Several clients have asked about the proposed SECURE Act legislation and its negative impact on IRAs. The new SECURE Act (Setting Every Community up for Retirement Enhancement Act) passed the House in a bi-partisan 417–3 vote on May 23rd of this year. It has not yet passed the Senate but due to bi-partisan support, experts expect that some version of the act will pass and become law. The House version of the Act contains a provision that would significantly reduce the tax deferral benefit of an IRA that is inherited by a non-spouse beneficiary. Under current law, non-spouse IRA beneficiaries are able to “stretch out” distributions over a lifetime. The new law would replace this feature with a new rule requiring a much shorter payout period. Before we describe the specifics of this legislation we will first revisit IRA required distributions and the stretch IRA concept in general.
Individual Retirement Accounts (IRAs) and Required Minimum Distributions (RMDs)
IRAs have been a tax-advantaged tool for Americans to build their retirement savings since the 1970s. However, the IRS did not want these accounts growing tax deferred indefinitely. As a result, IRA owners must take annual required minimum distributions (RMDs) when they turn 70 ½, regardless of whether they need the income. These required distributions are treated as ordinary income to the taxpayer.* Depending on the size of the IRA, these distributions can be significant. For example, in 2019, the required minimum distribution for a 73-year-old taxpayer with an IRA valued at $2 million is approximately $81,000. The distribution amount is calculated by dividing the IRA prior year-end balance by a divisor found in the IRS Uniform Lifetime Table which is based on life expectancy. The older an account owner, the shorter their withdrawal period. Per the IRS Uniform Lifetime Table, a 70 year-old has a 27.4 year life expectancy factor (projected distribution period), compared to a much shorter 11.4 distribution period for a 90 year-old. Older IRA owners therefore have a more accelerated distribution payout than that of younger account owners. Said another way, older IRA owners must take out more pre-tax money over a shorter period of time than younger IRA owners with similar IRA account balances.
The term “Stretch IRA” is tax jargon which refers to the option under current law for a non-spouse beneficiary to gradually draw down an inherited IRA over his or her life expectancy rather than taking a lump sum or other accelerated forms of distribution. Note that a spousal beneficiary also enjoys this favorable “stretch” treatment and the SECURE Act does not propose changing this for spouses as the SECURE Act modifications would only apply to non-spousal beneficiaries. Depending on the age of the beneficiary, the ability to stretch out the distributions can be significant. For example, an adult child of an 80-year-old IRA owner may have a remaining life expectancy of 20 years or more, while a grandchild may have a remaining life expectancy of 50 years! The stretch technique effectively resets the younger generation’s annual RMD at a much lower level than that of the original IRA owner. This allows the beneficiary to elect on an annual basis to distribute, and be taxed on, only the required minimum or to elect to take larger amounts if desired to meet spending needs or for tax-planning purposes. For example, the owner of an inherited IRA may elect to take larger distributions during years when he or she is temporarily in a lower tax bracket due to a job change or due to retirement. In essence the taxpayer is allowed great flexibility with the timing and amount of the IRA distributions as long as the annual required minimum is distributed.
SECURE Act Impact on IRAs
Under the proposed SECURE Act, non-spousal IRA beneficiaries would be required to fully distribute (and pay tax on) the IRA within ten years of the death of the original owner. This ten-year requirement is a dramatically shorter distribution window than that allowed today. The much more compressed distribution period is clearly an attempt to generate revenue for the Federal government.
Again, please note that under the House version of the SECURE Act, this ten-year distribution period would not apply to spousal beneficiaries.
While this article focuses on the negative aspects of the SECURE Act, there are many other provisions and some of them are taxpayer friendly. In particular, the act would increase the age at which IRA owners are required to take required minimum distributions from 70 ½ to 72 and it would completely remove the age limit for IRA contributions (currently 70 ½).
In summary, one of the attractive tax-deferral features of IRAs inherited by non-spouse beneficiaries may be eliminated by proposed legislation that is likely to become law. Regardless of the outcome, the legislation under consideration is a good reminder of the importance of staying abreast of tax laws and continually reviewing your financial and estate plans. Can you answer these questions?
Is my retirement income plan sustainable and tax efficient?
Are my beneficiary designations up to date and appropriate?
Should I consider Roth conversions?
Is my portfolio allocation among my various accounts (IRAs, Taxable Accounts, Trust Accounts) structured to maximize family wealth after taxes?
Please let us know if you would like to discuss the issues raised in this article. As always, thank you for choosing Bragg Financial Advisors.
*Roth IRAs are not subject to required minimum distributions. Amounts contributed to traditional IRAs on an after-tax basis are not subject to tax when withdrawn.
This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.