On December 20, 2019, the Setting Every Community Up for Retirement Enhancement (“SECURE”) Act of 2019 became law, significantly changing the rules for retirement accounts such as IRAs, 401(k)s, and 403(b)s. What does this mean for you?
If you’re not familiar with how retirement accounts work, it may be helpful to read my blog post, What Is A Retirement Account? Otherwise, read on!
First, the good news. One of the goals of the SECURE Act was to encourage saving for retirement using retirement accounts. SECURE therefore includes provisions attractive to accountholders, such as:
- Raising the age at which required minimum distributions (RMDs) must begin to age 72 (up from age 70.5). This provision applies to any accountholder younger than age 70.5 on December 31, 2019. A person may, but is not required, to take distributions earlier than age 72. Distributions made prior to the accountholder’s attaining age 59.5 incur an early withdrawal penalty. For more information about early withdrawals, see my blog post, Early Withdrawals: Usually A Bad Idea.
- Allowing contributions to a Traditional IRA (not a ROTH IRA) at any age, if the accountholder has earned income and is eligible to contribute. Previously, contributions made after the accountholder attained age 70.5 were not deductible from the accountholder’s gross income the year they were contributed. One of the hallmarks of a Traditional IRA is that contributions to the account are tax-deductible when contributed and taxable when withdrawn, so not allowing the deduction created a disincentive to contribute.
- No early withdrawal penalty imposed on withdrawals of up to $5,000 for births or adoptions. To qualify, the withdrawal must be made within the year after the child is born or, for adoptions, the year after the legal adoption of an eligible adoptee is finalized.
SECURE also liberalizes 529 plan rules by:
- Allowing distributions from 529 plans of up to $10,000 to pay student loan debt. The $10,000 limit applies to the 529 beneficiary and each of his or her siblings. So, a family with three children could use the new rules to repay $30,000 in student loan debt ($10,000 per child).
- Allowing distributions from 529 plans to pay costs of apprenticeship, i.e., fees, books, supplies, and equipment required to participate in an apprentice program registered with the Secretary of Labor.
Last but not least in my selected list of “good news,” the SECURE Act repeals a previous amendment to the “kiddie tax” that taxed income from a minor child’s self-funded SNT under the estate and trust tax brackets, rather than at the minor’s parents’ tax rates. Under the estate and tax brackets, unearned income above $12,750 (in 2019) received by a minor was taxed at a marginal rate of 37%(!). Thankfully, the SECURE Act repeals this punitive rule. For 2020 forward, unearned income subject to the “kiddie tax” is taxed as it was previously, using the child’s parents’ tax rates. This result is much more favorable for children with unearned income, including children with severe disabilities who have special needs trusts funded with money from a lawsuit.
However, the SECURE Act contains a major unfavorable change. When a retirement accountholder dies leaving a balance in his or her account, most non-spouse beneficiaries no longer will be eligible for “the stretch”, which allows RMDs on the inherited account to be made according to the life expectancy of the inheriting beneficiary. Rather, for most people, payout from the account required within 10 years. This is a dramatic change which accelerates and increases a beneficiary’s tax liability. A Forbes article by Leon LaBrecque of Sequoia Financial Group provides the following example:
For example, [under prior law,] if ‘Grandfather A’ left his IRA to his 25-year-old granddaughter, she could, based on her life expectancy, take distributions over 57.2 years. If she inherited a $1 million IRA, her first-year distribution would be $1,000,000/57.2 or about $17,482. Depending on her other income, she could pay federal taxes anywhere from about $548 (if the RMD was her only income) to about $6,468 (if she were in the highest bracket). Her inherited IRA, if it grew at a rate of 7%, would expand to about $1.75 million in ten years, and keep growing for most of her life. The new law completely changes this scenario. All nonspouse beneficiaries must take distributions within 10 years. For the granddaughter in the preceding example, that change would push her into a vastly higher tax bracket and the taxes on the distribution, depending on her other income, could be nearly $300,000-$400,000 more.
Why the change? It’s a revenue-generator. The Congressional Budget Office estimates this amendment will generate $15.7 billion in additional revenue over the next 10 years.
There are some exceptions that preserve the stretch for limited categories of beneficiaries, called “eligible designated beneficiaries.” These are:
- The account owner’s surviving spouse;
- The account owner’s minor child, during minority (once the child becomes an adult, the 10-year rule applies);
- A beneficiary who is disabled, as defined at 26 U.S.C. § 72(m)(7);
- A beneficiary who is chronically ill, as defined by 26 U.S.C. § 7702B(c)(2); and
- A beneficiary who is less than 10 years younger than the account owner.
A third-party special needs trust created for benefit of a person with a disability can qualify for the stretch; however, careful planning is necessary to ensure that the SNT meets the requisites.
Limitation of the stretch means that if you hold retirement accounts, it is wise to revisit your estate plan with your financial advisor and attorney (👋 ) to try to mitigate bad outcomes. This is particularly true if your age, health status, and/or the account’s balance are such that the account likely will not be exhausted upon your death, or if your retirement account names as beneficiary a “conduit trust” which limits trust distributions to the RMD. If you’re not sure, it’s better to be safe than sorry. Otherwise, the beneficiaries of your retirement account may have to write hefty income tax checks to the IRS.