If you think this is just for retirees, please don’t stop reading!
Recently the Secure Act, officially known as the Setting Every Community Up for Retirement Enhancement Act (who comes up with these names?), was passed with little attention received except one change which impacts retirees close to their Required Minimum Distribution (RMD) Date. The Secure Act however is much more important than just that one part and will have significant impact on legacies going forward.
Before we get into why this is so important for all age groups, let’s first review the major changes in the act. There are 10 major parts to the act but I am just going to focus on the major changes that will have the most impact (saved the most important for last).
- First, currently when someone turns 70 ½ they must start taking distributions from their qualified plan (401k, IRAs, 403b, etc.). This is called the RMD. In theory, the formula for the RMD is your account balance divided by the number of years left in your life expectancy determined by actuary tables. At 70 ½ the number was 27. Basically, the IRS is saying we let you keep this money for years without paying taxes but now we want our part of it. Whether you need the money or not, you are required to take this distribution. Doesn’t sound like that big of a deal when you are younger but once you hit that age, don’t need the money, have to take the distributions anyway, and start paying taxes on money you don’t need (this could also impact your Medicare and social security tax) , it becomes an issue quickly. There are some tax advantage methods to help with RMDs but this isn’t the place for that discussion. Call us if you want more detail on that. Back to the topic, The Secure Act now moves that age to 72 starting in 2020.
- The second nice new provision is new parents can now withdraw up to $5,000 from their IRAs penalty free for birth or adoption. The withdrawal is taxed but you will not be charged the 10% early withdrawal penalty.
- Next, congress is catching up to what the new retirement looks like in the next provision, or maybe the average age of congressmen and women just hit 70 ½, as they have repealed the rule preventing people over 70 ½ from making deductible contributions to traditional IRAs. You still need employment income before you may contribute.
- Finally, the most financially impactful change, which impacts people of all ages, is the new provisions regarding stretch IRAs. When the owner of an IRA passes away and the beneficiary is a non-spouse, RMDs must either start (if the owner was younger than 72) or continue if they were already taking RMDs. There was a very nice strategy called a Stretch IRA. Before the new provision, the RMD formula went from the owner’s years left in life expectance, prior to their death, to the beneficiary’s life expectancy. Thus, if an owner at 71 passes away and a 40 year old child is the beneficiary, the denominator goes from 27 to 43. That means if it is a $1,000,000 IRA, instead of a $37,000 RMD (41M divided by 27) it is now lower at $23,400 ($1M divided by 43). That is $14,000 that wouldn’t be taxed and could stay in the IRA to potentially grow.
How have the rules changed?
The rules have now changed significantly. Stretch IRAs are now limited to a 10-year max. Instead of deferring taxes over multiple decades, the IRA must be spent down in 10 years. Why is this important? Two reasons. First, on a smaller scale, it could have a significant impact on trusts that have a pass thru feature for IRAs. Please see your estate planner if this could possibly impact you. Two, from a perspective that may impact many more people, take a look at the following chart:
As you can see, top marginal tax rates are close to historical lows. With our national debt issues, is it realistic to expect these to stay low? Do you think they are likely to go lower? I don’t. It is important to note, this is important regardless if you are talking about distributions during your life or your beneficiary. You could possibly be deferring taxes into a much higher tax rate environment OR burdening your children with high tax liabilities.
When you are young, it is pounded into your head by the media and advisors who don’t think it through to “max out your 401ks.” Should you? If you don’t want to run the numbers, let us so you can see what happens if the tax rate tops out at 80% again and you deferred income. I believe most would agree that you should take advantage of the company match. What about after that? There might be better avenues, like:
- Roth IRAs, which do not have requirement minimum distributions in your lifetime because they aren’t taxable even if distributions are taken after 59 ½.
- Roth Conversions. This is when you convert a current tax deferred IRA into a Roth. Yes, you must pay taxes on the conversion today but please refer back to the chart above and see where your risk lies.
- Cash value life insurance. There are many benefits to cash value life insurance, with tax advantages such as growth, income and legacy building all being at the top. In my opinion, the number 1 misunderstood and ignored wealth builder and distributor in all of wealth management.
It is important to know your risk. It is also important to plan for the future when it comes to wealth. That is if you care to maximize your wealth.
If you would like more information on the three potential avenues listed above, please feel free to give us a call.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. The term “Stretch IRA” was a marketing term used to describe an IRA that was set up to extend the period of tax deferred earnings beyond the lifetime of the individual who created the account. The accounts were typically designed to last over multiple generations. The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change. Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation. The economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful.