Guiding Clients Through the SECURE Act: What Financial Advisors Need to Know

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In December 2019, Congress passed the Setting Every Community Up for Retirement Enhancement Act, or the SECURE Act, which has far-reaching consequences for Americans at every stage of their financial planning lives. The SECURE Act is one of the largest overhauls of the U.S. retirement system to date, with sweeping changes that could immediately impact investors’ short and long-term retirement planning. Considering the potential tax consequences, we thought we could help cut down on confusion by outlining some of the SECURE Act’s major provisions that advisors can discuss with clients.

Changes to IRA Required Minimum Distribution Age and Contribution Limits

For those in retirement or close to it, the SECURE Act is especially important when considering IRAs and access to certain tax-advantaged accounts. The Required Minimum Distribution Age (RMD) has been extended from 70 ½ to 72, which allows for continued contributions and growth of IRAs for an extra year and a half. While that may not seem like a lot, it gives IRA owners some flexibility, and the additional time gives them an opportunity to grow their tax-deferred assets while taking a deeper look into some of their tax and estate planning. Clients can also decide whether they want to take an early distribution and spread out the tax burden.

Another important provision of the SECURE ACT is the elimination of the age cap of 70 ½ for contributions to traditional IRAs; thus, contributions to those accounts can now be made indefinitely. This could impact your clients in a few ways, the major one being that if they are still working but stopped contributing to their traditional IRA once they reached 70 ½, they can start again and continue for as long as they are working.

Changes to Lifetime “Stretch” Provision IRAs

Probably the most notable change to arise from the SECURE Act will affect one of the most common ways that clients traditionally transfer wealth within their families. Previously, one of the more efficient methods of wealth transfer was for investors to leave retirement accounts (e.g. IRAs and 401(k) accounts) to their heirs with the amount of withdrawals allowed based on the beneficiaries’ life expectancy.

This let family members, specifically, children or grandchildren, “stretch” distributions from these IRAs over decades without moving into a higher tax bracket, meaning the amount of tax obligation was also spread out over their lifetimes. In stretching out distributions over decades, inherited IRAs also experienced decades of growth.

As of January 1, 2020, the life expectancy rule only applies to spouses. For anyone else, accounts must be completely depleted within 10 years, regardless of tax consequences. The only exceptions made are for recipients who are terminally ill, disabled or minors. Once minors reach the age of majority, which is 21 in most states, however, the 10-year rule applies.

Another potential issue created by the SECURE Act is that certain IRA trust accounts with specific withdrawal guidelines around amount and frequency that are left to heirs could be voided and replaced by the 10-year rule.

Mass-Affluents and the Great Wealth Transfer

As we enter the “great wealth transfer,” baby boomers are leaving approximately $68 trillion to their heirs, so investors and mass-affluents with significant assets in traditional retirement plans and IRAs may want to re-think some of those plans. Future non-spouse heirs could be faced with exceptionally high tax bills depending on the circumstances.

Most beneficiaries of the great wealth transfer will be in their 40s or 50s, which are generally known as peak income-earning years for many. A 10-year period is thus limiting, plus, it will likely push those beneficiaries into their highest-ever tax brackets for years to come. This also means that a younger beneficiary who was left money by a grandparent could inadvertently be pushed into a much higher tax bracket earlier than anticipated.

Even for those beneficiaries who have reached the “penalty-free” age for withdrawals, which is 59 ½, the 10-year limit still applies. One workaround for these clients is to take out as much money as they can for the first nine years while making sure they stay in their current tax bracket, and then take the remainder in the 10th year.

Roth IRA Conversion Strategies

Financial Advisor IQ recommends that certain IRA account holders might want to leave some of their IRAs in non-qualified accounts for beneficiaries. Even though that will generate capital gains, money bequeathed to heirs from non-qualified accounts can be withdrawn more slowly, and likely at a lower tax rate, than under the current SECURE Act’s 10-year rule. This is because heirs can take advantage of step-up allowances for inherited assets. Capital gains taxes are also likely lower than income tax rates for many.

Another recommendation is that clients try and convert as much of their 401(k) or IRA income as possible from a traditional IRA to a Roth IRA. While the conversion from a traditional IRA to a Roth is itself a taxable event, the inheritance is income tax-free.

Leon LaBrecque makes some of the following suggestions for Roth conversions:

  • As Roth IRAs do not have an RMD age for the owner, if someone grows a Roth until their death and leaves it to a spouse, the spouse can leave it to their children, who can let the account continue accumulating, tax-free, for another 10 years.
  • Consider a Roth Contributory IRA, which has a “First in, First Out” or FIFO rule that permits contributions to be withdrawn penalty tax-free at any time once a client turns 59 ½ . This is because the contributions made to the Roth Contributory IRA are subject to income tax the year the client earns the contributions, so when they’re withdrawn taxes are already paid.
  • Back-door Roth conversions allow for households earning more than $186K to contribute to a traditional IRA, which can be immediately converted into a Roth.

Additional Ways Investors Can Offset the Change in Stretch Provision IRAs

Given that spouses are not affected by the 10-year rule, Insurance News Net says that one way to navigate the SECURE Act change is by leaving an IRA directly to a spouse, who could in turn convert the IRA to their own name and then will it to the intended non-spouse beneficiaries. This allows for a longer withdrawal period. Assets can be stretched across the spouse’s lifetime and then passed on to children or grandchildren, who would still have 10 years to draw the account down.

Also, if investors who are older than 70 ½ have earned income, they may be able to bypass RMDs by contributing to a Roth IRA. Although the account would still have to be liquidated in 10 years upon inheritance, there would be no tax penalty once the Roth IRA has been open for five years.

Another consideration could be the purchase of a life insurance plan naming the non-spouse beneficiaries as life insurance plan proceeds are tax-free, and payment is guaranteed. Some have suggested that IRA account owners substitute life insurance for an IRA by taking a withdrawal at the RMD age of 70 ½ from the IRA to fund a life insurance plan.

Additional SECURE Act Considerations:

The SECURE Act has 30 different provisions, and while we’ve outlined the two most well-known points above, there are a few more taxpayer-friendly ideas financial advisors should discuss with clients.

Flexibility With 529 Plans

The SECURE Act has allowed for some flexibility with the use of 529 plans so that parents or grandparents can assist a college graduate with student loans. While the benefit is limited to a lifetime maximum of $10K, each 529 plan allows for one beneficiary or sibling of the beneficiary, so each child would be allowed to draw $10K tax-free to use for student loan payments upon graduating from college.

Penalty-free Withdrawals: Childbirth or Adoption

Under the SECURE Act, families now have an option should they need additional cash to offset the costs of the birth of a child or an adoption. Parents can take up to $5K out of a qualified IRA account penalty-free. The limit is $5K per child, and families have within one year of a birth or child adoption to withdraw funds (after, not before the event). It may not be the most tax efficient option, given that the $5K will be subject to income tax; however, it remains an option.

Qualified Charitable Distributions

Qualified Charitable Distributions (QCDs) have been indirectly affected under the SECURE Act as well. QCDs still require that anyone who wants to make a contribution be age 70 ½, but now that the RMD age has been raised to 72, clients can make charitable contributions prior to taking an RMD.

Those who would like to support a charity can still use non-taxable accounts for Qualified Charitable Distributions, up to $100K per year from an IRA to a qualified charity – and it doesn’t count as realized income from their distribution, since it’s voluntary. In the past, investors used QCDs to reduce the tax obligations for a Required Minimum Distribution because in doing so, they could avoid a large portion of tax ramifications from taking the distribution. Beyond reducing the IRA balance, future RMD amounts will not be affected.

Conclusion

The SECURE Act is a good impetus for financial advisors to reach out to clients, be they high net worth individuals, businesses and institutions, or mass-affluents. The acceleration of IRA payouts requires at least a conversation with clients about the myriad ways they can plan thoughtfully around willing of estates and retirement income to their beneficiaries.

While overall, this legislation has created mechanisms for most Americans to save more for their retirement, it is recommended that advisors strategize with their clients. For more information, contact us at B. Riley Wealth Management: https://brileywealth.com/.

Disclosure: Our firm is not a tax or legal advisor. Although this summary is not intended to replace discussions with your tax and legal advisors, it may help you to comprehend the tax implications of your investments and plan efficiently going forward.

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