In late December 2019, President Donald Trump signed into law the Setting Every Community Up for Retirement Enhancement Act (SECURE Act).
Many of the changes volleyed around Capitol Hill for years, and proponents tout it as the most comprehensive retirement changes since the 2006 Pension Protection Act. Given its bipartisan support, the changes aren’t exactly revolutionary. Most changes are incremental, tweaking the existing retirement account rules.
And being a bipartisan bill, it also includes a clever way to raise tax revenue without raising tax rates. Everyone in Washington gets to clap themselves on the back after such maneuvers.
As you plan your retirement, make sure you understand the new rules and adjust your estate planning based on the new rules on inherited IRAs.
Inherited IRAs: Drain in 10
Before the SECURE Act, people who inherited an IRA could spread out the withdrawals over their entire lifetime. They still had to take required minimum distributions (RMDs) based on their age, life expectancy, and the amount available in the account. But heirs could spread their withdrawals out over their entire remaining life expectancy.
The days of these “stretch IRAs” are over. The most significant change of the SECURE Act was to require people to empty all inherited IRAs within 10 years – a clause quickly labeled the “drain-in-10” rule. It removes annual RMDs, instead merely requiring that nothing remains in the account 10 years after passing to an heir.
Note that the drain-in-10 rule applies to non-Roth retirement accounts like traditional IRAs, 401(k)s, and SIMPLE IRAs. Roth accounts come with their own separate inheritance rules, which have remained unchanged. Heirs can take tax-free withdrawals from Roth IRAs for up to five years after inheriting them.
The Purpose of the Drain-in-10 Rule
Why did Congress stop allowing heirs to draw on their inheritance at a slower, more responsible pace?
In a word, revenue. The IRS taxes withdrawals from traditional IRA accounts as regular income. By forcing heirs to withdraw all the money relatively quickly, the withdrawals drive heirs’ taxable income into higher tax brackets.
Imagine you’re a single person earning a modest $40,000 per year. According to the 2020 federal income tax brackets, you pay 10% for roughly the first $10,000 of that and 12% for the next $30,000. Your last remaining parent dies and leaves you $400,000 from their IRA.
No matter what, you have to pay taxes on withdrawals. But previously, you could spread withdrawals over the rest of your life and enjoy much of that inheritance as retirement income. For example, you could take $15,000 per year from it to supplement your income, paying the higher 22% tax rate on it since it drove your income into the next tax bracket.
Because of the SECURE Act, you now must instead take $40,000 per year on it, plus returns. You pay the higher 22% tax rate on $40,000 rather than $15,000. The money also stops compounding, as it had been as untouched pre-tax funds in an IRA.
It amounts to serious tax revenue too. Estimates from the Congressional Budget Office put the additional tax revenue from this new rule at $15.7 billion over the next 10 years.
And if you fail to take the required minimum distributions, you must pay the IRS a 50% penalty on the amount you fail to take. Thus, if you were required to withdraw $10,000 but don’t, you pay a $5,000 penalty to the IRS.
Exceptions to the Drain-in-10 Rule
The SECURE Act took effect on Jan. 1, 2020, and is not retroactively applied. Anyone who inherited an IRA or 401(k) previously is exempt.
Other exceptions include spouses, heirs no more than 10 years younger than their benefactor – such as siblings – and people with disabilities. Spouses can roll the inherited IRA into their own traditional IRA or spousal IRA.
Nonspouses cannot roll over funds from an inherited IRA into their own. Their only option is to withdraw the money at regular income tax rates.
A fourth exception exists for minors. The drain-in-10 rule only kicks in once the child turns 18 and reaches the age of majority. As such, children who inherit an IRA have until age 28 to empty the account without facing IRS penalties.
Problems Trusts Create for Heirs
Some benefactors put their money into trusts upon their death, with detailed instructions for how to release the funds. In some cases, the trust pays out funds a little at a time or releases them only after a predetermined number of years.
These restrictive trusts can create a problem for heirs. For example, if a trust only allows the beneficiary to take the RMD, that could mean releasing the entire balance all at once after 10 years – and require the beneficiary to pay massive income taxes on it.
Forcing heirs to take the entire balance of trust funds in no more than 10 years can also defeat the whole purpose: to spread the inheritance out over many years to prevent the heir from blowing the money on sports cars and gadgets and designer clothing.
Ideas to Minimize Taxes
If you’re planning your estate, talk to a financial advisor before you do anything else. The tax rules on inheritances are complicated and made even more so by estate planning rules. If you don’t currently have a financial advisor, you can find one in your area through SmartAsset.
Benefactors who have set up trusts for their heirs to receive an IRA must consider their structure carefully and make sure they don’t force their heirs to take the entire amount all at once.
One option is to use part of the IRA funds to create a life insurance policy through Bestow with your heir as the named beneficiary. You do pay taxes on premium costs, but your heir doesn’t pay taxes on the payout.
You can also look into trustee-to-trustee transfers for IRA inheritances. But these get complicated quickly, so talk to an estate planning attorney or tax specialist through H&R Block.
If you’re on the receiving end of an IRA inheritance, common sense suggests spreading the withdrawals evenly over the 10 years to minimize your tax burden. You can put the money into your own tax-sheltered retirement accounts, whether an employer-sponsored account, like a 401(k) or 403(b), or an IRA.
Alternatively, if you’re near retirement age, you can wait until you retire before taking withdrawals. You avoid pulling money from the inherited IRA while also collecting earned income, so the combination doesn’t drive up your income tax bracket. Even better, you can delay pulling any money from your own retirement accounts, leaving them to compound and minimizing your sequence of returns risk.
Additional Retirement Account Changes
While the new drain-in-10 change to inherited IRAs stirred up the most controversy and angst among investors, it’s far from the only change created by the SECURE Act.
Make sure you understand all the rule changes, whether you’re planning out your own retirement investments or you’re a small-business owner considering a retirement plan for your employees.
1. No More Age Restriction on Traditional IRA Contributions
Before the SECURE Act, Americans over age 70 1/2 couldn’t contribute to their traditional IRA accounts.
But Americans are living longer, which usually means they need to work longer and save more to afford retirement. The SECURE Act allows Americans of any age to continue adding money to their traditional IRA.
And why not? From the perspective of the IRS, they can allow older Americans to keep contributing, safe in the knowledge the funds can only remain untaxed for a maximum of 10 years after the contributor’s death.
Particularly savvy planners can take advantage of the ceiling removal with backdoor Roth contributions, allowing them more flexibility to shuffle money based on that year’s income. But talk to a financial planner about such complex maneuvering before trying it at home.
2. Higher Age for Required Minimum Distributions
Under the previous IRA rules, account holders had to start taking RMDs at age 70 1/2. The SECURE Act raised the minimum starting age for RMDs to age 72. Again, it only makes sense, with Americans living and working longer.
The exception to the RMD age remains in place: Americans who continue working and don’t own more than 5% of the company where they work don’t have to take RMDs. After retiring, they must start taking RMDs if they’re over age 72.
3. Annuities in 401(k) Plans
Almost no employers included annuities as an option in their 401(k) plans before the SECURE Act. The reason was simple: the old laws held employers liable as having fiduciary responsibility for annuities included in their 401(k) plans.
But the insurance industry lobbied hard to change that rule, and their lobbying dollars paid off in the SECURE Act. The onus of responsibility now falls to insurance providers, not employers, which opens the doors for employers to start considering annuities as options in their retirement plans.
Annuities are complex investments that pay out income over time. Before choosing one in your employer-sponsored plan, speak with a financial advisor about the exact implications, risks, and rewards.
4. More Options for Part-Time Employees
Under the previous laws, employers only had to offer participation in their retirement plans to employees who worked at least 1,000 hours per year for them.
The SECURE Act requires employers to allow more part-time employees to opt in. While the previous rule still applies, employers must also allow access to all employees who work at least 500 hours per year for three consecutive years or more.
The requirement protects part-time employees increasingly piecemealing their income and participating in the gig economy. Saving for retirement is hard enough, even with an employer-sponsored plan. Surviving in a job without benefits makes it dramatically harder.
5. Penalty-Free Withdrawals for New Children
Having children is expensive. Really, really expensive.
The SECURE Act allows account holders to withdraw up to $5,000 from their retirement account when they give birth or adopt a child. The withdrawal is subject to regular income taxes, but it is not subject to the standard 10% penalty.
While not an earth-shaking change, it does make retirement accounts more flexible and encourages Americans to contribute money toward them. The new-child exception works similarly to the down payment exception, which allows account holders to withdraw up to $10,000 from their IRA penalty-free to buy a home.
6. Multiple-Employer Retirement Plans
In a bid to help more employers offer retirement plans, the SECURE Act makes it easier for multiple employers to band together to negotiate affordable plans.
The law removes tax penalties previously faced by multiple-employer plans if one employer failed to meet the requirements. The old law penalized all participating employers. The SECURE Act removed this so-called one-bad-apple rule.
The act also removes another restrictive rule: the requirement that employers must share a “common characteristic” to come together to offer their workers a multiple-employer plan. In practice, that typically meant only companies in the same industry formed multiemployer plans. Now, any group of employers can come together to negotiate with plan administrators and provide the best possible plans for employees.
7. Incentives for Auto-Enrollment
A 2018 study by Vanguard found a startling fact. When employees had to opt into employer-sponsored plans voluntarily, only 47% of them did so. When the employer auto-enrolled them, requiring them to opt out rather than in, the participation rate nearly doubled to 93%.
It makes sense. People tend to take the path of least resistance. But it also means one of the easiest ways to increase employee participation is simply to encourage employers to auto-enroll them.
The SECURE Act creates a new tax credit for employers who start auto-enrolling their employees in a company retirement plan. Though it’s only $500, the tax credit applies not only to employers who start a new retirement plan but also to those who start auto-enrollment for their existing plan. Employers can take it for up to three years after they start auto-enrolling employees for a maximum total tax credit of $1,500.
Finally, it raises the ceiling on what percentage of income employers can set as a default employee contribution. The previous default limit was 10%, and the SECURE Act raises it to 15%.
8. Increase in Tax Credit for New Employer-Sponsored Retirement Plans
Under the previous law, employers could take a maximum tax credit of $500 for up to three years when they started offering a retirement plan for employees.
The SECURE Act expands the tax credit. Employers can claim a tax credit of $250 per eligible employee covered, with a maximum tax credit of $5,000. Sweetening the pot, employers can also take the $500 tax credit for auto-enrolling employees on top of the tax credit for creating a new employer-sponsored retirement plan.
While these numbers seem small, they help offset the costs for small businesses who want to offer retirement plans but have little spare money to spend on them.
The SECURE Act is 125 pages long and includes additional provisions not listed above. For example, it requires 401(k) plan administrators to offer “lifetime income disclosure statements,” breaking down the income potential of various investments. Insurance companies can use these income potential breakdowns as a marketing device to pitch their annuities by demonstrating with convenient examples just how much better off they think employees will be if they opt for an annuity over “high-risk” equity funds.
For a full explanation of how the SECURE Act impacts your retirement planning, estate planning, and tax planning, speak to your financial advisor. While many of the changes in the act involve simple tweaks, the change in rules for inherited IRA funds in particular has complex implications for your estate planning.
When in doubt, invest more money in your tax-sheltered retirement accounts. After all, it’s better to build too much wealth for retirement than not enough.
What do you see as the most significant changes in the SECURE Act? How will the law affect how you invest for retirement and how you structure your estate planning?