The Rules Just Changed for Your Retirement
By Yvonne Marsh, CFP®, CPA
The SECURE Act was signed into law in late December 2019 with little public fanfare. But it’s sending shock waves through the retirement planning world. If you have a retirement account or will inherit a retirement account, it’s important to understand what just happened. The Act was designed to improve the ability of Americans to save for their retirement, which overall it did. But true to form, they slipped in a taxation change that is projected to raise over $15 billion in new tax revenue over the next decade, according to the Congressional Research Service. And we know whose pocket that is coming out of – yours and mine. Tax planning is truly imperative now.
On the good side, the SECURE Act raises the Required Minimum Distribution (RMD) age to 72 from 70 ½. This RMD age is when the IRS steps in and dictates an amount you must withdraw from your pre-tax retirement accounts and pay the associated income tax. Having more flexibility to wait until 72 is a plus for taxpayers. This change only applies to people who turn 70 ½ in 2020 and beyond – if you were born in July 1949 or later. For everyone else, the old rules still apply. The Act also removes the age 70 ½ restriction for contributing to an IRA. If you’re still working, you can keep contributing.
Also on the good side, to combat retirees’ fears of running out of money, the SECURE Act has made it easier for employers to add a lifetime income annuity as an investment option in retirement plans. This is an especially important change for those employees without access to a corporate pension, now giving them the option of saving into their own annuity that will provide lifetime income in retirement.
While the SECURE Act has many positive provisions beyond the two already mentioned, there is also a huge tax blow lurking for people who inherit IRA’s and Roth IRA’s beginning in 2020. Under the old rules, non-spouse beneficiaries could generally stretch their taxable inheritance distributions out over their lifetimes – thus leaving the bulk of the inherited IRA asset safely tax-deferred and generally growing at a rate that exceeded the required distribution. In theory, these inherited assets, especially Roth IRA’s could pass from generation to generation in a tax-sheltered way. But not anymore.
The new rules dictate that non-spouse beneficiaries must empty these accounts by the end of the 10th year following the year of inheritance, and it applies equally to traditional IRA’s and Roth IRA’s. For traditional IRA’s that “emptying” process is all taxable income. Your heirs have to report that income on top of their regular income, and at a time that they’ll probably be in their highest earning years. To think that a third of your IRA could be lost to taxes is a very real possibility.
What are we to do? Take action now while taxes are on sale! Our current lower tax rates are legislated to expire in December 2025, so you have 6 years left to do systematic Roth conversions and slowly convert your taxable IRA to a tax-free Roth. Think of it as you’re paying tax on the “seed” knowing that your heirs will reap a tax-free Roth “harvest” when they inherit it 20 or 30 years from now. Someone has to pay the tax; either you, now, on a smaller amount or your heirs, later, on a larger amount – there’s no escaping it.
There is no perfect solution, though. The SECURE Act has dampened the planning value of that Roth IRA “harvest” because even though it is importantly tax-free to your heirs, they still have to empty the Roth IRA within 10 years and invest it somewhere else. They can’t put much of it into their own Roth IRA because the contribution limits are extremely low and income limits apply as well. They’ll have to invest it into a taxable investment account, (thus having to report the associated income every tax year), or look to cash value life insurance to create their own version of a tax-deferred Roth IRA.
Needless to say, the SECURE Act has created tax planning needs at both ends of the inheritance spectrum. Proactively, for IRA account owners to minimize the taxation at their passing. And reactively, for heirs, to know how best to minimize the tax in that 10-year window and smartly invest their inheritance going forward.