The SECURE Act Becomes Law
Last August I wrote about bipartisan legislation, the SECURE Act, that had passed the House in May but was stalled in the Senate as a few politicians pursued unpopular changes. In early December, most of the Senate saw an opportunity to override this gridlock by attaching the bill to appropriation legislation that avoided a government shutdown. This is how the SECURE Act became law after President Trump’s signature on December 20, 2019. For a summary of its major provisions, please see my August 2019 Viewpoint column under the “News & Insights” tab on www.investprovident.com.
Now that the SECURE Act has passed, I’d like to provide some additional information and comment on steps you might need to take as you think through tax and estate planning. Before I do that, I’d like to correct one item in the August Viewpoint regarding Roth distributions. My read of the legislation led me to think Roth distributions would avoid the 10-year accelerated distribution period for non-spouse and other specifically defined beneficiaries. This is not the case as Roth distributions will be treated identically to traditional IRA distributions.
If you have an existing Beneficiary IRA, the SECURE Act does not change the Required Minimum Distribution (RMD) rules for these accounts. The new 10-year distribution rule applies only to new Beneficiary IRAs created after January 1, 2020.
If you turned 70½ by December 31, 2019, you follow the old RMD rules with your first RMD covering 2019 due April 1, 2020 and yearly RMDs thereafter. This is unfortunate as turning 70½ just one day later, January 1, 2020, would allow you to avoid RMDs for 2020 and 2021. This doesn’t seem fair and is likely an unintended consequence of the Act’s late 2019 passage. If you turned 70½ last year and have yet to take your first distribution, I’d recommend holding off on taking the 2019 RMD until the IRS has had a chance to put forth concrete rules for 2020 distributions. However, don’t wait too long as the penalty for RMD shortfalls is a stiff 50%!
The legislation does not impact the age at which you can make Qualified Charitable Distributions (QCDs), which remains at 70½. QCDs from a traditional IRA are a great way to reduce your taxable income as you don’t recognize any part of the distribution in your Adjusted Gross Income (AGI). You can make a QCD up to $100,000 per year. However, there is some confusion as to the tax treatment of a QCD that is greater than an RMD, and this is magnified by the delay in taking RMDs to age 72. Thus, if you are between 70½ and 72 I’d recommend waiting for the IRS to put forth concrete rules before making a QCD in 2020.
If the beneficiary of your IRA is a non-individual, like trusts, estates and charitable organizations, you will need to examine the impact of the SECURE Act immediately. Non-individual beneficiaries have only a 5-year window to distribute all IRA assets. For example, a trust that was written assuming “stretch” RMDs will need to be rethought and amended. The new 10-year window for IRA distributions versus 5-year period for non-individuals will make naming individuals as beneficiaries more attractive.
Getting rid of the “stretch” RMD will complicate the multi-generational goal of minimizing taxes, particularly with traditional IRAs. Here are some variables to think about as you look at your own situation:
IRA balances. The larger the traditional IRA balance, the more difficult it will be to avoid distributions that push the IRA owner or beneficiary into higher tax brackets. This was the intent of changing the RMD period as it will add an estimated $15.7 billion to government coffers over the next 10 years. Distributions from small IRAs might not do much to push income into higher tax brackets, regardless of recipient.
Number of beneficiaries. The more beneficiaries you name, the more the dollars from the IRA get split. For example, a $1 million traditional IRA, five beneficiaries each get $200,000 versus two that get $500,000 apiece.
Is an existing or newly named beneficiary an exception? Spouses, disabled or chronically ill persons, or persons not more than 10 years younger than the IRA owner use the pre-SECURE Act distribution rules. Minor children get to suspend RMDs until they reach the age of maturity, 18 to 21 by state law or 26 if still in school, after which they follow the 10-year distribution period. Note that grandchildren are not part of this exception list.
Marginal tax rates for both IRA owner and beneficiaries. To effectively minimize multi-generational traditional IRA tax consequences, the marginal tax rate for the IRA owner and each beneficiary must be determined. Yeah right! We know today that the 2017 tax law expires at the end of 2025, reverting to pre-2018 rules if Congress and the President do nothing. With the government running substantial budget deficits, the prospect of future higher tax rates seems assured.
Even so, rough “guesses” of marginal tax rates can help with decision making. For example, if the traditional IRA owner is in retirement and their marginal tax rate is low, taking a higher distribution than the RMD makes sense if children are expected to inherit the IRA during their peak earning years. However, higher IRA distributions for a retired IRA owner has negative tax consequences, including the portion of Social Security payments subject to tax, varying capital gains rates on taxable assets, and higher Medicare premium payments as income rises. These calculations are hard and require some guesswork.
Conversely, if beneficiaries have low marginal tax rates because they are younger or in lower income jobs, leaving them a large traditional IRA balance might not be a problem.
The composition of estate financial assets: taxable, traditional IRA, and Roth. Depending on balances for each asset class, it may make sense to name different beneficiaries and/or percentages. For example, a low marginal tax rate beneficiary might be a candidate to get a bigger chunk of traditional IRA assets while a high earner gets Roth. However, since most estates want to provide the same distribution value to each beneficiary, the calculations to equalize value across these tax-advantaged asset classes is not only complex but changes over time.
At the margin, the additional planning complexity for bequeathing traditional IRAs has diminished their appeal and made saving with after-tax dollars in a Roth IRA or 401(k) much more appealing. If it doesn’t place a client in a higher tax bracket, we often recommend Roth savings or taking traditional IRA distributions above their RMD and converting them to Roth. This has the double benefit that the traditional IRA balance is reduced, lowering future RMDs, plus heirs don’t have to worry about tax consequences. However, Roth conversions for their own sake can be a bad investment decision and generally make sense when the taxes on conversion can be paid from money outside the IRA, the marginal tax rate doesn’t get pushed too high and the owner has many years ahead to benefit from the power of compounding tax-free investment returns.
Now that the SECURE Act is law, we would be glad to talk to you about your financial situation and make suggestions on how you might think about its impact on your financial assets.
Daniel J. Boyle, CFA