By Joyce Beebe, Ph.D.
Fellow in Public Finance
In late December, Congress passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act that changed how Americans approach retirement savings. The SECURE Act was made effective on Jan. 1, 2020, less than two weeks after it became law. However, despite its impact on Americans’ retirement financial security, the act has not yet gotten much attention beyond the circles of tax professionals and personal finance practitioners. Several reasons contributed to the lack of discussion. First, other important concurrent national and international matters, including the impeachment, the crisis in the Middle East and trade negotiations, probably shadowed the media coverage of the act. In addition, the act might be overlooked because it was included as part of the massive year-end spending bill (H.R. 1865, division O) that prevents the federal government from shutting down.
This article focuses on the SECURE Act provisions that change the rules governing tax-preferred retirement plans, including both employer-sponsored retirement plans and Individual Retirement Accounts (IRAs). A separate article discusses a provision in the SECURE Act that allows new parents to withdraw up to $5,000 per parent from their tax-preferred retirement saving accounts without penalty.
The Good
The purpose of the SECURE Act is to enhance the accessibility and flexibility of tax-preferred retirement saving vehicles. Several of its provisions are generally considered welcome updates to the retirement saving rules. Prior to the passage of the act, a person who was 70 ½ years of age or older could not contribute to an IRA even if they were still working; they also needed to start taking the required minimum distribution (RMD) once they reached this age. The 401(k) accounts do not have similar age restrictions for contributions, and the account owners do not have to take the RMD at 70 ½ if they are still working.
The age limit of 70 ½ for IRAs was put in place in the 1960s, but with life expectancies increasing and people working later into their lives in recent years, it seems reasonable to increase the age limit for contribution and required distribution. The SECURE Act eliminated the age limit on contributions to IRAs and increased the RMD age to 72. However, the primary drawback is the revenue cost to the government. The Joint Committee on Taxation (JCT) estimates that raising the RMD age from 70 ½ to 72 would cost $8.9 billion over the next 10 years (FY 2019 to FY 2029).
Several provisions of the SECURE Act focus on expanding retirement benefits to more small business employers and part-time workers. Specifically, the act makes it easier for small business employers to join the multiple employer programs (MEP, generally provided by several employers in the same industry), which reduces the costs of administrating retirement plans and potentially provides more investment options. The JCT estimates the MEP expansion would cost $3.4 billion over the next 10 years. In addition, the act provides startup credits for small business employers who set up retirement plans and credits for small business employers who incorporate an automatic enrollment design to their retirement plans.
Prior to the SECURE Act, employers generally excluded part-time workers who worked less than 1,000 hours per year from participating in the company retirement plans. The SECURE Act requires that if an employee works for a company for three years and at least 500 hours each year, she would be able to participate in the employer’s retirement program.
Although the SECURE Act includes provisions that motivate small employers to set up retirement plans and to encourage worker participation, some observers remain cautious about their effectiveness. They indicate that similar plans, including the Simplified Employee Pension IRA, Savings Incentive Match Plan for Employees IRA and self-employed 401(k) plans already exist for small businesses but have not been widely utilized.
The Bad
Congress believes that these tax-deferred accounts are intended to provide individual retirement security, so the account owners can spend their retirement savings during their lifetime instead of transferring wealth across generations. As a result, the SECURE Act incorporates a provision — arguably the most consequential one — that mandates most inherited retirement account balances be distributed (and therefore taxed) within 10 years after the account owner’s death.
Prior to the SECURE Act, a commonly used wealth-planning strategy allowed individuals to name a younger descendant (child or grandchild) as the beneficiary of their IRAs or employer-sponsored plans, and the account balance could be distributed over the young beneficiary’s much longer life expectancy. This “stretch IRA” strategy has multiple tax benefits. First, the assets in these accounts continue to grow tax deferred after the account owner’s death. Second, if the account owner has other sources of income during his retirement years, he only needs to take the RMD each year, and the assets in retirement accounts could potentially grow faster than the RMD withdrawals. Finally, the account owner can minimize the tax consequences because the heir can stretch the distributions over a long period. Numerous smaller distributions are less likely to push the heir into a higher tax bracket than a few large distributions.
The SECURE Act shortens the distribution period for most beneficiaries from their lifetime to 10 years. The four major exceptions to the 10-year rule include spousal beneficiaries, beneficiaries who are no more than 10 years younger than the original IRA owner (which could apply to beneficiaries who are siblings or unmarried partners), disabled and chronically ill beneficiaries, or beneficiaries who are minor children (but not grandchildren) of the account owner (the 10-year rule starts to apply when the child reaches non-minor age). According to congressional estimates, limiting the stretch IRA would increase revenue by $15.7 billion over the next 10 years and is the one provision that makes the SECURE Act revenue neutral.
The Ugly
Implementing the 10-year restriction substantially limits the benefits of deploying the stretch IRA strategy on several grounds. First, limiting the deferral timeframe accelerates the heir’s income tax liability, which can push his taxable income into a higher tax bracket. These distributions, although typically derived from debt or equity-based securities, are taxed at higher ordinary income tax rates instead of at lower capital gains rates. Once distributed, beneficiaries who invest the after-tax proceeds no longer enjoy tax deferral. Some observers therefore criticize such an expedited timeframe because it essentially encourages lavish consumption and punishes taxpayers who are frugal and wish to leave a modest bequest to their family.
Although congressional estimates show that 75% of the amount currently in IRAs will not be effected by limiting stretch IRA rules, and the congressional intent is not to have tax-preferred retirement saving accounts become wealth transfer tools, some observers blatantly disapprove this policy. Their criticisms of this provision are no less dramatic than the impact of the policy itself. Some critics focus on the short time between the law’s passage and its effective date, calling it “the new death tax.” Others claim that it is unusual that the government does not provide a grandfather provision to existing account holders. They see this as the government prioritizing revenue instead of taxpayer benefit and have even suggested that Congress can’t wait to get its hands on American retirement assets, like “grave robbers opening King Tut’s tomb.” Another critic calls this new change a “sucker punch,” criticizing Congress’s sudden change of rules. Similarly, other critics see it as a betrayal of taxpayers’ trust in the stability of government policy, calling the new 10-year distribution requirement a “bait and switch” tactic by the federal government.
Planning Techniques
Regardless of the names the act is being called, just like any cat-and-mouse game, financial planners have already recommended several strategies in response to the law change. After exhausting the possibility of deferring taxes with the exceptions (e.g., transfer to the surviving spouse or unmarried partner close in age), the most commonly discussed strategy is the Roth conversion, which allows the account owner to strategically manage when she pays taxes during her lifetime instead of leaving the heirs only 10 years to pay taxes after the owners’ death. Although several factors, such as the amount accumulated in the retirement account, the tax bracket (income) of the beneficiary and whether it is more tax-efficient to take several distributions or just one at the end of the 10-year period, all need to be considered, this strategy essentially matches the Roth conversion with the account owner’s lower income years to avoid large tax bills.
For instance, a retirement account owner affected by the stretch IRA limitation can convert her IRA to a Roth IRA through a series of conversions in small amounts to avoid substantial income increase in a particular year. If the account owner can use this conversion approach during the years after she stops working (lower tax rate) but before she needs to take the RMD (increased income), she will have the best chance of minimizing her taxes. An additional benefit of the Roth IRA is that it is not subject to the RMD age requirement. Because the taxes have been prepaid, this means under the new rules the beneficiaries of the Roth IRA should wait until the end of the 10-year window so they can preserve the longest period of tax-free growth.
Second, some planners recommend using the annual gift tax exclusion of $15,000 to bypass the 10-year distribution rule. Because the $15,000 applies to each beneficiary per year without incurring gift taxes, the amounts do add up across the years if the retirement account holder has multiple grandchildren, children or heirs. The gift amounts also would not be considered part of the owner’s estate. However, unlike the Roth conversion technique, the account owner does give up control of the money during his lifetime, which to some is undesirable.
Third, financial planners generally would use a trust as a planning tool if the account owner’s assets are substantial. For example, account owners who would like to use their retirement savings to make charitable contributions may set up the Charitable Remainder Uni-trust. Strategies that are more sophisticated may also combine the annual gift tax exclusion and a trust. This type of strategy could involve, for instance, setting up a trust and naming the retirement account holders’ heirs as beneficiaries of the trust. The account holders buy life insurance and name the trust as the beneficiary of the policy. The account holders can continue to take RMDs and attribute the RMDs as their annual gift tax exclusions to pay for the life insurance premiums until their death, at which point the policy would pay the death benefit to the trust. The trust would in turn distribute the proceeds to the beneficiaries — the original account owner’s heirs. Because life insurance benefits are generally not taxable at the federal level, the trust beneficiaries essentially defer the tax for the whole period and bypass the 10-year rule.
Revenue Neutrality
Whether limiting the stretch IRA is fixing a loophole that people abused as a wealth transfer tool or it breaks people’s trust toward the government because of the exclusion of a grandfather provision, some describe it as a “necessary evil” to exchange for other beneficial improvements to the retirement saving system from a government revenue perspective. Supporters of the bill touted that the SECURE Act pays for itself, meaning that the portions of the bill that expand retirement saving benefit accessibility and flexibility do not create a revenue drain for the Treasury. However, revenue neutrality is solely dependent on the revenue gains from limiting the stretch IRA. If any of the planning techniques are widely adopted, it is highly likely the revenue projection would fall short.
Some claim that although the limitation of stretch IRAs accelerates revenue collection, whether the government would get additional future tax revenue is a separate issue, as it depends on what taxpayers do with the proceeds from retirement account distributions. If a beneficiary withdraws from the account and puts the money in other tax exempt or deferred vehicles (such as tax exempted muni bonds or 529 accounts), spends the money or reinvests the money in non-dividend paying corporate stocks and holds the stocks until death, the federal government will receive little, if any, additional tax revenue beyond original withdrawals. Therefore, they argue that, from a revenue perspective, the government may be better off not to impose the 10-year rule and to let the underlying assets increase in value.
Overall, the benefits created by the SECURE Act probably still outweigh the costs, as more people are saving more for retirement. However, there are winners and losers — including the federal coffer.