with difficult, uncertain choices with respect to distributions to non-spouse beneficiaries. As a result of the Act, there are seemingly no required distributions throughout the 10-year window—only one at the end. This sparks numerous questions, including:
- Will trustees be allowed to use their discretion to make distributions over this 10-year period?
- Will this be a breach of their fiduciary obligation to current or remainder trust beneficiaries?
- What responsibility will trustees have for efficiently managing the tax impact on the trust and beneficiaries?
The answers to all of these questions are unclear and will almost certainly require clarification through Treasury Regulations and state fiduciary laws. Until then, it is recommended that estate planners reevaluate the use of conduit trusts in their clients’ estate plans and determine if reversing course is necessary.
However, the use of conduit trusts for spouse beneficiaries still appears to be permissible and an effective estate planning strategy. Directing retirement account assets through a conduit trust set up for the benefit of a spouse will still enable the account owner to put spendthrift protections on the retirement account assets and preserve their intended beneficiaries of the account after the death of the surviving spouse (rather than giving the surviving spouse the ability to change the beneficiary to a new spouse, charity, disproportionately among children, or otherwise).
Income-tax-related provisions of the SECURE Act.
While the most substantial provisions of the SECURE Act are directed toward retirees, retirement account beneficiaries, and retirement plan employer sponsors, a few notable individual income tax provisions made their way into the bill, as well.
- Expanded permissible uses of 529 plan funds. In an effort to chip away at the student loan crisis brewing in the U.S., the SECURE Act now allows up to $10,000 of 529 plan funds to be used to pay student loan principal and interest on qualified student loans for each designated beneficiary or one of their siblings. In recognition of the increasing amount of students attending trade and vocational schools, funds can now be used toward expenses incurred in registered apprenticeship programs.
- Kiddie tax changes…again. Just a few short years ago, the Tax Cuts and Jobs Act of 2017 changed the way that the unearned income (i.e., interest, dividends, capital gains, and other passive income) of dependent children was taxed. Rather than subjecting it to tax at their parents’ rate as was historically done, it began to be taxed according to trust tax rates. This increased the tax burden on many children, particularly those who received government payments for a variety of unfortunate reasons, such as the death of a parent. Retroactive to the start of the 2018 tax year, the SECURE Act unwinds the Kiddie tax based on trust tax rates and returns it to the previous regime of taxation at the parent’s tax rate.
- Additional penalty-free withdrawals from retirement accounts. Distributions from retirement accounts before the age of 59 ½ are generally subject to income tax at ordinary rates as well as a 10% early withdrawal penalty. Various exceptions to the 10% penalty, such as distributions in the case of financial hardship, have traditionally been allowed. Starting in 2020, there will also be an exception to the 10% penalty for withdrawals up to $5,000 per person for expenses related to the birth or adoption of a child, per qualified event. Keep in mind, however, that any distributions will still be included in income and subject to taxes at ordinary rates.
- Non-tuition fellowship payments and stipends treated as compensation. Starting in 2020, any non-tuition fellowship payments or stipends received by a graduate or postdoctoral student will now be treated as compensation (i.e., earned income) for purposes of determining eligibility to make contributions to IRAs. Such students will now be able to start saving for retirement earlier than they would otherwise be able to.
Post-SECURE Act strategic planning.
The SECURE Act has significantly changed the landscape for financial planning around retirement accounts, both during the lifetime of the owner and in the disposition of their estate. However, every significant change presents new planning opportunities and considerations.
- Given the elimination of the lifetime stretch and the 10-year distribution window, strategic income tax planning around when to recognize income related to retirement account assets will become even more important. Account owners and their advisors need to consider the overall impact on family wealth of distributions taken during the owner’s lifetime, along with Roth conversions, to control the efficiency of the overall taxation of the assets. The same holds true for spouse beneficiaries, who still have the ability to stretch the distributions over their remaining life expectancy.
- Beneficiaries who are not exempt from the 10-year distribution rules need to manage their recognition of income efficiently throughout the window. As stated earlier, there is no requirement that the assets be distributed ratably throughout the period, only that they are all out by the end of the term.
- When considering possible beneficiaries, account owners may need to pay more attention to their individual tax situations in an attempt to maximize and balance the after-tax value of their entire estate being passed to their heirs.
- Leveraging the excepted beneficiaries from the 10-year rule to preserve and protect assets through an accumulation or conduit trust may still be an effective estate planning strategy, and may result in long periods of tax-deferred growth.
- For account owners with charitable intentions, leaving retirement account assets to their favorite charities instead of other estate assets becomes even more attractive in a post-SECURE Act environment. For those who would still like (or perhaps need) their family members to receive some financial benefit from their retirement accounts but still have charitable intent, incorporating a charitable remainder unitrust into planning for the disposition of retirement account assets may enable family members to still have the ability to stretch distributions over their remaining life expectancy, providing longer tax-deferred growth of the assets, along with the preservation of the assets and sustainability of the distributions, as opposed to that of the 10-year implications.
Over the coming months, new planning opportunities surrounding the provisions of the SECURE Act will emerge, and we will get some clarity on how to treat nuanced situations (which, inevitably, will also lead to planning opportunities!).
Given our integration of income and estate tax planning, financial and retirement planning, and investment consulting, our team at Sanderson Wealth Management is uniquely equipped to evaluate how our clients will be impacted by the SECURE Act and to assist our clients in adjusting their financial profiles accordingly.