The SECURE Act: What It Means to Your Retirement and Your Estate Plan

The Setting Every Community Up for Retirement Enhancement (SECURE) Act is the most significant retirement reform legislation in more than a decade. It was signed into law on December 20, 2019, and many of its provisions took effect on January 1, 2020. The act was passed to encourage individuals to increase their retirement savings and motivate businesses to offer retirement plans. While many of the changes are positive, there are some that could cause major tax problems if you are not careful.

First, the good news:

• The age for starting required minimum distributions (RMDs) from qualified plans has been increased to age 72 from the previous 70 ½. People are living longer, so it makes sense to delay taking money out of retirement accounts as long as possible. People born on or after July 1, 1949, can now wait until age 72 before having to take RMDs. Those who turned 70 ½ before January 1, unfortunately, will need to start taking RMDs at 70 ½ as before.

• IRA contributions can now be made at any age. Previously, once you hit 70 ½, you could no longer put money into an IRA. But now you can continue to put money into traditional IRAs if you are still working, even if you’re past age 72. Again, people are living longer and choosing to work, so they can continue to shelter some of their earned income by putting it an IRA. Note that this applies only to IRAs. Contributions to 401(k) and other qualified retirement plans must still end by age 72.

• There are now no penalties for taking money out for birth or adoption of a child. Generally, if you take a distribution from an IRA or other qualified plan before the age of 59 ½, the money is subject to a 10% penalty unless an exception applies. The SECURE Act now adds an exception for the birth or adoption of a child. Each parent may take up to $5,000 out of their retirement accounts, penalty free.

• Money from 529 plans can be used for trade schools and student loan debt. The money from a 529 plan can now be used to cover the costs of registered apprenticeship programs. Not everyone is interested in college, and there is a critical shortage of skilled workers in many trades. The act also now allows a 529 plan beneficiary or their sibling to take a distribution of up to $10,000 to repay student loan debt. Again, this is a recognition of today’s reality.

The elimination of stretch IRA (almost)

The biggest change embedded in the SECURE Act, however, is the almost total elimination of the stretch IRA. This could have enormous tax implications for millions of people and their beneficiaries.

The stretch IRA allowed someone inheriting an IRA or some other qualified retirement account to elect to take RMDs from the inherited IRA over their life expectancy. That could be decades, providing an income stream for life and allowing the funds in the account to continue to grow tax deferred.

What Stretch IRAs made possible. For example, take a 37-year-old daughter who inherited a $500,000 IRA from her father. She was required to start taking RMDs from the account immediately, but she was allowed to stretch the distributions over her life expectancy. According to the uniform table, someone age 37 has a life expectancy of another 46 ½ years. As her father’s beneficiary on his IRA, she could have spread the distributions over 46 ½ years. She could always have taken more, and any distribution she took would have been subject to income taxes.

But the beauty of choosing to take the money over her life expectancy was 1) she could have a stream of income for her entire lifetime, providing her financial security, 2) she could continue the income tax deferral of that IRA over the 46 ½ years, and 3) she could also manage the income tax impact by taking more money in a year when she had less taxable income and then redistributing that distribution into another tax bucket, like buying a home or purchasing permanent life insurance.

But all that has changed with the SECURE Act. Now, with few exceptions, a non-spouse inheriting an IRA or other qualified account is required to distribute the entire account within 10 years. They can elect to take it all in year one and pay a huge income tax bill. Or they can take a little bit each year over 10 years, or some in year two, some in year five, or even wait till year 10 to take a lump sum.

There are exceptions if the beneficiary is disabled, chronically ill, or is less than 10 years younger than the original owner – they can continue to take distributions over their full life expectancy. A minor child of the owner can also take distributions over their life expectancy until the child reaches age of majority, then they are subject to the 10-year rule.

For those who already inherited a stretch IRA, they are grandfathered for their lifetimes and can continue to take RMDs over their life expectancy. However, anyone who inherits any remaining money from their inherited IRA will be subject to the new 10-year limit.

The larger tax implications

The elimination of the stretch IRA option will have a big impact on many people’s tax situation. Most of us have some form of qualified plan or IRA, and it’s likely we won’t end up using all of it in our lifetimes. If we leave it to our spouse, they can rollover such assets into their own accounts without any tax or penalty. Any non-spouse beneficiary, however, will have to withdraw the money and pay taxes on it within 10 years.

This may have a significant impact on trusts as a beneficiary of IRAs or qualified plans for the benefit of children or grandchildren. While the rules are complex and circumstances may vary, if the trust retains any of the money, the funds may be taxed on the RMDs at a much higher rate than if the money went directly to the beneficiaries.

This is a change that is likely to affect all of us at some time in our lives. If you have a large IRA or other qualified plan, it may well be worth talking to a financial professional about your situation. Sometimes the owner of an asset is in a lower tax bracket than any of the heirs, in which case it might make sense to distribute money from the plan now, pay the tax, and put it in a more tax-efficient vehicle. A Roth conversion might also be an option, where the tax is paid now and the money continues to grow tax-free.

There are excellent strategies available for people who want to minimize the tax implications when passing an IRA or other qualified retirement accounts on to their heirs, but such strategies require advanced planning. Talk to your financial professional to understand your options.

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