If you have an IRA or 401(k), please take the time to read this post. The Setting Every Community Up for Retirement Enhancement (“SECURE”) Act could pass the Senate this week. If it does, you should re-examine how you have planned for your retirement accounts.
The future of this new law was in doubt just a few days ago. The bill came out of the House Ways and Means Committee this spring with unanimous bipartisan support. But it ran into a snag in the Rules Committee. One of its original provisions would have allowed 529 plans to be used for several new purposes, including homeschooling expenses. The Democrats on the Rules Committee didn’t like the homeschool provisions. So, in a last-minute decision, they stripped most of the education provisions from the bill by adding it to a manager’s amendment. It passed on a party-line vote. Although this didn’t sit well with many Republicans, it was a minor part of a bill that had overwhelming support. It passed the House 417-3. Had the homeschool provisions not been removed, it would have been unanimously approved in the Senate. However, Ted Cruz was mad enough about the procedural move to block the bill. For a while it looked like the law might pass, if at all, several months from now. But now it appears that the Senate may have worked out a deal. It is anticipated that the new law will be attached to a must-pass budget bill, which will be voted on by this Friday.
If passed in its current form, the SECURE Act will make significant changes to retirement accounts. Most of the changes are intended to make retirement accounts more useful for retirement. That is, after all, why they were created. For instance, the law would allow contributions at any age, push back the age to start taking required minimum distributions (“RMDs”) to 72, and make it easier for smaller employers to implement retirement plans. It would also allow certain penalty-free withdrawals in the event of a qualified birth or adoption. But one big issue will be the effects on estate planning, specifically, the strategic use of the stretch IRA.
One opinion in The Wall Street Journal compared the new taxation scheme to “grave robbers opening King Tut’s tomb.” Under the current rules, a non-spouse beneficiary who inherits your retirement account has the option to stretch the RMDs over his or her lifetime. Small plans are often cashed in and taxes are paid immediately. However, larger accounts are usually allowed to continue growing tax-deferred for many years. The SECURE Act would shorten the life of an inherited IRA such that the funds must be withdrawn, and therefore taxed, within 10 years of the death of the original holder. There are some exclusions from this requirement, and the original Senate bill had an exemption for smaller accounts. But there will be big changes for large IRAs.
If you have significant tax-deferred savings, there are two practical issues that you must wrestle with. Both relate to asset protection and taxes. The first is whether you should adjust how you are leaving your retirement accounts upon your death. This will depend on the value of your retirement accounts at the time of your death. Of course, the value of those accounts at your death will depend on how you manage them during your lifetime, which is the second practical issue to address. While deciding how to leave retirement assets is an important and complicated decision, deciding how to manage them may be even harder. Anyone with a large retirement account should sit down with their financial advisor, accountant, and estate planning lawyer to figure out these issues.
There are three ways to leave retirement accounts: outright, to a conduit trust, or to an accumulation trust. Because of the statutory creditor protection, many people leave their retirement accounts directly to their responsible adult children. Although there are still a lot of things that could go wrong, the principal of an inherited IRA is protected if the beneficiary lives in N.C. Those who want to add incapacity protection, control the contingent beneficiaries (i.e. make sure that if your daughter dies young your IRA goes to your grandchildren instead of your son-in-law), and ensure that those accounts are protected if a beneficiary moves out of N.C. often leave these accounts to a conduit trust created under a will or a revocable living trust. Even under current law, those people who want the best creditor protection possible establish a standalone accumulation trust that is drafted for the sole purpose of handling retirement accounts.
The new law will not affect the asset protection of accumulation trusts. But it will have a major effect on the other two methods. Under current rules, if you leave an IRA outright to your 40-year-old son who lives in N.C., the RMD in the first year is likely to be less than the investment returns. Even if you left the IRA to him outright, if he only took the RMD, the remainder would be protected from creditors. Although the RMDs will rise over time, he can continue to protect the principal and defer taxes over his lifetime. The SECURE Act would force him to withdraw those funds within 10 years of your death. The asset protection disappears, and he has an additional $500,000 in taxable income at some point during those ten years. That is not an ideal situation for either asset protection or tax planning. In certain cases, it could be catastrophic.
If asset protection of qualified accounts is a concern, then either an accumulation trust or a trust that does not qualify as a designated beneficiary will be the only options for long-term protection. But leaving retirement accounts to a trust could mean that income taxes will be even higher.
The real work in adjusting to the SECURE Act is going to be determining the best way to plan for retirement. One of the goals for many of our clients will be to minimize the value of 401(k)s and traditional IRAs at death. One way to do that is to use them up. These new required “lifetime income disclosures,” could easily be considered an advertisement for annuities. David Moon, a columnist with the Knoxville News Sentinel, called the SECURE Act “a piece of insurance company legislation jokingly masquerading as something to help the little guy.” While this bill may make it easier for the person with a $50,000 401(k) to estimate retirement income, it will complicate greatly the management of large accounts.
One of the reasons to contribute to tax-deferred plans is the idea that you will be in a lower tax bracket in retirement. That is often not true. And even if your tax bracket drops, it is impossible to know what the rates may be. It would be hard for me to conceive of a scenario where tax rates on the upper middle class will go down in the future. In fact, unless Congress agrees to change the law, we know that taxes will go up. If the 2018 tax law sunsets, tax rates will go up in 2026. Tax bracket management will become increasingly important. This is something that you must discuss with your financial advisor and accountant.
The coordination of legal, financial, and tax strategies will be critical for large accounts. Under the SECURE Act, a Roth IRA can continue to grow tax deferred for your life plus 10 years. It can also be held after your death in a properly drafted trust. Roth conversions may make sense now even if they did not a few months ago. Using RMDs to pay for permanent life insurance that will be paid to a trust with lifetime asset protection may be a tool that is more appropriate than ever. Charitable remainder trusts could become a more attractive option. There may be other strategies as well.
The important takeaway is that the retirement landscape is changing. Probably this week. If you have large 401(k)s or IRAs, it has never been more important to seek the advice of advisors whom you trust.
UPDATE: The SECURE Act did not pass the Senate at the send of July. Stay tuned.