Ok folks, we're one week into 2020 and I hope everyone is happy, healthy, and optimistic about the future.
In an effort to focus on year-end client needs (notably, Roth IRA conversions and establishing retirement accounts), I took most of December away from this newsletter.... But there has been A LOT to read and digest. Most notably, the passage of the SECURE Act that will impact almost every one of us.
Sweeping reform like this rarely occurs, so I wanted to make this version of Three Things a special one to cover the three most important pieces of the SECURE Act and how it may affect you.
Adam Harding, CFP / Smartvestor Pro
If this is your first time receiving this email, here's some background: "Three Things" is a quick weekly email to recap some things that stood out to me in the previous week. I try to find inspiration in articles, videos, images, and anything else that I can tie into a financial planning or investment tip. Let me know if there's something you'd like to see covered, or if you happen to spot something interesting which you'd like to share. I hope you find this insightful!
First A Little Overview...
When the Secure Act went into effect on January 1st, 2020, it changed several rules and regulations around saving in retirement accounts, distributing those savings during retirement, and how your heirs will inherit them. At first look, the Act will have some provisions which will affect nearly all savers; this newsletter is going to just focus on those items:
First, the SECURE Act is an acronym which stands for:
S - Setting
E - Every
C - Community
U - Up for
R - Retirement
E - Enhancement
Pretty good, right? Maybe I should establish an acronym for my firm:
H - Hope for
A - A
R - Really
D - Darn
I - Impressive
N - Net
G - Gain
...Although this doesn't really sum up our value proposition of helping clients build wealth while simplifying their financial lives, so I'll have to work on that a bit more.
Okay, back to the Act.
Here are Three Things that will almost certainly affect you at some point:
THING #1: Changes to RMD Rules and Late IRA Contributions
- Prior to the passage of this act, investors had to make sure they took Required Minimum Distributions (RMDs) from Pre-Tax retirement accounts (like IRAs, 401(k)s, SEP IRAs, etc.) after they reach age 70½.
- Under the SECURE Act, investors aren't required to take RMDs until they reach age 72.
- Key Takeaway: Investors can defer paying taxes for a couple more years unless they voluntarily take retirement account withdrawals (or make Roth IRA conversions)
- For investors who turned 70½ in 2019 or earlier, the old rules apply to you and you must begin --or continue-- taking Required Minimum Distributions.
- Prior to the passage of the SECURE Act investors weren't allowed to make contributions to Traditional IRAs beyond age 70½. Investors can now contribute to their traditional IRA after age 70½, provided they have earned income. However, they still may not make 2019 (prior year) traditional IRA contributions if they are over 70.
- There are no changes to the contribution rules for Roth IRAs.
NEW RULES AROUND INHERITED IRAs FOR NON-SPOUSES
(When a spouse inherits an IRA, the IRA simply becomes owned by the surviving spouse, so this isn't applicable to those situations).
The SECURE Act changed one commonly-used strategy for withdrawing funds from an inherited IRA --the "stretch" provision.
First, a little context:
The IRS wants you to eventually have to pay taxes on assets, which is the reason Required Minimum Distributions exist at age 72. However, when someone inherits an IRA they are required to begin taking distributions regardless of their age...
Before the passage of this Act, a beneficiary of a retirement account would have the ability to stretch out the annual required distributions over the course of their entire life by taking the smallest distribution legally allowed.
When the amount withdrawn from the account is small, so is the income tax associated with those withdrawals.When the amount each year is small, the odds of those withdrawals having a significant impact on the effective income tax rate of the individual are low... Thus, a common strategy under the old rule was to take out only the required minimum.
And just like that, The SECURE Act puts the Kibosh on the whole strategy.
Under the new rules, the entire inherited retirement account must be withdrawn within 10 years.
That may not sound like a big deal, but it could be for some wealthy individuals.
For example, let's say a beneficiary is still working and they inherit a parent's pre-tax IRA with a balance of $1,000,000.
Assuming the unlikely scenario of 0% investment growth over the next 10 years, there would need to be an average of $100,000 withdrawn per year, then claimed as income, and subsequent income taxes paid.
As a reminder, here are the 2020 Federal Income Tax Brackets:
As you can see above, $100,000 per year in additional income is enough to cause at least some of that income to be taxed a higher rate (not all of the income though: recall that our system is a progressive tax system).
Under the flexibility of the old "Stretch" approach, the investors could moderate their withdrawals to take out more in low income tax years and less in high income tax years.... When the entire balance must be taken out in 10 years, this optionality goes away.
At the end of the day, this doesn't impact every investor but it's certainly something to think about as you're building a multi-generational wealth plan.
If you find yourself in a low current tax bracket and plan to leave pre-tax retirement assets to your heirs, then it can make some sense to pull funds from those accounts (or convert them to Roth IRAs) during your lifetime.
I'll continue to discuss these matters with clients, but don't hesitate to reach out to me about this if you have questions or want to talk strategy.
401(K) PLANS TO EXPAND AVAILABILITY OF ANNUITIES
As the SECURE Act was passed just before everyone's New Year's Eve celebrations, I can imagine that the annuity salespersons started popping bottles of champagne much earlier than the stroke of midnight.
Why? Because regulations were repealed to prevent widespread adoption of annuities within 401(k) plans. The potential for fat commissions paid to these "advisors" just got bigger.
I'm not a fan of this part of the Act, although it's not all bad...
WHY I DON'T LIKE ANNUITIES IN 401(K) PLANS
Would you own a municipal bond that pays tax-free income in an account that is tax sheltered? Of course not.
This is why I don't like annuities in tax-favored accounts.
Wrapping investments within an annuity adds another layer of fees on a portfolio. In some cases, this layer of fees is justified, particularly when non-retirement (aka "taxable") assets are placed in an annuity and the structure of the product allows for taxes to be deferred.
In other words, an annuity is much like a municipal bond in that it has some tax optimization characteristics which can make it viable in certain circumstances. However, when an IRA or 401(k) already has those same tax optimization characteristics (tax deferred growth), the annuity and its additional layer of fees isn't practical or justified.
WHY ANNUITIES CAN MAKE SOME SENSE EVEN IF THEY'RE NOT TAX OPTIMAL WITHIN A 401(K)
Here's how it looks in the world I live in:
All investors are disciplined creatures who get great professional advice and they're able to stick to an investment strategy and retirement income plan.
In "my world", we realize that we should be able to do better than an annuity over the long run if we don't add those unnecessary fees and surrender charges if life changes on us (as it usually does).
After all, why would an insurance company take your money and promise you a lifetime stream of annuity payments if they didn't think they'd be able to either (1) investor your money, pay you some amount lower than the rate of return, and keep the excess, or (2) only have to pay you for a few years and then keep your account balance when you die younger than expected.
Okay, here's the thing about "my world" and why it's okay that these annuities will be offered in 401(k) plans:
Many people don't stick to a plan, they don't want to pay a firm like ours to help them, or they want a guarantee that an annuity provides and they don't care that another route may be better.... And that's okay.
I think there's some value in helping investors transition into retirement with the guarantees provided by an annuity. However, there are really good and REALLY bad annuity options.
The SECURE Act will increase the frequency of these pitches retirement savers will see; if you're being recommended something, don't hesitate to reach out for my opinion on it.
While this Act isn't perfect, I'm okay with many of the new rules. Over the coming months I'm sure there will be more to digest.
In the meantime, maybe we can just celebrate that something passed with bipartisan support.
That’s all for now, have great week!
Adam Harding, CFP®
Three Things: SECURE Act Edition
January 08, 2020