The SECURE Act: What it Could Mean For IRAs and Why it Makes Me Feel Less Secure
The Setting Every Community Up For Retirement Enhancement (SECURE) Act of 2019 has been presented to the public as a bill that will help most Americans save for retirement. Admittedly, it does have some saving friendly provisions that could help spur more businesses to establish new retirement plans or expand opportunities for employee participation in existing plans. For those who are nearing retirement, these expanded saving options won’t help much; but the bill does propose to delay taxable Required Minimum Distributions (RMDs) to age 72, rather than the current age of 70½ (later is generally better from a lifetime taxation perspective). So what’s not to like?
The SECURE Act will effectively eliminate one of the largest tax saving benefits for those who have a significant amount of retirement savings in a traditional IRA account: the ability for non-spouse beneficiaries to “stretch” the RMDs over their lifetime. Here is an example of how this works. If I have a $500,000 IRA with my wife named as the primary beneficiary and my child as the alternate beneficiary, and my wife and I pass away at the same time, my child will inherit a $500,000 IRA. Under current law, my child will be required to take annual distributions from the inherited IRA even though they have not reached age 70½. From a tax perspective, this is bad news because those annual distributions will be taxed each year as ordinary income (similar to wages), even if they don’t need the money right now. The good news (or the not-so-bad news) is they are allowed to “stretch” those required annual distributions over their lifetime based on their own age (rather than mine) to determine the annual distribution amount. Using the current actuarial tables, if my child is only 30 years old when they inherit the IRA, they will divide the value of the IRA by 53.3 to determine the amount of required distribution in the current year. If the IRA value on December 31st of the prior year was $500,000, their current year distribution will be just $9,381 ($500,000 divided by 53.3). If they are currently in the 22% tax bracket, they will have to pay $2,064 of additional tax this year ($9,381 multiplied by 22%) due to the distribution.
If the SECURE Act is enacted into law, it will eliminate the “stretch” option for non-spouse beneficiaries by requiring all inherited IRAs to be cashed out within a 10-year timeframe. Going back to my last example, if my child is age 30 and now has to cash out a $500,000 inherited IRA over a 10-year period, the best they can do is to take distributions of $50,000 per year and pay $11,000 ($50,000 multiplied by 22%) of tax per year. This would result in nearly $9,000 of additional tax per year for the first 10 years, which could have stayed invested in the IRA to grow tax deferred for a much longer time period. That’s assuming the additional $50,000 of taxable income each year doesn’t push them into an even higher tax bracket! When accelerated taxable distributions force heirs into a higher tax bracket for 10 years, the long-term negative financial impact will be much more severe. The effective rate for heirs who are currently near the top of the 12% tax bracket, for example, could nearly double under the new law.
To be clear, the SECURE Act does not eliminate the option for a surviving spouse to stretch RMDs over their lifetime…it only impacts non-spouse beneficiaries. However, a majority of my clients have spent their lifetime working hard and saving for retirement through their company sponsored retirement plans, and the odds of their surviving spouse needing all of those funds during their lifetime are low. This means the odds of eventual inheritance by a child or other relative are generally high.
In summary, if the SECURE Act is passed, it will be presented to the American public as a bi-partisan victory. But for those of us who have made personal sacrifices in order to aggressively save for retirement with the hope of someday blessing our children with some of those tax deferred savings, the passing of this act might feel more like a defeat.
Paul Hansen, CFP ®