SECURE Act Planning Implications

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.

The Recent Death of Stretch IRAs Could Mean Your Estate Plan is a Mess

In the good ole days of “stretch IRAs” (i.e. before 2020 – more on that to come), children or grandchildren could inherit an IRA or other retirement account and stretch distributions over their respective lifetimes, thereby exploiting the tax-favored treatment of these accounts well beyond the original owner’s lifetime – often an additional half century or longer. One commonly recommended strategy for individuals with a meaningful IRA (or other retirement plan) balance was to name a “look-through” trust for their children and/or grandchildren as beneficiary of the account rather than the individuals, directly. Although this approach was not ideal for all situations, these qualifying trusts generally delivered a win-win-win scenario.

Such trusts directed that the required minimum distributions (RMD) set by the IRS for an inherited retirement account would pass through to the underlying beneficiary(ies) each year. Properly setting up the look-through trust as the beneficiary of a retirement account with the necessary language ensured that the inherited account would qualify for the most tax-favored distribution schedule (the so-called “stretch”). This resulted in deferring taxes as long as possible or, in the case of an inherited Roth account, retaining the benefit of tax free growth as long as possible. The approach helped avoid the high tax rates within the trust, created a multi-year tax-efficient legacy that was hard for the beneficiary to mess up, and added an element of creditor protection. The win-win-win result meant that the ideal estate plans often included a look-through trust unless unique circumstances warranted something different.

When the SECURE Act recently became law in December 2019, it effectively squashed the stretch strategy by requiring that most non-spouse retirement account beneficiaries distribute retirement accounts inherited after December 31, 2019 within a 10-year period (qualified with “most non-spouse beneficiaries” because there are eligible designated beneficiaries such as siblings and disabled individuals who still qualify for stretch treatment).

To be clear, this is not a favorable development and will effectively reduce the benefit of IRAs, Roth IRAs, and other retirement accounts as estate planning vehicles.

By significantly changing retirement plan distribution rules, the SECURE Act has an immediate impact on future estate planning and on existing estate plans. There is another article to write on beneficiary designation planning after the SECURE Act – the intent here is to explain the important impact it has on existing look-through trusts.

From a big-picture perspective, look-through trusts can be set up in one of two ways: as conduit trusts or as accumulation trusts. The conduit trust setup is what has been described thus far – required minimum distributions from the retirement account go into the trust and then are passed through to the beneficiary during the same tax year.

Alternatively, the accumulation trust still qualifies as a look-through trust for required distribution purposes but does not mandate that the required distributions pass through to the beneficiary. The trustee has discretion on whether to retain funds from the required distribution in the trust or distribute to the beneficiary. Leaving retirement account or IRA distributions in the trust results in higher tax rates but has clear utility if the beneficiary is a child with disabilities, spending problems, or drug dependency issues.

Importantly, there is a potential big problem with conduit look-through trusts under the SECURE Act distribution rules. Imagine someone names a conduit look-through trust as beneficiary of a $1 million IRA and then dies in 2020. Furthermore, the trust language directs that required minimum distributions from the IRA, starting in the year after death, be paid to the trust and passed through to the individual beneficiary.

Except now there is no required distribution in 2020. Or 2021. Or 2022. Or any of the first 9 years after death. Only in the 10th year is there a required distribution and all the funds in the IRA get paid in that one year, likely creating a massive tax liability and terribly tax-inefficient planning. So, the tax benefit that was intended with the look-through trust is basically non-existent and the idea of parsing out distributions over the beneficiary’s lifetime is destroyed.

The result of most accumulation look-through trusts is only slightly better. There remains the issue of no required minimum distributions until one massive lump-sum distribution in the 10th year. This results in the same unavoidable mess of a massive tax liability in year 10. There is, however, still a control benefit as the beneficiary does not necessarily receive the full $1 million plus the 10-years of growth all in one payment. Because the trustee has discretion, he/she can choose to distribute from the trust over time, as he/she deems appropriate.

Does this all mean that retirement account owners should no longer name look-through trusts as beneficiaries of these accounts? No – but It does mean that the language of any look-through trusts named as beneficiaries needs to be carefully examined. If the trust language simply mandates that the retirement account required minimum distributions be paid to the trust each year without any discretion, there is likely a big problem that needs to be immediately addressed.

Language that gives some discretion to the trustee offers a much better solution under the new law. Consider the following language:

If any trust created under my Will becomes the beneficiary of death benefits under any qualified retirement plan, my Trustee shall withdraw from the trust’s share of the plan, in each year, the required minimum distribution required under Section 401 (a)(9) of the Internal Revenue Code. My Trustee may withdraw such additional amounts from the trust’s share of the plan as my Trustee deems advisable; but, only if the dispositive terms of the trust authorize my Trustee to immediately distribute the withdrawn amount as provided below.

Note that the part in bold here gives the trustee discretion to withdraw additional funds from the retirement account beyond the required minimum distribution. Even though there may not be any required distribution in the first nine years after death, the trustee has authority to more evenly withdraw funds from the retirement account in each of those years and pass them through to the beneficiary so that the tax impact is potentially spread over 10 years at lower tax rates.

The bottom line is that the new law has a dramatic impact on IRA and retirement plan beneficiary designations. Trusts that worked perfectly well in 2019 as beneficiaries may be disastrous in 2020. And because of the dramatic change, it’s not just trusts as beneficiaries that need to be re-examined – it’s the entire big picture of how IRAs and retirement accounts now fit into the estate plan.

The World is a Risky Place

The modern world of instant-everything means a 24-hour, never-ending barrage of polarizing news headlines and alerts.  One hour, it is the China trade negotiations.  Another hour, it is impeachment hearings or presidential election jockeying.  A few hours later, you get news alerts about Ukrainian phone calls, Turkey’s military offensive in Syria, and escalating riots in Hong Kong.  You open your Twitter feed or your blog subscriptions and read about the inverted yield curve, slowing economic growth, and the Federal Reserve’s latest actions.  Hello 21st century news cycle.

Several years ago, I hosted a monthly conference call for advisors who subscribed to get a monthly update on the markets, economy, tax policy updates, etc.  After I finished summarizing the current landscape each month, one advisor (always the same one) inevitably remarked about how “there seems to be a lot of uncertainty and elevated risk right now” – or some variation of that sentiment.  Nearly every single month.  It eventually became something that we both could joke about.

The reality that I tried to politely convey each month is that there has never been a shortage of risks or reasons for caution.  Never.  Ever.  Point to any month or any day in history and, while it might seem in hindsight as if that was a period of calm, there were substantial risks at that time.  Lots of them.  We easily forget about grave risks of yesterday like the spreading contagion of Detroit’s bankruptcy or the Ebola scare or oil prices at $110/barrel or the fiscal cliff and sequestration or Russia invading Crimea or Iran’s nuclear capability advancements.  There’s an enormous list that could keep us here awhile longer. 

We forget about these risks as just a little time passes but in the here and now, they’re of momentous concern because we are overly influenced by recent events, the latest economic data, or today’s attention-grabbing political headlines.

Not only do we get bombarded daily with risks but we then dramatically overestimate the probability of them escalating into something really bad.  Our brains are molded by more than 200,000 years of adaptation to survival optimization.  That is, our ancestors evolved to instinctively reduce uncertainty by reacting to a rustle in the weeds and retreating to safety.  Even if 99 times out of 100, the rustle was merely caused by a wind gust, our ancestors survived by treating all 100 occurrences as if a saber-toothed tiger was approaching.  Great for survival.  Not good for investing.  

A real-life example occurred in the months following the tragic events of September 11th, 2001.  Americans reacted to the recency of the disaster and altered their behavior – avoiding air travel in favor of the roads.  Passenger miles in the US increased by 12-20% during the final months of 2001 although highway driving was and still is roughly 100x more deadly than flying per mile travelled.  Researchers suggest that an additional 1,595 Americans died in car accidents during the final quarter of 2001 from this change in behavior and the reliance on a much riskier means of transportation.        

So, we are overly influenced by the most recent events rather than by centuries of data, we overestimate the probability of these events having a material impact, and then we act as if we are above average in our ability to interpret and respond to the risks.  That is, we are overconfident in our abilities. 

Consider an individual investor who reads about the recent yield curve inversion, the slowdown in GDP growth, the weaker manufacturing data, and the uncertain impact of next year’s Presidential election.  He then interprets that these risks are likely to be bad for the stock market and reduces his stock exposure.  The reality is that none of this news is proprietary or just available to him.  Moreover, there is a better than 90% probability that the buyer on the other side of the trade is an institutional investor – a professional trader with far more information, experience, and analytical resources than our retail investor.  So when our naïve investor is selling stock because he interprets the data to be bad for stocks, the likely buyer is a large pension fund or hedge fund with overwhelmingly more data, resources, skill, and experience.

What can we do about our tendencies that help us survive but not invest well?  The keys are self-awareness and humility.  To be successful investors, we must recognize the tendency of our brains to make stupid investment decisions.  We must accept our predisposed risk tolerance and not try to stretch it.  We should turn off the financial pornography – all the business news channels business news channels that saturate us with the noise of today and then pretend to know what’s going to happen tomorrow.  We should be humble in our abilities and appreciate that we likely know much less than the institution on the other side of the trade.  And we should differentiate the forest from the trees such that we avoid getting lost in the irrelevant details of today’s headlines.