The House of Representatives passed a bill on May 23rd known as the SECURE Act (Setting Every Community Up for Retirement Enhancement Act of 2019) which would initiate the biggest changes to retirement accounts in over a decade. The bill had bipartisan support, passing with a vote of 417-3. It now heads to the Senate which seems likely to approve the legislation, perhaps with subtle changes, and send it to the President for signature.
Many of the bill’s provisions relate to changes that impact 401k plans and other employer-provided retirement accounts. The purpose here is to specifically address three sections of the bill that will directly impact individuals and likely have widespread applicability.
1) Increase in Beginning Age for Required Minimum Distributions (RMDs)
Under current law, individuals are required begin minimum distributions from retirement accounts starting at age 70.5 (with a few exceptions). The SECURE Act changes the beginning age from 70.5 to 72 to keep up with increased life expectancies. It is worth pointing out that one of the related Senate bills increases the RMD age to 75 so there is the possibility that this provision improves further.
Planning Implications: This change in the SECURE Act will be valuable by delaying required IRA distributions and the resulting taxes (and/or higher Medicare premiums) by 1-2 years.
It is important to note that the bill does not impact the qualified charitable distribution(QCD) age which will remain 70.5 (and unlike the RMD, not the calendar year in which you turn 70.5 but the day on which you turn 70.5). This means that individuals who reach age 70.5, even though they will not be subject to required minimum distributions, can still make gifts from Traditional IRA accounts directly to charities without the distributions being treated as income for tax purposes.
Unfortunately, the SECURE Act does not add reprieve for individuals who turned 70.5 in 2018 or 2019. The amendment only applies to individuals who attain age 70.5 after December 31, 2019. As a result, someone born on June 30, 1949 will be required to begin distributions in 2019 whereas someone born a day later (July 1, 1949) will get to wait until 2021 to begin distributions.
2) Expansion of Qualified Section 529 Plan Uses
There’s a bit of confusion in this area. The new legislation was supposed to expand qualified Section 529 education savings account usage to include homeschooling, apprenticeships, special needs therapies, student loan repayment (including those for siblings), and expanded costs associated with K-12 schooling. It still reads that way on the House of Representatives bill summary and has been reported this way by many financial news outlets. However, a truly last-minute change to the bill withdrew the allowance for homeschooling costs, special needs therapies, and other K-12 expenses to come from 529 Plans due to objections from the American Federation of Teachers (AFT) and the National Education Association (NEA). The final bill only includes apprenticeships and student loan repayments as expanded qualified expenses for 529 Plans. That said, the Senate seems apt to add back the homeschooling, special needs, and expanded K-12 expenses so we’ll cover the planning implications of the original bill rather than the last-minute amended version.
Planning Implications (Expanded K-12 Expenses): In this Astute Angle post from last year, we explained how Congress has repeatedly expanded the benefits and flexibility of 529 College Savings Plans over the past 20 years, with the idea of encouraging parents and families to use them. The new benefits in the SECURE Act provide yet another round of added flexibility that further advocate for aggressive use by high income families.
The Tax Cuts and Jobs Act of 2017 permitted 529 Plan assets to be used for elementary and secondary school tuition – up to $10,000 per year. The SECURE Act simply expands the permitted expenses (while maintaining the same $10,000/year limit) to include items beyond tuition like tutoring, supplies, equipment, and special needs services. Qualified K-12 expenses also includes homeschooling costs and educational therapies for students with disabilities.
It is still not encouraged that 529 Plans be raided for K-12 expenses as the real benefit of tax-free growth accrues over extended time periods. Funding these accounts early when children are young and allowing the assets grow until college is still likely to be far more advantageous than using them for elementary and secondary school. However, the added flexibility of qualified K-12 expenses encourages aggressive funding for high income taxpayers when children or grandchildren are young such that if the accounts are eventually deemed to be overfunded because of high growth or other reasons, the expanded qualified expenses make it easier to resolve the overfunded “problem” without taxes or penalties.
Additionally, parents and grandparents who live in states that offer a tax deduction for 529 contributions and who are not presently maximizing this deduction ought to consider running newly qualified expenses for things like tutoring, online educational materials, or any instructional materials through a 529 Plan account to make use of the deduction (I explained the logistics and tax benefit of this activity here following passage of the Tax Cuts and Jobs Act).
Planning Implications (Student Loan Repayment): We occasionally get the question of whether 529 Plan assets can be used to pay off student loans. Up to now the answer was yes, but not without incurring a 10% penalty and taxes on any growth attributable to the 529 Plan distribution. The SECURE Act permits distributions of up to $10,000 from a 529 Plan with no taxes or penalties for student loan principal and interest payments.
It’s worth noting that:
- The $10,000 limit is a lifetime limit per 529 Plan beneficiary, not an annual limit;
- Any student loan interest payments made with funds distributed from a 529 Plan will not qualify for the student loan interest deduction;
- The bill also allows 529 Plan assets to also be used to repay student loans for the beneficiary’s siblings, but still subject to the $10,000 lifetime limit per sibling.
This new 529 Plan allowance for student loan payments provides a nice benefit but the applicability may be limited as it’s rare for an individual to have existing student loans and an outstanding 529 Plan balance (usually the result of poor financial planning). However, consider the case where a grandparent funded four 529 accounts, one for each grandchild. Assume that one grandchild, Sally, graduated college without using all of her balance and that another grandchild, Timmy, spent through his 529 balance in the first two years of college and had to assume loans to cover the remainder. The grandparents could elect to use the balance in Sally’s account to help Timmy pay down $10,000 of loans.
Furthermore, individuals burdened with student loans who live in 529 tax deduction states (as described above) ought to consider running their student loan repayments through the 529 Plan (make contributions to the 529 Plan of up to $10,000 and then immediately distribute from the 529 account to pay down student loans). To the extent that an individual qualifies for the student loan interest deduction, this strategy loses some or all of its benefit.
3) Modifications to Required Minimum Distribution Rules
Whereas the other items described above all provide expanded benefits, this is the revenue provision that will help pay for all the benefits in the bill. Under current law, non-spousal beneficiaries of inherited IRA accounts, 401k accounts, or other retirement plan accounts are required to take minimum annual distributions from these inherited accounts. However, the required distribution amount is generally based on the beneficiary’s age such that distributions can be “stretched” over decades, especially for relatively young beneficiaries. This stretch benefit can be worth millions of dollars if employed effectively.
The new legislation requires that beneficiaries are generally required to fully distribute the retirement account by the end of the tenth calendar year following the year of the account owner’s death. There are exceptions for surviving spouses, disabled individuals, children of the account owner who have not yet reached the age of majority, or beneficiaries who are within 10 years of age of the account owner.
This 10-year provision severely hampers the “stretch IRA” – a financial planning strategy to maximize the tax efficiency of inherited IRA and other inherited retirement accounts. We predicted in this 2016 Astute Angle post that the stretch IRA was one of three tax-planning strategies that was likely to be limited or eliminated so it is not a huge surprise to see this change but it has important ramifications.
It is worth noting here that this change does not impact existing inherited retirement plan accounts or inherited accounts for anyone who dies before January 1, 2020. No need to panic if you are already the beneficiary of an inherited IRA as nothing changes during your lifetime.
- Naming young grandchildren as retirement account beneficiaries, which can be highly effective under the current rules, generally loses much of the benefit. While the stretch benefit will be reduced from current law, naming minors as beneficiaries may still be advantageous since it can extend the 10-year payout window to as long as 30-years.
- For anyone who desires to leave assets of any size to a charity at death, using a tax-deferred IRA or retirement account as the source of funding starts to make even more sense.
- Naming an accumulation trust or special needs trust as retirement account beneficiary should become far more common since the currently unfavorable tax treatment would be less unfavorable (relative to naming a person or persons directly as beneficiaries).
- One “stretch IRA light” solution to consider will be to name a charitable remainder trust (CRT) as Traditional IRA beneficiary. Naming a CRT as beneficiary would both preserve the tax deferred treatment of the IRA and set up regular (monthly, quarterly, or annual) annuity payments to the intended living beneficiary or beneficiaries which often is a desire of parents or grandparents. After a fixed period (up to 20 years) or the annuity beneficiary’s lifetime, any assets remaining in the trust would be passed to a charity of the deceased’s choosing. For example, a parent might name a CRT as IRA beneficiary of a $1 million IRA with his/her child receiving $56,000/year over 20 years. All taxes from the IRA would be deferred and the child would receive a total of $1,120,000 over the 20 years. Assuming 6.0% growth of the trust assets over the 20 years, the intended charity also receives $1,147,142 at the end of the trust’s term.
- Late-in-life Roth conversions still have utility in some situations but start to make less sense since these conversions are generally done based on the thinking that the ultimate beneficiary can preserve the tax free growth benefit of an inherited Roth IRA for decades to come. Any retirees considering Roth conversions based on the current law really should stop to evaluate whether the conversion economics still make sense with the required 10-year payout period.
- Roth account beneficiaries subject to the new 10-year payout requirement would be best served (from a tax perspective) to avoid taking any distributions until the 10th calendar year following the owner’s death.
- Traditional IRA and retirement account beneficiaries need to be thoughtful and careful in taking distributions over the 10-year period. Waiting to take distributions until the end of the period could have negative tax ramifications for some and beneficial tax ramifications for others but it will be highly dependent on the unique circumstances. Given the increased flexibility of distributions under the new law, wise distribution planning is likely to add significant post-tax value, when done well.
Notably, there are plenty of other components of the bill which will have significant impacts if the bill becomes law but these three items seem to have the most direct impact on individual tax planning.
Have comments on these changes, questions about these planning strategies, or additional tax/financial planning suggestions? Please do not hesitate to share in the comments section below.