Most people don’t know the first thing about the Secure Act and yet it has great impact on their retirement planning.
With little fanfare, the Secure Act (Setting Every Community Up for Retirement Enhancement Act) was signed into law on Dec. 20, 2019. It’s an important piece of retirement legislation that includes many reforms that could make saving for retirement easier and more accessible for many Americans.
For example, the law expanded access to employer-sponsored retirement accounts, raised the required minimum distribution age to 72 and allowed families to use 529 college saving plan funds to pay back student loans.
These are all good things for individual investors.
However, there is one potential downside: The Secure Act made a major change for beneficiaries of individual retirement accounts and 401(k) plans.
One of the bill’s provisions requires that inherited qualified retirement accounts must be liquidated within 10 years. That means if you inherit an IRA or a 401(k) plan from someone other than your spouse, the Secure Act could impact your retirement savings plans or strategies to transfer wealth to future generations.
Prior to the act, if you inherited an IRA or 401(k), you could “stretch” your taxable distributions and tax payments out over your life expectancy. To be sure, many people have used stretch IRAs and 401(k) plans as a reliable lifetime income source. Now, for IRAs inherited from original owners that passed away on or after Jan. 1, 2020, the new law requires most beneficiaries to withdraw assets from an inherited IRA or 401(k) plan within 10 years following the death of the account holder.
It could result in millions of Americans paying tens of thousands of dollars in additional taxes each year. And the rub? Not many investors have a clue it could happen, nor, for that matter, do some financial advisors.
To illustrate the stakes, consider a hypothetical newly retired couple. They have $3 million in assets — $2 million from non-qualified accounts and another $1 million from an IRA.
Any competent financial advisor would direct them to live mainly off Social Security and their non-qualified investments (which come from sources already taxed) and use IRA proceeds (which tax-deferred) sparingly.
Assuming the couple owns their home and their health is good, this approach would allow them to live comfortably and keep their taxes low. The 10-year drawdown provision, however, could cause some investors like this to be more mindful of their heirs.
For instance, let’s say the couple has a sole heir, a single-filing daughter whose annual income is just under $70,000. Before the Secure Act, she could have inherited a $1 million IRA – which is possible depending on the type of account, market conditions and how old her parents were when they died – without absorbing much of a tax hit. All she would have to do is make sure she didn’t take too much, too soon.
Post-Secure Act, however, her taxes will spike. Even if she spreads out the mandated withdrawals evenly over 10 years ($70,000 + about $100,000 = $170,000), she will jump two tax brackets (from 22% to 32%). All told, it could easily add up to a six-figure hit.
What about a joint-filing heir in the same situation? Granted, while the ramifications wouldn’t be quite as severe, their taxes would still go up, perhaps complicating their financial planning.
Therefore, retirees whose taxable income is less than their heirs’ – which is the case for most retirees – should at least consider whether it makes sense to approach things differently. Were they to draw down their qualified assets more aggressively and keep larger non-qualified account balances, here’s what could happen:
Their tax obligation could be far lower than what their higher-earning heirs may pay in the future.
At the same time, they could make strategic withdrawals from non-qualified accounts to ensure that their rate doesn’t go up too much (i.e., pushing the limits of one bracket without going into the next one).
Meanwhile, because their qualified accounts receive a step-up in basis, this would reduce their heirs’ tax burden even further. That’s because the gains on such accounts are taxed based on the value when the benefactor dies.
Not everyone, of course, will embrace a plan like this. You may feel like you’ve saved and invested for decades and therefore shouldn’t have to worry – or, frankly, care – about whether your adult child must pay a bit more in taxes each year. (After all, they’re getting an inheritance!)
But, again, we’re not talking about pennies on the dollar. Indeed, the stakes for some could be well over $100,000. So just as many put in place estate-planning strategies to protect more of their wealth, it’s at least worth sitting down with an advisor to think about if it makes sense to do the same when it comes to the implications of the Secure Act.