In May 2019, the House of Representatives passed a bill known as the SECURE Act (Setting Every Community Up for Retirement Enhancement Act of 2019) with overwhelming bipartisan support (417-3) that looked like it would quickly be approved by the Senate and President. Other legislative matters derailed the Senate and it was late December 2019 before the SECURE Act finally reached and passed a Senate vote.
A lot has been made of the SECURE Act and its widespread changes but, to be fair, many of the Act’s new provisions will have minimal impact both in dollars and in applicability. Rather than touch on every nuanced change of the Act, the following is intended to summarize a few of the more impactful financial planning ramifications.
1) Increase in Beginning Age for Required Minimum Distributions (RMDs)
Under current law, individuals are required begin minimum distributions from retirement accounts starting at age 70.5 (with a few exceptions). The SECURE Act changes the beginning age from 70.5 to 72 to keep up with increased life expectancies.
Planning Implications: This is a valuable change by delaying required IRA distributions and the resulting taxes (and/or higher Medicare premiums) by 1-2 years for everyone under age 70.5 as of 12/31/19.
It is important to note that the bill does not impact the qualified charitable distribution (QCD) age which will remain 70.5 (and unlike the RMD, not the calendar year in which you turn 70.5 but the day on which you turn 70.5). This means that individuals who reach age 70.5, even though they will not be subject to required minimum distributions, can still make gifts from Traditional IRA accounts directly to charities without the distributions being treated as income for tax purposes.
2) Expansion of Qualified Section 529 Plan Uses
The final version of the SECURE Act expanded qualified Section 529 education savings account usage to include apprenticeships and student loan repayment – up to a $10,000 lifetime limit.
Planning Implications (Student Loan Repayment): Individuals occasionally ask whether 529 Plan assets can be used to pay off student loans. Up to now the answer was yes, but not without incurring a 10% penalty and taxes on any growth attributable to the 529 Plan distribution. The SECURE Act permits distributions of up to $10,000 from a 529 Plan with no taxes or penalties for student loan principal and interest payments.
It’s worth noting that:
- The $10,000 limit is a lifetime limit per 529 Plan beneficiary, not an annual limit;
- Any student loan interest payments made with funds distributed from a 529 Plan will not qualify for the student loan interest deduction;
- The law also allows 529 Plan assets to also be used to repay student loans for the beneficiary’s siblings, but still subject to the $10,000 lifetime limit per sibling.
The student loan repayment provision is an interesting one but likely to have limited applicability since it’s generally not the case that someone has savings in a 529 account and student loans (It is highly recommended that individuals use 529 balances before amassing student loans and/or pay off existing student loans in their entirety before investing in a 529 Plan for their children. The possible exceptions are individuals with highly subsidized loans where the interest rate is <3% or individuals who expect to qualify for loan forgiveness).
One noteworthy usage of this new provision might be the case where a grandparent funded multiple 529 accounts – one for each grandchild. Imagine the scenario of grandparents who funded separate 529 accounts for their two grandchildren – Sally and Timmy. Sally graduated college without using all of her balance. Timmy spent through his 529 balance in the first two years of college and had to assume loans to cover the remainder. The grandparents could elect to use the balance in Sally’s account to help Timmy pay down $10,000 of loans.
Another noteworthy opportunity is for individuals burdened with student loans who live in 529 tax deduction states such as Georgia and South Carolina. Individuals in such states ought to consider establishing a 529 plan in their home state and running their next $10,000 of student loan repayments through the account. The caveats to this advice are: 1) it loses its appeal for individuals who qualify for the federal student loan interest deduction; and 2) individuals in 529 tax deduction states where the state has elected not to go along with federal code (by continuing to treat 529 distributions used for student loan repayment as non-qualified distributions) will do more harm than good by using this strategy.
3) Modifications to Required Minimum Distribution Rules
Whereas the other items described above provide expanded benefits, this is the revenue provision that will help pay for all the benefits in the bill. Non-spousal beneficiaries of inherited IRA accounts, 401k accounts, or other retirement plan accounts are and were required to take minimum annual distributions from these inherited accounts. This is not changing. However, the required distribution amount for accounts inherited before January 1, 2020 are based on the beneficiary’s age such that distributions can be “stretched” over decades, especially for relatively young beneficiaries. This stretch benefit can be worth millions of dollars if employed effectively.
The new law requires that beneficiaries are generally required to fully distribute the retirement account by the end of the tenth calendar year following the year of the account owner’s death. There are exceptions for surviving spouses, disabled individuals, children of the account owner who have not yet reached the age of majority, or beneficiaries who are within 10 years of age of the account owner.
This 10-year provision severely hampers the “stretch IRA” – a financial planning strategy to maximize the tax efficiency of inherited IRA and other inherited retirement accounts.
It is worth noting here that this change does not impact existing inherited retirement plan accounts or inherited accounts for anyone who died before January 1, 2020. No need to panic if you are already the beneficiary of an inherited IRA as nothing changes during your lifetime.
Planning Implications:
- Naming young grandchildren as retirement account beneficiaries, which was highly effective under the old rules, loses much of the benefit.
- For anyone who desires to leave assets of any size to a charity at death, using a tax-deferred IRA or retirement account as the source of funding makes far more sense now.
- Conduit look-through trusts that used to be an excellent option as a retirement account beneficiary need to be revisited. With the wrong language, these trusts that are typically created after death by a will, can be a disaster if named as a retirement account beneficiary.
- Qualified Charitable Distributions (QCDs) become even more valuable. Notably, this strategy is only applicable for individuals over age 70.5 and that age doesn’t change. Any dollars remaining in an IRA at death become less valuable because of the new accelerated distribution rules. That inherently makes it more beneficial to get those dollars out of the IRA during life by way of the QCD if you were already planning to make charitable contributions. With a few exceptions, almost everyone over age 72 who does charitable giving would benefit from using qualified charitable distributions to complete their giving – even if it’s only a few hundred dollars.
- For anyone who desires to leave assets to siblings (within 10-years of age), naming the sibling as beneficiary of an IRA or retirement account now tends to make more sense as opposed to leaving assets to the sibling through a will.
- Naming an accumulation trust or special needs trust as retirement account beneficiary should become more common since the currently unfavorable tax treatment is now less unfavorable (relative to naming a person or persons directly as beneficiaries).
- One “stretch IRA light” solution to consider – but only for charitably inclined individuals – will be to name a charitable remainder trust (CRT) as Traditional IRA beneficiary. Naming a CRT as beneficiary preserves the tax deferred treatment of the IRA and sets up regular (monthly, quarterly, or annual) annuity payments to the intended living beneficiary or beneficiaries which often is a desire of parents or grandparents. After a fixed period (up to 20 years) or the annuity beneficiary’s lifetime, any assets remaining in the trust would be passed to a charity of the deceased’s choosing. For example, a parent might name a CRT as IRA beneficiary of a $1 million IRA with his/her child receiving $56,000/year over 20 years. All taxes from the IRA would be deferred and the child would receive a total of $1,120,000 over the 20 years. Assuming 6.0% growth of the trust assets over the 20 years, the intended charity also receives $1,147,142 at the end of the trust’s term.
- Late-in-life Roth conversions still have utility but start to make less sense since the benefit of tax free growth has a more limited window of 10-years rather than the beneficiary’s lifetime.
- Roth account beneficiaries subject to the new 10-year payout requirement are best served (from a tax perspective) to avoid taking any distributions until the 10th calendar year following the owner’s death.
- Traditional IRA and retirement account beneficiaries need to be thoughtful and careful in taking distributions over the 10-year period. Waiting to take distributions until the end of the period could have negative tax ramifications for some and beneficial tax ramifications for others but it will be highly dependent on the unique circumstances. Given the increased flexibility of distributions under the new law, wise distribution planning is likely to add significant post-tax value, when done well.
Have comments on these changes, questions about these planning strategies, or additional tax/financial planning suggestions? Please do not hesitate to share in the comments section below.