At the same time many of us were caught up in a holiday flurry this past December, Congress was also busy—crafting a major new tax bill. The SECURE Act became law on December 20, 2019, and introduced another broad array of changes to US tax law (the first coming with the passage of the Tax Cuts and Jobs Act of 2017 just two years ago). The SECURE Act intersects with Individual Retirement Accounts (IRAs) in a number of ways. While the changes are generally helpful in encouraging more saving for retirement, a new limitation on inherited retirement accounts will make it more difficult to transfer retirement assets to your heirs tax-efficiently. Here are three big changes for 2020 you should know about.
Contribution rules
Prior to the SECURE Act’s passage, you were not allowed to make contributions to a traditional IRA after age 70 1/2. Beginning in 2020, the long-standing age restriction is gone; you may now make contributions at any age. You still need to have earned income (i.e., salary or wage income from work, not investment income) to make a contribution, and the contribution can’t be more than that earned income. Also, the old income tax deductibility rules still apply to IRA contributions in 2020: the tax deductibility of your contribution may be reduced if you (or your spouse) are covered by a retirement plan at work and your income exceeds a threshold amount.
The new rule went into effect on January 1, 2020. Unfortunately, you cannot make a contribution in 2020 for the 2019 tax year if the old rule would have prevented you from making a contribution in 2019.
If you plan on spending your whole traditional IRA account during your lifetime, this change can make a traditional IRA even more advantageous. Having unlimited time to save into an IRA allows you to sock away more money to use in your later years. However, if you plan on passing on some of your traditional IRA account to heirs, you may want to consider making Roth IRA contributions or completing IRA-to-Roth-IRA conversions instead of saving more to your traditional IRA. That’s because of the new rules for inherited IRAs, which I’ll get to shortly. First, though, let’s look at a new distribution rule.
Distribution rules
A second major rule change for IRAs in 2020 is pushing out the age when required minimum distributions (RMD) must start, to age 72. Previously, IRA account owners (except Roth IRA account owners) were required to take money out of their IRA accounts each year beginning when they turned 70 1/2 years old.
Just to be clear, you are not now required to take out the entire balance of your IRA account at age 72, as I’ve heard mentioned a few times since the new law passed. The new rule just means you can delay when you begin taking the required minimum amount from your account each year.
The new rule applies to IRA holders who turn 70 1/2 after December 31, 2019 (if you were born after June 30, 1949). If you already turned 70 1/2 in 2019 or before, you must take required minimum distributions according to the old rule.
The new rule will be helpful for IRA account owners who want to delay having extra income on their tax return and allow their account to continue its accelerated, tax-deferred growth even longer before having to start withdrawals. Distributions from IRA accounts (except Roth IRAs) are taxable as ordinary income in the year of the withdrawal. Pushing RMDs out to age 72 can give you an extra year or two, depending on your birthday, to avoid having to include IRA distributions in your income.
One example of how the push-out might be helpful is in the case of Roth IRA conversions. If you are pursuing a strategy of converting some of your IRA accounts to Roth IRA each year to get more money into the popular tax-free account type, lower income as a result of pushing out RMDs can allow you to continue IRA-to-Roth-IRA conversions an extra year or two at lower tax cost.
Inherited IRAs
Here’s where the changes in the SECURE Act get a little more complicated. If you may inherit an IRA from someone other than your spouse, or plan on leaving an IRA to your kids, there’s a significant shift to be aware of. Previously, upon the death of an IRA account owner, the person (or persons) who were beneficiaries of the account were able to take required minimum distributions (RMDs) from the account over a number of years, what the IRS estimated to be their lifetime. Withdrawals from inherited IRAs are taxed as ordinary income to the beneficiary and that income is added to their other income in figuring their income tax. The prior rule allowed beneficiaries to minimize the amount of income they received from an inherited IRA in any one year, thus helping reduce their taxes.
With the SECURE Act, the new general rule is that beneficiaries must withdraw the remaining account balance within ten years from the date of death of the original account owner. The new rule may significantly shorten the time period for withdrawals, thereby increasing the amount of withdrawal per year, potentially increasing the amount of income received, and tax paid by, beneficiaries.
As with the other changes, the new rules for inherited IRAs are effective beginning in 2020.
As a simple example of what this might look like, let’s assume that a daughter, age 50, inherits her father’s IRA account. She is in her peak earning years, making a large income and paying income tax at the highest federal tax rate. This means she would be better off under the old rule that allowed her to “stretch out” the distributions she must take from her inherited IRA over her lifetime, reducing the amount of income directed to her each year from the inherited IRA and thus not subjecting the inherited IRA withdrawals to the high income tax rates she faces during her working years. Under the old rule, she could take larger distributions later, once she is retired and potentially in a lower tax bracket. Yet with the new rule, she is forced to withdrawal all of the funds from the inherited IRA within ten years.
Not all beneficiaries will have to do this, though. There are specific exceptions to the ten-year payout rule, including those for a:
Surviving spouse;
Child who has not yet reached the age of majority;
Chronically ill individual; and
Individual not more than ten years younger.
These exempted beneficiaries may continue to take RMDs over their life expectancy. For them, the old rules still apply and they still benefit from the “stretch out.” A surviving spouse has a choice to i) roll over the deceased spouse’s IRA to his or her own IRA account and then begin RMDs at age 72 or ii) continue as beneficiary of the deceased spouse’s IRA (i.e., the IRA would become an inherited IRA) and take RMDs over his or her lifetime. Upon the surviving spouse’s death, the new ten-year payout rule would then apply to his or her beneficiaries. Similarly, a child who has not yet reached the age of majority (which varies by state) will take RMDs over the child’s life expectancy and then any remaining balance would be paid out over ten years to the child’s beneficiaries. The SECURE Act gives a strict definition for chronically ill individuals, which may not apply to many people. Siblings would be a common example of individuals not more than ten years younger. As with the other noted exempted beneficiaries, the ten-year payout applies after their death.
Another type of beneficiary of an IRA account is a trust, and the new rules affect this situation as well. Trusts might be used when the beneficiaries include minor children or individuals with special needs or be used to distribute assets to heirs over a certain period of time rather than upon death of the account owner. The SECURE Act ten-year payout rule now applies in many of these cases, making trust and estate planning around IRA accounts more complicated. Estate planning attorneys are reviewing the impact of the SECURE Act on existing trusts as IRA beneficiaries and developing strategies to adapt to the new rules. If you have a trust as beneficiary of an IRA account, you may want to check in with your estate planning attorney for a recommendation on this issue, which could have a significant impact on your estate plan.
An important point is that the new ten-year payout rule just requires an inherited IRA account be fully distributed by the end of ten years—there are no requirements for distributions in the intervening years. This presents planning opportunities; in many cases taxes may be minimized by revisiting your plans for inherited IRA withdrawals at least annually. Different situations suggest different optimal paths.
For example, in the case of inherited Roth IRAs, it might make sense to wait until the end of ten years to take a lump sum distribution. That way, the money in the Roth IRA will continue to grow tax-deferred as long as possible. And because distributions from Roth IRAs are tax-free, bunching the withdrawal all in one year has no effect on the account owner’s income taxes.
In another example, a 60-year-old beneficiary who inherits a traditional IRA (not a Roth IRA) and plans to retire in five years may decide to not take distributions from the inherited IRA for the first five years and then take five equal distributions over the final five years of the ten-year distribution period. Using this approach, there would be no additional income from the IRA during the beneficiary’s final five years of working, which will keep income tax as low as possible during that time. Then income from the inherited IRA can be spread over the first five years of retirement (in this example, the final five years of the distribution period) when there is no concern over minimizing income from work to reduce tax on income from the inherited IRA. This payout approach simultaneously allows the account to grow tax deferred for a full five years and then continue growing tax deferred each year after five for the undistributed portion of the account.
Each individual’s situation will be different and many factors affect the best strategy for withdrawing from an inherited IRA.
The new SECURE Act rules bring a number of changes. It will be important to think and plan carefully to derive or maintain the fullest benefit possible.
