Planning for the Negative Tax Impact of the SECURE Act on your IRA and 401(k) Beneficiaries

Tax | Jonathan Gold | Jan 13, 2020

In this era of Congressional contentiousness, any legislation that comes out of those chambers with bipartisan support deserves note. Such is the case with the SECURE Act, an acronym for “Setting Every Community Up for Retirement Enhancement,” which was passed last July by a near-unanimous vote in the House of Representatives. But the SECURE Act also warrants a note of caution for those heavily invested in IRAs and/or 401(k) plans because it truly is a “game-changer,” and not for the better, when it comes to the distribution and taxation of withdrawals from inherited plans.

Ostensibly, the SECURE Act, signed into law by the President on December 20, 2019, seeks to address the unpreparedness for retirement of many U.S. citizens, a generation that witnessed the near disappearance of “defined benefits,” that is, traditional pension plans, and the rise of “defined contributions,” 401(k)s et al. Some say the retirement crisis stems in part from this fact:

Pension plans were/are managed by retirement investment professionals, while 401(k)s are managed by, well, anybody who has one. And participation is voluntary, so now 1 in 5 Americans have NO retirement savings, and over a third have less than $25,000 saved.

Enter the SECURE Act, designed to relieve the problem with a package of benefits that include:
• A maximum penalty-free withdrawal from 529 plans of $10,000 to repay student loans. (Student loan debt, now estimated at $1.5 trillion, affects one in four Americans.)
• Relaxed rules for employers with sponsored retirement plans that offer annuities.
• Tax credits and protections on collective Multiple Employer Plans for small businesses who want to offer 401(k) plans to their workers.
• As a nod to the “gig economy,” SECURE allows long-term part-time employees to receive retirement benefits.
• A family friendly provision permits up to a $5,000 withdrawal from retirement plans for the adoption or birth of a child.

On the retirement front, SECURE has:
• Eliminated a maximum age, which used to be 70-1/2, for making retirement contributions.
• Changed the age for the beginning of required minimum distributions (RMD) from 70-1/2 to 72.

Regarding SECURE and retirement, that is the good news. We can now keep expanding our contributions, and we get an extra year and a half to let them grow before taking distributions. But, and this is a big BUT: It is estimated the government will need about $16 billion to finance SECURE benefits. So, now the bad news.

Those familiar with longstanding required minimum distribution rules know that before SECURE, retired individuals started taking distributions at 70-1/2 and did so each year for as long as he or she lived. And, when one spouse passed, the deceased’s IRA would be rolled over by the surviving spouse creating a larger account from which he or she took annual RMDs.

When both spouses had passed, that account was usually inherited by the children of the couple who took distribution also for a lifetime. These so called “Stretch IRAs” literally “stretched” the time over which the IRA was distributed, even from one generation to the next. This not only made for a consistent income, but also a low-level of tax impact over time. The SECURE Act has changed all of that for one group in particular: beneficiaries who inherit an IRA or 401(k).

Under SECURE, the traditional “stretch” aspect of an inherited IRA still applies to beneficiaries who are surviving spouses, chronically ill/disabled, within 10 years in age of the IRA’s original owner, or below the age of 18 (but once 18, the new rules apply).

The new rules for all other beneficiaries under the new SECURE Act are very clear. The entire amount in an inherited IRA must be distributed within 10 years after the death of the original owner. If all funds in the IRA have not been distributed within that 10-year period, the remaining amount will be distributed as a lump sum.

The deleterious effects of this change are several.

One, if the beneficiary inherits and must take a distribution of the IRA during a decade that occurs in his or her peak earning years such as his or her 40s and 50s, the withdrawals will be taxed at that individual’s income tax bracket at that time. Result: A much higher tax burden than if the amount was distributed over literally a lifetime, or the non-peak earning years in the latter part of life.

Two, rather than supplying a steady stream of income over a number of years, the recipient is forced to take the money during the 10-year period.

Three, since any amount can be taken at any time during the 10-year period, the tempering effect of the RMD system on those tempted to “cash-out” disappears. Although, a benefactor may put in place a “pass-through trust” which can dictate how the overall amount is distributed, but it still must occur during a 10-year period.

So, who feels the pinch from the new SECURE Act? As Leon LaBrecque writing for Forbes put it, “A whole lot of people. First, realize this affects all qualified plans, so §401(k), 403(b), 457(b), 401(a), ESOPs, Cash Balance plans, lump sums from defined benefit plans and IRAs.” To give a sense of the breadth of the effect of this new rule, LaBrecque says, “Is it big? The total assets of traditional IRAs topped $7.85 trillion.” Yes, that’s trillion with a T.

So, in the end, SECURE offers a host of benefits designed to alleviate what many, including Congress, see as a “retirement crisis” in the United States. But, like all solutions, it comes at a price, and to be blunt, that price will be paid by the beneficiaries of citizens now living who have the most invested in their retirements. And, if you are among those citizens, we at Prager Metis agree with LaBracque when he says, “This is no time for panic, but it is time for a conversation.” That is, a conversation with your Prager Metis advisor to explore possible estate planning and retirement savings alternatives.