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The SECURE Act: What it Means for IRAs and Why it Makes Me Feel Less Secure

If a significant portion of your estate value is held in traditional IRAs, 401k plans, or other qualified (pre-tax) retirement accounts, you should strongly consider talking to your financial advisor about reviewing your lifetime tax strategy and estate plan. It’s likely that both need to be revised due to the SECURE Act.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 was presented to the public as a bill that would help most Americans save for retirement. Admittedly, it does have some saving friendly provisions that could help spur more businesses to establish new retirement plans or expand opportunities for employee participation in existing plans. For those who are nearing retirement, these expanded saving options won’t help much; but the new statute does delay taxable Required Minimum Distributions (RMDs) to age 72, rather than the current age of 70½ (later is generally better from a lifetime taxation perspective). So, what’s not to like?

The SECURE Act effectively eliminates one of the largest tax saving benefits for those who have a significant amount of retirement savings in a traditional IRA account: the ability for non-spouse beneficiaries to “stretch” the RMDs over their lifetime. Here is an example of how this works. If I have a $500,000 IRA with my wife named as the primary beneficiary and my child as the alternate beneficiary, and my wife and I pass away at the same time, my child will inherit a $500,000 IRA. Under previous law, my child would have been required to take annual distributions from the inherited IRA even though they had not reached age 70½. From a tax perspective, this was bad news because those annual distributions are taxed each year as ordinary income (similar to wages), even if they don’t have a financial need for the distribution that year. The good news (or the not-so-bad news) was they were allowed to “stretch” those required annual distributions over their lifetime based on their own age (rather than mine) to determine the annual distribution amount. Using the current actuarial tables, if my child was only 30 years old when they inherited the IRA, they would divide the value of the IRA by 53.3 to determine the amount of required distribution in the first year. If the IRA value on December 31st of the prior year was $500,000, their first year distribution would have been just $9,381 ($500,000 divided by 53.3). If they were in the 22% tax bracket, they would have paid $2,064 of additional tax that year ($9,381 multiplied by 22%) due to the distribution.

With the SECURE Act enacted into law, the “stretch” option for most non-spouse beneficiaries is eliminated by requiring all inherited IRAs to be cashed out within a 10-year timeframe. Going back to my last example, if my child is age 30 and now has to cash out a $500,000 inherited IRA over a 10-year period, the best they can do is to take distributions of $50,000 per year and pay $11,000 ($50,000 multiplied by 22%) of tax per year. This would result in nearly $9,000 of additional tax per year for the first 10 years, which could have stayed invested in the IRA to grow tax deferred for a much longer time period. That’s assuming the additional $50,000 of taxable income each year doesn’t push them into an even higher tax bracket! When accelerated taxable distributions force heirs into a higher tax bracket for 10 years, the long-term negative financial impact will be much more severe. The effective rate for heirs who are currently near the top of the 12% tax bracket, for example, could nearly double under the new law.

To be clear, the SECURE Act does not eliminate the option for a surviving spouse to stretch RMDs over their lifetime—it only impacts most non-spouse beneficiaries. In addition to surviving spouses, the previous stretch provision is still available to certain “designated beneficiaries,” which includes disabled and chronically ill individuals (per IRS rules), and beneficiaries who are no more than 10 years younger than the IRA owner. Additionally, the 10 year clock does not start for minor children until they reach the age of majority (usually age 18 or 21).

The majority of my clients have spent their lifetime working hard and saving for retirement through their company sponsored retirement plans, and the odds of their surviving spouse needing all of those funds during their lifetime are low. This means the odds of eventual inheritance by a child or other relative who does not qualify as a “designated beneficiary” are generally high.

In summary, the passing of the SECURE Act has been presented to the American public as a bi-partisan victory. But for those of us who have made personal sacrifices in order to aggressively save for retirement with the hope of someday blessing our children with some of those tax deferred savings, the passing of this act feels more like a defeat.

K. Paul Hansen, CFP®, CPA

LEGAL INFORMATION & DISCLOSURES

This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. Community First Bank, HFG Trust, and HFG Advisors have no duty or obligation to update the information contained herein. Further, Community First Bank, HFG Trust, and HFG Advisors make no representation, and it should not be assumed that past investment performance is an indication of future results. Moreover, wherever there is potential profit there is possibility of loss. This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services, banking services, or an offer to sell or solicit and securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Community First Bank, HFG Trust, and HFG Advisors believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, included the information contained herein, may not be copied, reproduced, republished, or posted in any form without the prior written consent of Community First Bank and/or HFG Trust and/or HFG Advisors. HFG Advisors, Inc, is a wholly owned subsidiary of HFG Trust, LLC. HFG Trust, LLC is a Washington state-registered Trust company and wholly owned subsidiary of Community First Bank.