The SECURE Act and Effective Tax Planning
Posted Feb 10, 2020
Congress recently passed the most sweeping legislation in the last 15 years for retirement. The SECURE act brings lots of benefits, but also numerous challenges for investors and retirees that require proactive planning. There are three major parts to the SECURE Act: 401k’s, annuities in 401k’s, and changes to required minimum distributions (RMDs). For the purpose of this blog, we will really only be talking about the challenges that the RMD changes bring for tax planning purposes.
For the RMD changes, one of the benefits was that congress pushed back the RMD age from age 70½ to age 72 for any individual that was not 70½ at the end of 2019. This means that if you turned 70½ in 2019 then you will still be held to the previous 70½ RMD age, however for all the “younger” investors, we now have a couple more years to defer those IRA distributions. Another small change is that individuals over age 70½ that have earned compensation can now contribute to their IRA. This likely won’t help a big number of people, but there will be some individuals that are working past 70½ that could benefit from a deductible IRA contribution.
The biggest change and challenge comes from the elimination of the stretch IRA. Previous to the SECURE act, non-spouse beneficiaries had the ability to take RMD’s according to their own life expectancy table set by the IRS. This meant that a child inheriting a parent’s IRA would be able to stretch their distributions out for the rest of their life (40+ years), thereby maintaining the tax deferment of the investment and minimizing taxes for an extended period of time. This was a great option for families interested in legacy planning over generations.
Now with the SECURE Act, non-spouse beneficiaries must distribute the entirety of the IRA within 10 years of the decedent’s death. This means that the beneficiary has the ability to take 10% each year for 10 years or not take a dollar out for 9 years and then take it all out in the last year. What the 10 year distribution period does is that it eliminates the long-term tax deferment of the investments and it has the potential to cause large distributions that could push beneficiaries into much higher tax brackets. This causes some serious planning challenges and for investors that looking to leave their kids an inheritance, they should probably start to look at multi-generational tax planning strategies.
An important multi-generational tax planning strategy to deal with this SECURE Act challenge is to start considering doing Roth IRA conversions more aggressively. With the RMD age pushed back to age 72, investors now have more time to convert their traditional IRA to a ROTH IRA. The benefit of doing ROTH conversions will be that the investor/retiree has the ability to fill up lower income tax brackets and take advantage of historically lower tax brackets. They also have the ability to control their taxable situation because they can take as much or as little as they want in distributions prior to their RMD age. Their children may get stuck paying excessively high taxes during that 10 year period which would hurt the overall goal of legacy planning. I spoke about this issue in this article from InvestmentNews about the SECURE Act. There are several other planning strategies, but ROTH conversions will likely be the most common and valuable method.
While we can argue the merits and flaws of the SECURE Act at length, it does present some serious challenges to families. There are tax planning strategies that we can start today to help lower the overall lifetime tax burden associated with an investor’s IRA, but they are things that have to be planned for properly and they need to start happening soon.