Most of us have had the experience of trying to fix a problem, and discovering that the solution creates its own new set of problems. That’s not a bad summary of what has happened with the federal SECURE Act, which passed at the end of 2019. Its primary purpose was to make it easier for small companies to offer retirement plans to their employees. But one of its consequences has been to create fresh headaches for the beneficiaries of certain retirement plans.
SECURE stands for “Setting Every Community Up for Retirement Enhancement.” The title isn’t the only thing awkward about this legislation. It offers welcome flexibility to people saving for retirement, by easing some of the rules about contributions and required minimum distributions after certain ages. But it also imposes new costs on those people’s heirs.
It does that by abolishing so-called “stretch” provisions that govern how inherited IRA or 401(k) assets are distributed, and how they are taxed. This affects mainly children, grandchildren, and other relatives – heirs other than spouses – who are beneficiaries of a retirement account. The crux of this is the “Required Minimum Distribution.” It used to be that people who inherit these retirement funds could spread out their required distributions over their own expected lifespan.
No more. Effective this year, those beneficiaries will have to take the entire inheritance as income within ten years. Other than spouses, the only exceptions to this are minor children (and their exemption lasts only until they come of age), people with disabilities or chronic illnesses, and those close in age to the retirement plan’s original owner. So, for example, a surviving sister seven years younger than her deceased brother would not be subject to this rule, because there was less than ten years difference in their ages. But an adult nephew 25 years younger would have to take all the proceeds within ten years.
This obviously can make a difference in those beneficiaries’ tax burden. Compressing the payout into just ten years, instead of a lifetime, can add substantially to taxable income in each of those ten years.
The good news about the SECURE Act is for those who set up Individual Retirement Accounts for themselves, and to some extent those covered by employer 401(k) plans. Those advantages are twofold.
It used to be that you couldn’t contribute to your IRA any longer once you were 70 and a half years old. Now, depending on a complex set of qualifying conditions, those older savers can potentially save up to $7,000 a year, or $14,000 for a couple. Those contributions may or may not be deductible, depending on the details. This is valuable for the many people who are continuing to work, at least part-time, into their retirement years.
The other advantage concerns those Required Minimum Distributions, which used to begin at age 70 1/2. Now – for anyone who hadn’t reached that milestone by the end of 2019 – it will not be necessary to start drawing from your IRA or 401(k) until your 72nd birthday.
So if you own one of these accounts, you may be able to take advantage of this new flexibility in how long you put your money in, and when you start to take it out. But you should also review your beneficiary designations. If you don’t, your heirs might end up with tax burdens you didn’t intend to impose on them.
For instance, you might have named your children as beneficiaries to ensure that they would have a lifetime income from whatever is left in your retirement account after your death. But the law now forces that income to be compressed into just ten years. Another strategy, such as creating a charitable remainder trust and/or buying life insurance policies, may now be a better alternative.
Especially important to consider: If you already have a trust designated as your retirement fund’s beneficiary, the new law may create some very unwelcome consequences for your heirs. A trust that was designed under the old rules may say an heir can collect only the required minimum distribution each year. But the new law creates a “gotcha” for those situations, because there is no RMD until after ten years. And then, the RMD equals “everything.” That Catch-22 could mean the trust’s beneficiary couldn’t get any money until a decade after your death – and then be forced to take a big, and substantially taxed, lump sum.
For some, these new rules may make it worthwhile to shift assets from a conventional IRA into a Roth IRA. The reason: while people who inherit Roth IRAs are subject to RMD requirements, their assets aren’t taxable – having been created to begin with from post-tax money. A Roth IRA conversion might help a retiree build more wealth and pay fewer taxes. It can especially help heirs work around the new ten-year RMD rule.
This is not the place to address all the possible complexities. Suffice it to say these changes mean it’s timely to review your estate plan, and especially any trusts, to be sure they can still accomplish what you want under the new law.
Keeping up with the complexities of retirement plans, tax law and trusts is not easy. But it’s a vital part of the job for professional financial advisers. The estate-planning experts at Old North State are savvy about how to make these requirements work to your benefit and can help ensure that you don’t inadvertently leave a problem for your heirs.