.png?width=440&name=bryant_logo_lockup_edc_color%20(002).png){kind=logo}
The SECURE Act signed into law in late 2019 delivers new opportunities for employers to offer retirement plans to employees and for individuals to enhance their retirement savings. But is there a tax trap in the legislation that could ultimately undo the benefits for unwary clients and their families?
Attached to a 1,700-page appropriations bill, President Trump signed into law the Setting Every Community Up for Retirement Enhancement (SECURE) Act on December 20, 2019. The bill provides the most sweeping changes to retirement plans and retirement planning since the Pension Protection Act of 2006. While there are over 25 items in the legislation, this article will cover areas in the SECURE Act that have direct impact on retirement planning for individual clients and with which most financial planners deal regularly in advising individual clients.
Impact on “Stretch” IRA Strategy
Under previous law, a beneficiary of an IRA or defined contribution plan like a 401(k) could potentially stretch out RMDs from the plan over several generations. For example, the first beneficiary could distribute RMDs based on their own life expectancy. The first beneficiary could also name another person as their beneficiary and that person could then spread out the RMDs of any remaining balance in the IRA over their own life expectancy, and so on.
However, starting on Jan. 1, 2020, the beneficiary will only have 10 years after the year of death to distribute the entire retirement account. Exempted from the 10-year stretch provisions are surviving spouses, minor children up until the age of majority, individuals within 10 years of age of the deceased, the chronically ill and the disabled. This significant change makes it imperative for financial planners to know the rules and review accounts with the client to determine the impact of the law change on the client’s objectives.
Retirement plan beneficiary designations should be reviewed to determine if changes are merited. A current designation may now be outside of the exempted designations, thus increasing taxes to a beneficiary. Now is also a good time to consider Roth IRA conversions. We currently enjoy the lowest personal income tax rates in many years, which may make Roth IRA conversions more appealing. While Roth IRAs require RMDs for nonspouse beneficiaries, distributions will be tax-free if the qualified distribution rules are met.
Another strategy that may benefit certain clients is to split the beneficiary designations for a retirement account. Perhaps a client currently has named an adult child as the primary beneficiary. At the owner’s death, the adult child will be required to distribute the entire account balance within 10 years, instead of over their life expectancy. This condenses and increases the taxes. The overall financial plan goals will need to be reviewed and the assets to deliver the goals, but perhaps a retirement account could have a surviving spouse as beneficiary for half the account balance and the adult child as beneficiary for half. The surviving spouse is not required to distribute the entire balance within 10 years and can name the adult child as the beneficiary. The adult child would be subject to distribution within 10 years for half the account but would inherit the spouse’s remaining account at the spouse’s death and a new 10-year clock would apply.
Repeal of Maximum Age for Traditional IRA Contributions
The legislation repeals the prohibition on contributions to a traditional IRA by an individual who has attained age 70 ½. As Americans live longer, an increasing number continue employment beyond traditional retirement age.
Compensation (earned) income is still needed to make contributions. Deductions for contributions are still subject to rules regarding active participation in an employer-sponsored retirement plan and MAGI threshold limits. An MFJ couple beyond age 70 ½ may be able to benefit from fully deductible IRA contributions if at least one spouse has enough compensation under the spousal IRA rules.
Increase in Age for Required Beginning Date for Mandatory Distributions
Under previous law, participants were generally required to begin taking distributions from their retirement plan at age 70 ½. The new law increases the required minimum distribution age from 70 ½ to 72. Taxpayers who had not attained age 70 ½ by December 31, 2019, may defer commencement of RMDs until age 72. Taxpayers who attained age 70 ½ prior to December 31, 2019, must continue RMDs under the previous law.
Allowing Long-term Part-time Workers to Participate in 401(k) Plans
Under previous law, employers could generally exclude part-time employees (employees who work less than 1,000 hours per year) when providing a defined contribution plan to their employees. The SECURE Act will require employers maintaining a 401(k) plan to have a dual eligibility requirement under which an employee must complete either a one year of service requirement (with the 1,000-hour rule) or three consecutive years of service where the employee completes at least 500 hours of service each year. In the case of employees who are eligible solely by reason of the latter new rule, the employer may elect to exclude such employees from testing under the nondiscrimination and coverage rules, and from the application of the top-heavy rules.
Portability of Lifetime Income Options
The legislation increases access to lifetime income options (annuities) inside retirement accounts. It also permits qualified defined contribution plans, section 403(b) plans, or governmental section 457(b) plans to make a direct trustee-to-trustee transfer to another employer-sponsored retirement plan or IRA of lifetime income investments or distributions of a lifetime income investment in the form of a qualified plan distribution annuity, if a lifetime income investment is no longer authorized to be held as an investment option under the plan. The change will permit participants to preserve their lifetime income investments and avoid surrender charges and fees.
Certain Taxable Non-tuition Fellowship and Stipend Payments Treated as Compensation for IRA Purposes
Graduate school and post-doctoral students will now be able to treat certain taxable non-tuition fellowship and stipend payments as compensation for IRA purposes. The change will enable these students to begin saving for retirement and accumulate tax-favored retirement savings.
And, finally, not exactly directly related to retirement planning, but good news for clients to whom it applies:
Expansion of Section 529 Plans
The SECURE Act legislation expands 529 education savings accounts to cover costs associated with registered apprenticeships, homeschooling, up to $10,000 of qualified student loan repayments (including those for siblings), and private elementary, secondary, or religious schools.
Penalty-free Withdrawals from Retirement Plans for Individuals in Case of Birth or Adoption
The legislation provides for penalty-free withdrawals from retirement plans for any “qualified birth or adoption distributions,” subject to a $5,000 maximum.
