On May 23, 2019, the House of Representatives passed the Setting Every Community Up For Retirement Enhancement (SECURE) Act 417-3, with 12 abstentions. This bill represents the largest change in retirement savings since the 2006 Pension Protection Act. The Senate previously had a companion bill, the Retirement Enhancement and Savings Act, but is now expected to take up the SECURE Act instead. With broad bipartisan support, the bill is expected to pass which will mean changes for financial planners, administrators of retirement plans, and estate planners.
The most discussed provisions of the bill affect Individual Retirement Accounts (IRAs). These changes focus on ensuring people use their IRAs for the intended purpose of retirement but may have negative effects on estate planning.
The Act does propose a number of beneficial changes of which individuals and planners need to be aware. In order to contribute to an IRA, the individual needs to have earned income. Previously, the definition of earned income did not include stipends and fellowship payments for students. The new act will include both. For graduate students and their parents, this represents a great way to transfer wealth. The parent can use some of the yearly gift tax exemption to fund an IRA, likely a Roth IRA, for their academically inclined child, allowing it to grow tax free throughout the child’s life. This is an excellent way to push assets out of the parents’ estate and maximize savings.
New parents, whether natural or adoptive, will also benefit from the Act. IRA distributions (and distributions from other qualified plans) prior to age 59 ½ normally come with a 10% penalty in addition to any income taxes owed on the distribution. This rule has very few exceptions. The SECURE Act will add one more. Under the bill, new parents will be able to withdraw up to $5,000 from the IRA or other qualified retirement plan to pay for birth or adoption without incurring a 10% penalty.
The Act also recognizes that more and more Americans are working later in life and repeals the maximum age for IRA contributions. As it is now, individuals can only contribute to traditional IRAs until they reach 70 ½ years old, although they could continue to contribute to a Roth IRA. Those people working later in life will be able to make tax deductible contributions to their IRA. In conjunction with this change, the Act will also increase the age at which the individual is required to begin tax minimum distributions from 70 ½ to 72. These two changes will likely mean more money can be deposited into IRAs. Unfortunately, if the account holder passes away with substantial assets still in the account, their beneficiaries may suffer unanticipated tax consequences.
With all of these benefits, the SECURE Act comes with a huge cost. While it encourages people to push more money into their IRAs, it also changes the rules on beneficiary distributions. Today if an account holder passes away, the IRA goes to a designated beneficiary. The beneficiaries must receive a required minimum distribution every year when they inherit an IRA. The distribution is calculated by taking the total account value on December 31st of the prior year and dividing that by the beneficiary’s life expectancy on the IRS chart. For example, a 40 year old who inherits a $1,000,000 IRA would be required to take $22,935 in the first year. For a traditional IRA, that amount is included in the beneficiary’s taxable income. That figure would change every year based on the withdrawals from and interest accruing on the IRA as well as the changing life expectancy of the beneficiary. This formulation has allowed estate and financial planners to treat the IRAs as a sort of income trust. The beneficiary is unlikely to get hit with a huge tax bill because of the distributions and the account can continue to accrue interest and value tax deferred over the beneficiary’s lifetime.
The SECURE Act will do away with this important tool and failure to engage in estate planning will cost beneficiaries dearly in income taxes. The Act will require that the entire amount of the account be distributed within 10 years of the death of the account holder. This will add considerable income to the beneficiary even if they were to divide the IRA distributions over the 10 year window. With interest over 10 years, a $1,000,000 IRA could turn out $100,000 distributions every year for 10 years.
Each of the distributions would be taxable income to the beneficiary. For many people, that would likely mean a step up in tax brackets, so a greater proportion of the IRA will be relegated to tax payments. While this may seem, in some ways, like a good problem to have, most people are trying to pass on as much of their assets to their children as possible. Now instead of passing tax free inheritances, the account holder would be pushing income tax liability to their beneficiaries.
There are options to save these inheritances from the taxman such as IRA conversions, additional life insurance, and spending changes. It is important that individuals consult with both their financial planners and an estate planning attorney to plan to avoid these issues in the future. If you have IRA or estate planning questions, one of our estate planning attorneys can assist you. Call John Leonard, Heidi Anderson, Paul Schultz or Robert Atkins at (215) 567-1530 or find us online at leonardsciolla.com.