On December 20, 2019, President Donald Trump signed into law a spending bill containing the SECURE Act (Setting Every Community Up for Retirement Enhancement Act). The new legislation took effect on January 1st of 2020, giving only 11 days (minus holidays and weekends) for everyone to adjust. This has left many financial institutions and financial professionals affected and scrambling to prepare.
Everyone seems to be trying to get their arms around it all and determine how to answer the questions they are getting from their customers. New details seem to emerge weekly.
Some of the bigger positive takeaways from this new legislation are considered to be the following:
- Delayed Required Minimum Distributions (RMDs), Up until this point, RMDs were required to begin in the year when an IRA owner reaches age 70 ½ but will now begin at age 72. That is unless you had already begun taking RMDs. If an IRA owner was required to have started taking required minimum distributions in 2019 or prior, they will have to continue to take distributions. For those folks who are not yet required to take distributions beginning in 2019, they will not have to take any distributions until they reach age 72.
- The age restriction on IRA contributions has been repealed. In the past, unlike workplace retirement plans and Roth IRAs, even if you had earned income you could not contribute to an IRA if you were age 70 or older. By eliminating the age restriction for contributing to an IRA, it opens the door for those still working at a later age to add to their retirement savings. The new change brings contribution rules for IRAs in line with those of workplace qualified plans and Roth IRAs.
- The SECURE Act paves the way for annuities to be offered within employer-sponsored plans like 401(k)s by creating Safe Harbor rules to protect plan sponsors against certain potential liability for doing so. It also requires that each year plan administrators provide participants with a lifetime income disclosure statement demonstrating how much their account balance might generate as a lifetime income stream if they purchase an annuity.
- Multiple employers with unrelated business ownership are now permitted to band together to offer employer sponsored retirement plans. Known as Multi-Employer Plans, or MEPs. MEPs would potentially reduce the cost to both plan sponsors and participants by taking advantage of economies of scale through pooling expenses across multiple small employers. In theory, this would open the door for a many more Americans to have access to a workplace retirement plan who currently do not have access because their employer finds the expense of starting an operating a plan too burdensome.
- There’s also a measure that allows for 529 funds to be used to pay for registered apprenticeship programs, as well as a provision permitting up to $10,000 per year to be used to pay student loan debt.
Considering these positive outcomes, the SECURE Act is looking like a net win for many Americans. However, the good government giveth and the good government taketh away.
So, what are the tradeoffs for all of the positive implications? In other words, how does a deficit-ran federal government plan to pay for all these goodies?
Say goodbye to stretch IRAs
Prior to the SECURE Act, Stretch IRAs provided a pathway for non-spouse beneficiaries who inherit pre-tax dollars to spread out the tax burden of their inheritance over several decades. However, all good things must come to an end.
Under the SECURE Act, beneficiaries who receive pre-tax dollars as an inheritance will be required to distribute the tax-deferred money over a period of 10 years or less. There’s no set schedule as to how much must be distributed each year, allowing for some flexibility, but by the 10th year all money must be distributed.
Without the option of a Stretch IRA, non-spouse beneficiaries of IRA owners will have to distribute pre-tax dollars over a much-condensed period of time. With that being the case, there is an expectation of increased tax revenue.
Stretch IRAs were never a birthright
We published an article on June 26, 2019, titled Pending Legislation Could Affect Inherited IRAs in a Big Way. In that article, we gave a short history of Stretch IRAs, and I do mean “short” because it wasn’t that long ago that the Stretch IRA rules as we know them, were passed into law. We also discussed the reasons why they were likely not to last.
The fact that Inherited IRAs have been under attack by many legislators over the last decade or two led us to believe that counting on Stretch IRAs as part of a larger long-term wealth transfer strategy was likely to come back to bite us.
For years leaders within the federal government have been slipping similar language into spending bills, but most of them were partisan with little chance of passing. The SECURE Act was the first piece of legislation containing language to dismantle Stretch IRAs that was bi-partisan, and more likely to be signed into law.
So, what will the fallout of this legislation look like and how will this change to Stretch IRAs potentially impact your clients and their beneficiaries?
Clients who have sizable pre-tax accounts that they are likely not going to use throughout their lifetime would be the folks that you would want to connect with immediately.
In addition to clients, their beneficiaries (often their children), should really understand what this may mean to their inheritance, how they receive it, and how much they are likely going to get to keep.
Successful beneficiaries, who will likely be in their primary earning years when the wealth passes from their parents to them may find it unappealing to inherit large sums of pre-tax money to which they’ll have to fork over a sizable percentage to the state and federal government. The impact it will have on their own taxable income and the effective tax rate they pay may be shocking as well.
Meet Mr. and Mrs. Didalot: Hypothetical couple who may be affected by the SECURE Act
Imagine for a moment you have clients who did a lot to save and prepare for retirement. We’ll call them the Didalots. Mr. and Mrs. Didalot are 65 years old and transitioning into retirement. You’ve done a complete comprehensive written plan. Between retirement income sources like pension and Social Security, accompanied by supplemental distributions from their pre-tax savings like 401Ks and IRAs, they will be able to maintain their standard of living.
They are currently sitting in the 12% tax bracket, with a $15,000 cushion before hitting the next highest marginal tax bracket. They have a $250,000 in an IRA asset that they really don’t need. This is money that they will likely never need to use throughout their lifetime, and it will be passed to the next generation. Their distributions from the other pre-tax assets used to supplement their retirement income is enough to satisfying all the RMDs. Therefore, this money will grow undisturbed.
Mr. and Mrs. Didalot have an average life expectancy as a couple according to the Society of Actuaries (SOA) of 92. At 6% rate of return net of fees, their $250,000 IRA will grow to over a $1 million by age 90. Neither may be around by then, but it’s statistically plausible that one of them could be.
The couple has two daughters. Both are college educated, married, and earning sizable household incomes. Both daughter’s households are generating an annual taxable income that would put them at the top end of what today would be the 24% tax bracket. It won’t take much to push them over into the 32% bracket.
When Mr. and Mrs. Didalot have both passed, each child is set to receive 50% of the IRA assets. If either Mr. or Mrs. Didalot live to age 90 or beyond, the daughters are each likely to receive a little over $500,000 in pre-tax money.
Even if the children stuff it in a bank account (don’t invest it for growth) and distribute all of their inherited pre-tax money equally over 10 years, they will be adding $50,000 per year to their existing income pushing them into what would now be the 32% bracket. All of this increases their effective federal tax rate.
Would you say they’re being rewarded or penalized because mom and dad were good savers, and they have had successful careers and households?
Some might argue that they’re being penalized for being successful.
A likely scenario is that the daughters inherit the pre-tax money, and end up delaying making any distribution decisions immediately. Maybe they invest it for a rate of return or save it in an interest-bearing account. They may not know the rules, what to do, and they may not have a trusted financial professional to guide them.
Since there is no required distribution schedule to follow, for several years they take little to no distributions before realizing that time is running out and they have to distribute everything before the end of the 10th year. It’s possible that they could end up bunching taxable distributions over an even shorter period of time.
So, why are we even having this conversation?
What’s happening today is a consequence of long-term tax deferral promulgated over decades by tax and financial professionals, as well as financial institutions selling investment products. Many folks seem to think that they’re getting a tax savings by putting money in an IRA, for instance, when the reality is, they’re just kicking the can down the road to a later date. It’s not a tax savings, it’s a tax deferral, and at some point, the money must be distributed and taxed at whatever income tax rate the recipient is subject to.
Following the theoretical advice of “save tax now by contributing to a qualified plan” has resulted in a paradigm shift in retirement savings. Where past generations may have saved in after-accounts with little saved in pre-tax accounts, today’s near retirees are the first generation to have the overwhelming majority of their wealth saved in pre-tax accounts.
What does that mean for you?
Greater opportunities to serve clients
There are often blatantly obvious and then not-so-obvious opportunities to serve your clients any time legislation like this occurs. To make sure you take advantage of all opportunities to serve your clients, knowing the rules is a good first step. Get educated on the new rules that will likely impact your clients. Study them and understand them completely.
Next, take a step back and look for ways to apply the new rules to improve your client’s lives while simultaneously avoiding the unintended consequences created by the legislative changes. One way to more easily accomplish this is by using computer aided design programs, like Retirement Analyzer or E-Money, to simulate possible corrective actions before acting on your educated guesses.
If you’re willing to do the work and complete a comprehensive analysis on each of your clients, there is a possibility you can turn the counterproductive tax impact of the SECURE Act into a positive for them, their beneficiaries, and your business.
Use the SECURE Act as inspiration for a new strategy
One way to potentially impact the Didalots would be to begin taking strategic distributions from their pre-tax accounts prior to the age at which they are required to do so. Having a plan to strategically distribute pre-tax dollars and minimize their taxable footprint by creating a tax equilibrium throughout their retirement years might be a start.
Imagine making pre-tax distributions while controlling the next highest marginal tax bracket. Withdrawing just enough money to be used to pay the taxes due, yet have enough left over to fund a wealth transfer strategy that will leave tax-free dollars to the beneficiaries, and create a pool of assets to be used by Mr. or Mrs. Didalot if either of them experiences a long-term care event.
There are many tools available to you in the insurance industry today that did not exist a decade ago. Rather than continuing to increase the pool of pre-tax assets for the Didalots, you might want to consider making strategic distributions throughout their retirement years. They can leverage those to offset the impact of the SECURE Act on their beneficiaries who are likely to inherit large sums of pre-tax money during their prime earning years.
Recalling from earlier, the Didalots are currently in the 12% bracket, and they have a $15,000 cushion before they hit the next highest marginal tax bracket. It is likely they could make distributions each year, pay federal and state taxes, and still have about $12,000 annually to fund a strategy that will pass tax-free dollars while simultaneously covering expenses associated with a long-term care event should either of them become chronically ill via rider on the life insurance policy.
A $15,000 distribution from a $250,000 pre-tax account is about a 6% distribution rate. Is 6% withdrawal rate reasonable to rely on as funding for this strategy, considering that there’s no need to adjust for inflation on the life insurance premiums paid? Maybe yes, maybe no?
However, if the ongoing reliability of this spend rate is concerning, there are several annuity products options available today that may potentially guarantee a similar income stream as long as both spouses are alive. The annuity payments could be leveraged to fund a second-to-die life insurance strategy that will pass tax-free dollars to the beneficiaries, while also providing Mr. and Mrs. Didalot access via a rider on the life insurance to be used if either one experiences a long-term care event.
In closing…
Although change can be scary, it can also open our eyes to ways we can better serve our clients and recommend new strategies that could actually be more beneficial to them.
If you’d like to discuss strategies like the one mentioned in this post, reach out to a member of the sales team today.
