Your client’s retirement nest egg should feel more secure now that the President has signed the Setting Each Community Up for Retirement Enhancement (SECURE) Act. However, depending on how much money is in their retirement nest egg, they may not be SECURE at all.
In May of 2019, the SECURE Act passed the House of Representatives by a practically unanimous margin of 417 yeas to 3 nays. In the Senate, a few Senators objected as the SECURE Act didn’t permit workers to use 529 college savings accounts to pay tuition for K-12 schools. Thus, the SECURE Act stalled in the Senate for the next six months.
The U.S. Congress then crafted a bipartisan 2020 budget bill that would avoid a government shutdown and provide a combined $1.4 trillion for the fiscal year 2020 across military and civilian departments. Looking to get the SECURE Act passed, Congress added the SECURE Act to the 2020 budget bill, and it was signed by the President into law on Dec. 20, 2019.
ONE CHANGE TO AFFECT MANY
One change that will affect virtually all your clients is the change to the required minimum distribution (RMD) Rules. Before the SECURE Act, Americans needed to take a required minimum amount from their IRA in the year starting at age 70.5. Under the new law, the SECURE Act increases that age to 72.
The SECURE Act also eliminated the maximum age for someone to make a traditional IRA contribution. Under the old law, once someone reached age 70 ½ they were no longer allowed to make an IRA contribution. Under the SECURE Act, an individual over age 70.5 can now make an IRA contribution of up to $7,000 as long as they have that much-earned income.
There is a caveat to this new law. Anyone who turned 70.5 years old in 2019 will still need to withdraw their required minimum distributions this year. Failure to do so results in a 50% penalty of their RMD. Americans who are expected to turn 70.5 years old in 2020 will not be required to withdraw RMDs until they are 72. This rule grandfather all participants that were already taking their ‘Stretch IRA’s prior to Dec 31, 2019.
THE BAD NEWS
Some of the good news concerning the SECURE Act is largely overshadowed by the bad news. The SECURE Act has just disrupted any previous retirement distribution/estate planning a client may have previously completed.
ELIMINATING THE STRETCH ADVANTAGE
The change that’s responsible for the largest financial hardship to the client is the change to the length of time a non-spouse beneficiary that inherits a traditional IRA must make their distributions and pay their associated tax obligations. The ability to spread out these distributions after the death of the IRA owner for a limitless amount of time was known as the ‘Stretch IRA’. That has now been changed as follows. If the beneficiary is more than 10 years younger than the IRA owner, they must liquidate the account within 10 years unless they are a spouse, disabled or chronically ill, or a minor child, which we’ll discuss more in detail below. For example, under the old law, IRA owners could pass their IRA onto their children and grandchildren. Their kids or grandkids could stretch the IRA distributions over the life of the beneficiary.
For example, if a 25-year-old inherited a $1 million IRA, they would take a distribution over their life expectancy of 57.2 years. Their distribution would be approximately $17,482. The federal tax, assuming a 24% bracket, would be about $4,195. Under the SECURE Act, the beneficiary would have to withdraw all the money within 10 years. Thus, they could withdraw $100,000 per year and pay $24,000 in taxes each year or withdraw all the money in the 10th year and pay the prevailing tax at that time. One way to offset that higher tax burden on the beneficiaries would be for the owner of the IRA to gift IRA assets to be used to purchase additional life insurance to make up for the additional taxes due for the increased distributions, as well as for the higher rates as a result of having to bunch up their distributions over a shorter period of time particularly in their peak earning years.
IRA owners certainly considered naming a non-spouse beneficiary to their IRA. However, the income tax they would have to pay was an issue. To avoid the large income burden, RMDs were paid to a “conduit trust” that would pass the RMDs to the beneficiary. Using a trust, preserved the balance of the IRA by protecting it from beneficiaries who might spend all of the inheritance. Under the SECURE Act, the IRA assets in a Conduit Trust would have to be distributed within the new 10-year period.
The elimination of the Stretch creates changes that require the need to review a client’s current estate plans to avoid any unwanted changes. A client can consider gifting Roth IRA’s or using a charitable trust to regain the stretch beyond 10 years. To make up for the assets donated to the charity, they may consider gifting a premium to pay for an amount of tax-free life insurance to make up for the donated asset.
EXCEPTIONS FOR RECIPIENTS
Congress did give an exception to certain people from this new 10-year rule. Spouses can roll retirement assets, like IRAs, 401ks, and other retirement plans, over to their own IRA and take their required minimum distributions once they reach age 72.
Other exceptions include chronically ill heirs and disabled heirs. Chronically ill is defined as someone unable to engage in any substantial gainful activity because of any medically determinable physical or mental impairment which can be expected to result in death. Chronically ill is also defined as an illness that is indefinite duration. Under the SECURE Act, disability is defined as being unable to perform (without substantial assistance from another individual) at least two activities of daily living for at least 90 days due to a loss of functional capacity. That means on the date of death, a chronically ill beneficiary will need a doctor’s note stating that on the date of death they were chronically ill unable to engage in any substantial gainful activity. This may result in higher taxes on disabled or ill people who couldn’t prove their disability or illness.
The last exception is for minor children. If the child is considered a minor, the 10-year rule doesn’t apply. Once the child is no longer considered a minor, then the child must withdraw the IRA proceeds within the 10-year period. There is a question as to what age a child is considered a minor. Most state that the age of majority is 18, but it can be argued that the federal age of majority can be based on an extended time if one is engaged in a specific course of education and is under age 26.
FUTURE PLANNING OPPORTUNITIES
Now that the SECURE Act has passed, what should your clients do now? Anyone who has left money to a child, grandchild, or trust will need to revisit their estate plan and beneficiary forms to see how the SECURE Act has affected them. Special consideration should be paid to retirement plans and certain IRA institutions. Without a beneficiary on file, some retirement plans and certain IRA institutions will default to the estate. This would be devastating to a spouse who should have inherited the money and would have avoided the 10-year rule. Without a beneficiary on file, the estate would pay the tax immediately on the retirement asset.
A WORD ABOUT LIFE INSURANCE
Life insurance will become a more important planning tool as people will need a way for children and non-spouse beneficiaries to pay the increased income taxes for the increased distributions. While life insurance is an ideal tool that can be used to prevent the further erosion of their inheritance, care must be taken to not only select the right type of life insurance, but to also understand the risks associated with the different types of life insurance, and most importantly to properly manage the policy over the years to assure that it will be there when needed.
There will be many useful and creative new ways to use life insurance and annuities to supplement and ease the tax burden of the beneficiaries. One way to offset that higher tax burden on the beneficiaries would be for the owner of the IRA to gift IRA assets to be used to purchase additional life insurance to make up for the additional taxes due for the increased distributions, as well as for the higher rates as a result of having to bunch up their distributions over a shorter period of time particularly now that many of the beneficiaries may be in their peak earning years.
Some of the most popular planning strategies include conversion to a Roth IRA, making a charity a beneficiary, and replacing the bequest to the family using a life insurance policy.
The government is also doing its share to make it easier for retirement accounts to be converted to a lifetime annuity through safe harbor provisions that allow employers to offer annuities inside qualified plans. Unfortunately, there will be other not so sound suggestions by the myriad of agents looking at this new law as a bonanza for selling new life insurance. Some will espouse the benefit of using life insurance as a leveraged less expensive way to pay the taxes but keep in mind that there are many different types of life insurance products each with their own best use.
Make certain that your clients are aware of the various risks involved with each product they’re considering. It’s also important to be aware of the various costs for those products with guarantees as opposed to products without such guarantees. An advisor must manage their client’s expectations with full disclosure as to what a life insurance product can and can’t accomplish.
EASIER RETIREMENT PLAN ACCESS FOR SMALL BUSINESS
If a business does not have a 401(k) plan, the SECURE Act made it easier for small businesses without a 401(k) to get one and it provides incentives. There are new and increased tax credits for employers to start a plan. There is also an additional $500 per year tax credit (up to three years) for employers to use automatic enrollments in their 401(k) plan.
In addition, retirement plans can now be established retroactively. The SECURE Act extends the period of time for companies to adopt a new retirement plan beyond the end of the year. The new date to start a retirement plan is the same date as IRAs; it’s now the due date for filing the company tax return. This gives accountants additional time to do some tax planning with their clients. However, this new extended period of time applies only to profit sharing and matching contributions. It doesn’t apply to 401(k) contributions.
Thus, clients who start retirement plans in 2021, for the 2020 tax year, will be limited to 25% of compensation (or 20% for self-employed people) and may not be able to contribute the maximum. For example, assume someone starts a retirement plan in 2021, for the 2020 tax year. They earn $100,000 on a W-2 and will be limited to a $25,000 contribution. They will not be able to contribute the maximum of $57,000 ($63,500 for those over 50 years of age) as 401(k) contributions may only be made prospectively and not retroactively. Only profit sharing and matching contributions may be made retroactively.
For small businesses looking to get into a low cost 401(k) plan, the SECURE Act changed the Multiple Employer Plans (MEPs) rules. There are two types of MEPs―open and closed. Closed MEPs have become very popular for businesses that had some commonality. For example, businesses that belonged to a trade group, a chamber of commerce, or a similar business association were considered a closed MEP. Since all members of a trade group or association had something in common, they could all belong to the trade group’s 401(k) plan. With everyone coming together under one plan, all of the members could get better pricing on the 401(k); since they had more money and more negotiating power.
Open MEPs, on the other hand, were businesses that had no commonality and due to bad legislation, were prohibited from banding together to get better 401(k) pricing. However, the SECURE Act contains adjustments to MEP provisions that make it much easier for small businesses to start or join a MEP. Your business no longer needs to have any commonality with other businesses in the MEP 401(k). Thus, you will not have to join a trade group or association to get a low cost 401(k) plan. The new MEP provisions will not take effect until Jan. 1, 2021.
Another benefit to come from the SECURE Act, is that 401(k) plans can now be set up before the due date of the tax return. Under current law, a 401(k) would need to be set up before the end of the plan year. This gives businesses a great tax planning opportunity to set up a 401(k) in January or February for the previous tax year. In addition, employers will now be required to advise employees of the amount of sustainable monthly income that their 401(k) balance could support. This rule now opens the door to income planning, which may include annuities and educational advice that many employees and their families will benefit from.
EASIER RETIREMENT PLAN ACCESS FOR PART-TIME EMPLOYEES
Since 401(k)s started, they were predominately for full-time employees. Part-time employees who worked under 1,000 hours could be excluded from 401(k) and profit-sharing plans. The SECURE Act now allows employees who work at least 9½ hours per week and have been with the employer for at least three consecutive years to contribute to a 401(k). The SECURE Act also excludes these long-term part-time employees from profit-sharing, matching, and top-heavy contributions. It even removes them from non-discrimination testing, which is of great news to business owners. This new long-term part-time employee rule will not take effect until 2021 and any service before 2021 will not be counted toward the three consecutive year rule.
THE BAD NEWS FOR BUSINESSES
Not all of the SECURE Act is good news. The SECURE Act does increase certain fines and penalties for 401(k) and other retirement plans. When a business has a retirement plan, it needs to file a Form 5500 with the Department of Labor. Form 5500 is due seven months after the close of the plan year, which is July 31 for a calendar year plan. There is a two-and-a-half-month extension available, allowing calendar year businesses to file on October 15.
The IRS penalty for submitting the 5500 late was $25 per day up to a maximum penalty of $15,000. The SECURE ACT increased the penalty to $250 per day up to a maximum of $150,000. The Department of Labor can also levy a fine for not filing the Form 5500 promptly. The Department of Labor penalty is $2,194 per day with no maximum. The Department of Labor penalty is in addition to any penalty that the IRS may levy. For being one year late with a Form 5500, potential penalties are in the hundreds of thousands and could bankrupt a small business. Thus, it behooves all accountants to make sure that their clients file the Form 5500 on time.
Businesses with retirement plans will need to amend their plans for all of these new rules. The deadline to amend plan documents for these law changes is the last day of the plan year beginning after Dec. 31, 2021 (i.e., Dec. 31, 2022, for calendar year plans).
While the SECURE ACT does make beneficial changes, the changes don’t go far enough to help Americans save for retirement. Also, the changes are very complex and accountants will need to become familiar with these changes as well as to guide their client’s through the maze of options explaining what the individual benefits and detriments are for each choice. Perhaps the CPA’s most important role is to have the client focus on the new rules, coordinate their new planning options with the client’s trusts and estate attorney, and to assist the client in taking advantage of what they want to accomplish for their loved ones in the most economical and tax-efficient manner.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Henry Montag CFP, Managing Director of The TOLI Center East in practice since 1984 with offices in Long Island, N.Y., has authored articles and acted as a source regarding life insurance matters and strategies for NYSBA, NYSSCPA , Bloomberg, and The Wall Street Journal. He provides continuing education credits to NYSBA, ABA, NYSSCPA, and co-authored an American Bar Association Flagship publication, 2017, titled; ‘’The Advisors’ & Trustees’ Guide to Managing Risk”
Brett Goldstein is President of The Pension Department Inc. and a pension expert for 29 years. He’s reached millions of consumers as a media personality featured or quoted in Forbes, Bloomberg, Fox Business Network, Kiplinger’s, Wall Street Journal Radio, MarketWatch.com, New York Daily News, The Chicago Tribune, and many other media outlets.