In last month’s Viewpoint, Dan Krstevski outlined Individual Retirement Account (IRA) distribution rules and alluded to legislation making its way through congress called the SECURE Act. SECURE stands for “Setting Every Community Up for Retirement Enhancement.”
We don’t usually like to talk about pending legislation in Washington, but almost all the changes to 401(k) and IRA retirement saving plans contemplated within the legislation enjoy strong bipartisan support. The House passed the SECURE Act on May 23rd by vote of 417-3. While not yet taken up in the Senate, support for the legislation is nearly universal. President Trump has also expressed his desire for these retirement changes. The late Steve Jobs used to say, “It’s not done until it ships,” which is quite true in this day of divided government. However, we feel the changes contemplated by the SECURE Act are significant enough that they may impact your retirement and estate planning decisions.
The SECURE Act is a response to lengthening life expectancies and the need to bolster incentives for individuals to save earlier and more aggressively for their retirement. Many mistakenly assume that Social Security is going to cover much of their needs. According to the Social Security Administration, as of this year Social Security replaces only 41% of the average career earnings of workers making $51,894 per year. High earners are in for more of a shock as the replacement rate drops to 27% for those making $128,400 per year. Further, odds are that future income replacement rates will continue to fall in the face of demographic challenges and persistent U.S. budget deficits that will likely force benefit reductions and/or higher taxes.
The SECURE Act proposes these changes:
- Increases the age for taking Required Minimum Distributions (RMDs) from 70½ to 72.
- Encourages inclusion of annuities in 401(k) plans by providing guidelines to protect employers from future lawsuits if the chosen annuity provider does not pay claims. An annuity can generate consistent lifetime income much like the payments from a pension plan.
- The legislation includes various tax credits and encourages small companies to band together to offer a common 401(k) plan, helping spread the cost of administration and risk of legal liability.
- Part timers can now qualify to participate in a 401(k) plan with only 500 hours worked per year, down from 1,000.
- The percentage of contribution for automatic enrollment to 401(k) plans is increased to 6%.
- Repeal of the age limit for making traditional IRA contributions.
- To help workers understand what their savings will support in retirement, employers are required to disclose on 401(k) statements the amount of sustainable monthly income their balance can provide.
- Penalty free withdrawals of up to $5,000 for adoption or birth of a child (but the distribution is taxable income).
- Up to $10,000 from 529 savings plans can be used to pay some student loans.
- Employers can provide a 401(k) match to employees paying off student loans without the employee making a matching contribution.
To pay for these changes the SECURE Act makes major changes to Beneficiary IRAs, often called by their slang name “stretch” IRAs.
Under today’s law, non-spouse beneficiaries that inherit a traditional pre-tax IRA can take RMDs that are determined by their actuarial life expectancies. RMDs are calculated as a percentage multiplied by the value of the IRA at the end of the previous year. For example, a 30-year-old expected to pass away at age 80 has an RMD percentage in the first year of inheriting an IRA of 2.0% (1/50). The second year, at age 31, the denominator is reduced by 1, increasing the IRA distribution percentage to 2.04% (1/49). At age 50, the IRA distribution percentage is 3.33% (1/30). At age 70, the IRA distribution percentage is 10.0% (1/10).
A common estate planning technique has been to name young beneficiaries, such as children and grandchildren, for IRAs. This is because the power of compounding returns in the early years of investing the Beneficiary IRA can support growth of the account balance that far exceeds the very low payout percentage. The asset growth can then be used for the retirement of the beneficiary.
Effective January 1, 2020, the SECURE Act shortens the period for the RMD of a new traditional Beneficiary IRA to ten years. This will have the effect of significantly increasing the RMD percentage and, therefore, the taxable income of the beneficiary. Due to the progressive nature of the tax system, more tax dollars will be collected from the change. This is the intent of Congress to pay for the tax revenue forgone to the other changes in the SECURE Act.
There are exceptions to the accelerated 10-year RMD payout. Spouses are still allowed to inherit traditional IRA assets and take RMDs calculated as if they had made the original contributions. Other exceptions include the disabled, chronically ill, and beneficiaries within ten years of age of the deceased. Minor children are also exempt, but when they reach the age of maturity (18) the 10-year RMD payout begins.
I have some concerns about the SECURE Act. I’ve never been a fan of annuities. Insurance companies have done a good job of selling annuities as a combination of insurance and an investment vehicle, but the low return rate and high fees from ongoing management and surrender charges don’t qualify them as a good investment. Annuities don’t make sense for younger employees that are years away from retirement and would do much better by buying and holding high-quality growth stocks through up and down-market cycles. Not surprisingly, the insurance industry is a strong proponent of the SECURE Act.
Raising the age to begin RMDs to 72 is a step in the right direction, but I’d like to see RMDs for retirees completely removed. This would make tax minimization easier and help preserve assets longer, reducing the uncertainty for many of running out of money before their life ends.
I’d like to see the SECURE Act incorporate automated portability of 401(k) plans. Most employees can expect to work for multiple employers in their career and often cash out their 401(k) balance when they switch jobs, especially if the amount is small. Fortunately, the Labor Department is looking into this and expected to implement automated portability rules.
Finally, the loss of today’s very favorable RMDs for “stretch” IRAs will impact financial planning decisions, particularly for wealthy IRA holders. Interestingly, the accelerated 10-year RMD rules don’t apply to Roth (post-tax) retirement assets (Roth retirement assets can still follow the “stretch” RMD rules). Further, as budget deficits grow and Social Security and Medicare/Medicaid spending outpace the growth of tax revenue, pressure for tax increases will likely push up future tax rates, eating more heavily into accelerated RMD payouts.
We would be glad to discuss your particular financial situation with you and help determine if Roth contributions and/or traditional IRA to Roth conversions make sense.
Daniel J. Boyle, CFA