When Congress passed the SECURE Act in late December — during the busiest time of year for most people — they gave Americans only two weeks to wrap their heads around the upcoming changes.
Catch up on the act’s biggest changes in this episode with Marc Bautis. Today, he discusses the SECURE Act’s most important features to uncover the possible impacts on your financial plan. Marc also shares new planning opportunities that have arisen from this act.
In this episode, you will learn:
- How the age limit has changed for contributions to retirement accounts
- Guidelines for withdrawing money from your IRA without being penalized
- Whether you can only use 529 plan money for post-secondary education
- How to inherit an IRA without tax consequences
- And more!
Tune in now to learn about the SECURE Act’s biggest changes and what they might mean for you.
The secure act is a big deal. Changes like this only come every 10-15 years. On today’s show we are going to break it down and discuss the most important features of the Act and what planning opportunities we can take from it.
Not only was the SECURE Act a big change, it became a law in mid-December with the changes taking place two weeks later on January 1st, 2020. So there was very little time to prepare for it.
There was a lot of good intention with the bill and it is really geared toward making it easier for people to save for retirement and give people more control over their retirement accounts.
I talk to a lot of people who love getting a tax deduction for their retirement plan contributions, but they some of the restrictions on retirement accounts
- They have to wait until age 59 ½ to access the funds
- At age 70 ½ they are forced to start withdrawing money from their retirement accounts.
I think the government took note of that and tried to make some changes in hopes of getting more people to save for themselves when it comes to retirement. And that’s definitely a good thing.
We can break the bill up into two categories.
- Quality of Life Changes
- Regulatory Changes
Elimination of Age Limits on Traditional IRA Contributions
Before the SECURE Act, once you turned 70 ½ you could no longer contribute to your Traditional IRA. This change is to make Traditional IRA contributions more inline with employer sponsored plans. With 401k plans you have always been allowed to contribute past age 70 ½. Even with a Roth IRA you have always been allowed to contribute past age 70 ½ as long as you have earned income.
Previously once you turned 70 ½ you were not able to contribute to a traditional IRA anymore. Again, it’s the government saying that people are working and living longer and that it’s good to put money into an IRA. Now if you are over 70 ½ you can still put money into your IRA.
This also helps someone who is working part time in retirement still be able to save money in an IRA.
The one caveat is that you have to have earned income to contribute to the IRA. If you are retired and not working, you’re not able to contribute.
Change in Required Minimum Distributions
The next important change of the SECURE Act is that the required minimum distribution age has been increased by 18 months. It went from 70 ½ to 72. And this one I’m ] seeing so far in the short time that it’s been in place, is the one change that people are liking the most. People do not like the government telling them when they have to start taking money out of their retirement accounts.
Does it make that big of a difference? It’s only 18 months. It doesn’t make that big of a difference and the IRS will still collect their tax, , but people just seem to like the fact that yes, they now have another 18 months, that they don’t have to listen to what the government requires them to do. And it’s growing tax deferred for that extra 18 months.
The other piece of it that’s good is they got rid of this funky half year. Explaining to people that even though they were 70, they didn’t turn 70 ½ until the next year so they could hold off on taking an RMD was cumbersome.
A quick overview on RMDs. Every year that you were working and putting money into your IRA or 401k you were getting a tax deduction.
Once you now turn 72 the IRS says it’s time for them to start collecting their tax. They force you to take money out. Which then shows up as ordinary income on your tax return.
There is a calculation that’s done each year to determine how much of an RMD you have to take out. The calculation looks at the balance of the IRA on January 1st and your age and determines your RMD. You have until December 31st to take that money out. You could always take out more, but that’s the minimum that has to come out each year. That process repeats every year for the rest of your life. As you get older you start having to take more money out.
Changes to the 10% Early Withdrawal Penalty Exception
This change impacts someone who needs to withdraw funds from their retirement account prior to age 59 ½. That age is enforced by the government. They claim that they are giving people a tax deduction for saving money in a retirement plan but they want people using those funds for retirement not as a piggy bank. If you take out money prior to age 59 ½ not only will you have to pay taxes on it, but also a 10% early withdrawal penalty.
Prior to the SECURE Act there were only a couple of exceptions to the 10% early withdrawal penalty.
- The most frequently used exception was for a first time home purchaseThe first one was for a first time home purchase.
- The second one was if you had medical expenses over a certain percentage of your income.
It either of those two situations occurred, you still had to pay tax on the money you took out of your IRA or 401k, but you didn’t have to pay the 10% early withdrawal penalty.
With the passing of the SECURE Act there are a couple of additional exceptions to the 10% penalty.
- The birth or adoption of a child. You are allowed to withdraw $5,000 penalty free. It’s great for people starting a family. They may miss some time from work due to the birth or adoption and it’s a way to help and give people more control over their accounts. Being able to offset some of those costs, that’s a great benefit.
Changes to 529 College Savings Accounts
Now you are able to use your 529 account to pay up to $10,000 of student loans. This is on top of the significant change to the 529 as part of the 2017 Tax Cuts and Job Act where you can use $10,000 a year to pay for private school prior to college.
I think the government is recognizing that there is a student loan problem and hopefully this change can help with giving people more flexibility to address that. Whenever I talk to someone about saving in a 529 there used to be some hesitancy because they were pigeonholed into what it could be used for. I think with the changes it’s making people more at ease with utilizing a 529 because it can be used for more things. there’s a little bit of hesitancy because. 529’s can still be a great estate planning tool.
How a 529 works
You contribute money to a 529 account and as long as it’s used for one of these qualified expenses you do not have to pay tax on any of it.
- Private middle and high school
- Student Loans
The next change with 529’s they should look at is adding some flexibility with the investments inside them. 529’s are similar to 401k’s in that there is a menu of investment options that you can pick and choose from. It would be great to get it to how an IRA works where you have an almost unlimited menu of investment options to choose from to put together a strategy that works for you.
Changes with Employer Retirement Plans
Changes occuring in the SECURE Act weren’t limited to just IRA’s. There were some that impacted employer plans like 401k’s.
Auto Enrollment Cap
401k plan sponsors can auto enroll employees into the company’s 401k plan. This means that instead of an employee having to opt into the plan to participate, they are automatically enrolled. If they do not want to participate in the plan they have to take the action of opting out. Auto enrollment was done to promote saving for retirement. I usually see employers opting in employees at a 3% contribution rate. The employers usually add an auto escalation feature that each year increases the employees contribution by 1%. So the first year the employee is in the plan, they are automatically in at 3%. Next year it automatically increases to 4%, and the year after to 5%. Once the automatic increase hit 10%, it had to stop. The SECURE Act allows the automatic increase to go up to 15%.
When I talk to people about 401k’s, the first question I receive is how much should I put into it. I tell them that if you start in your 20’s saving 10% of your salary each year to your 401k, you should be fine for retirement. But for someone who doesn’t start saving until they are in their 30’s and 40’s the percentage they need to save is usually much higher than 10%.
How Will The SECURE ACT BE PAID FOR
Most of these changes are positive for people, but that means that there is a cost associated with them. Allowing people to take deductions on their IRAs past 72 and not having to claim RMD’s for an extra 18 months means less revenue for the IRS. The government wanted to make this a revenue neutral bill so there was a change that was introduced that takes away the Stretch IRA. By taking away the Stretch IRA strategy it will generate the revenue needed to pay for the other changes.
The Elimination of the Stretch IRA
When a non-spouse beneficiary inherits an IRA they have to start withdrawing minimum distributions from it. However they are allowed to stretch those distributions over their lifespan.
As an example if a parent passes away in their 60’s and passes their IRA to their daughter who is in their 30’s, the daughter would have to take out a little bit from the IRA each year. But they are allowed to keep the majority of it in the IRA to grow tax deferred. The daughter’s lifespan may be another 50 years, so it is growing tax-deferred over a significant period of time. That’s how the Stretch IRA worked prior to the SECURE Act.
With the SECURE Act, that inherited IRA has to be depleted within 10 years. So now the IRS is guaranteeing that they’ll collect the full tax on that IRA within 10 years, and not have to wait 30, 40, 50 years to get it.
Most people won’t like this change because they are losing control over the account, being forced to deplete it in 10 years. But there are planning opportunities that arise from this
The new rule says that it has to be fully withdrawn by the 10th year. Your options include:
- Withdrawing the whole IRA immediately as soon as you inherit it
- Spread out the distributions evenly over the 10 years
- Do nothing for 9 years and withdraw the entire IRA in year 10
Advisors have to help figure out what is the best option to take. You usually will want to smooth your income out meaning that you don’t want the distribution to put you in a higher tax bracket or subject you to AMT, additional Medicare surcharges, …
If we look at this at a high level, most people die in their 70’s, 80’s, or 90’s, where they most likely leave money to their kids who are probably in their 50’s or 60’s. When you are in your 50’s and 60’s you most likely are in your peak earnings you. If all of a sudden you start having to deplete a $1 million IRA in 10 years, you have to figure out what’s the best way to do it so you don’t get crushed with taxes.
Maybe someone who is 62 inherits an IRA and plans on working another three years until 65. They may want to hold out three years before taking any distributions. And then at age 65 they spread out the distributions over the remaining seven years. It will get combined with Social Security and any pension they are receiving to determine what the tax would look like, but it is most like better than taking it in years where they are also drawing an income.
If you are inheriting it at age 50, a totally different strategy may make sense.
We approach it by taking a systematic approach to that decision and by looking at different scenarios. We have software that can calculate what it looks like and what is the best option to take in terms of your taxes.
One more thing on the stretch, IRA that I wanted to talk about is that it is important that you name a beneficiary on your IRA. If you do not designate a beneficiary, you don’t even get 10 years to distribute the IRA. You have to fully distribute it in 5 years. It’s important that you name a beneficiary and if you don’t it will go through probate and your will will dictate where it goes. If you don’t have a will the state will dictate who gets it.
But to take advantage of the stretch IRA, which is now a 10 year stretch, you have to name a beneficiary.
One thing to note is that the rules with a spouse stay the same. The spouse is not subject to the 10 year distribution.
When a spouse inherits an IRA, it gets transfers into an IRA in their name and the RMD’s are based on their life expectancy.
Just like we found out with the passing of the Tax Cuts and Job Acts of 2017 (TCJA) there will be planning opportunities that arise from the SECURE Act. I tried to cover the major changes at a high level, but it probably makes sense for everyone to take a deep dive to see which changes you can take advantage of.