When is the last time you recall a piece of legislation passing the House of Representatives by a 417-to-3 vote? It’s rare, but it happened with the Setting Every Community Up for Retirement Enhancement Act just before Memorial Day. As of this writing, the Senate has not passed the SECURE Act, but with such bipartisan support, it appears likely to become law.
If you have invested in any type of qualified retirement account, you will be affected by this new law. This refers to IRA, Roth IRA, SEP, 401(k), 403(b) and more, but for this purpose, I’m referring to them all as individual retirement accounts, or IRAs.
How IRA law works today
The government wanted us all to take more responsibility for our own retirement needs and said that within some limits, we can deduct a sum from our taxable income (take a current income tax deduction) if we deposit it into an IRA. The IRA can be invested in practically any type of financial instrument. None of the growth in this IRA (interest, dividends, capital gains, etc.) will be taxed as it occurs. We cannot draw money out before reaching 59.5 years old, lest we be charged heavy penalties. When we reach age 59.5, we can draw money out without penalty, but we pay income tax on every dollar. This assures that in the end, we are taxed on the original money invested, plus all growth.
The completely-tax-deferred growth can last until age 70.5, but then we must start drawing out a little bit each year, paying tax on the withdrawals. The amount we must withdraw is based in part on our age and statistical life expectancy. If we don’t need the withdrawn money to live on, we can still reinvest what is left after tax but in a more traditional taxable investment.
An IRA has been a good way to defer taxable income into future years when, retired perhaps, you will be in a lower tax bracket.
If you die before you have withdrawn the whole IRA, your designated beneficiary can receive the account, make annual withdrawals and pay the taxes. If the beneficiary is your spouse, the spouse can take the IRA as if it were his or her own and defer any withdrawals until they reach age 70.5 — or withdraw and pay the taxes more quickly, if they choose. But any other beneficiary’s withdrawals (required minimum distributions, or RMDs) are based on their age and life expectancy. This is where the concept of a “stretch-out IRA” comes from.
Let’s say you die leaving an IRA to your daughter, age 51, or an asset protection trust for her. In the year after your death, she must withdraw 3% (1/33.3, because her statistical life expectancy is 33.3 years) of the account balance and pay income taxes on that amount. All the money not withdrawn (97% of the account) is still growing tax-deferred. She can always withdraw more, pay the taxes, and be done with it. But if she wants to maximize tax-deferred growth, in year two she is only required to withdraw 1/32.3, and in the next year 1/31.3, and so forth until finally she withdraws the last dollar from the IRA in the 34th year.
You might say, “But Roth IRAs are tax-free.” Yes, and the RMDs for an inherited Roth IRA mirror the pace of RMDs from a taxable IRA. Tax-free growth for 34 years is fantastic.
What would change?
So, what difference will the SECURE Act, if passed, make for you and your family?
The good news is that it changes the age cap. Currently, you can make tax-deductible contributions to an IRA only until you reach age 70.5. That age cap would be removed. Second, instead of having to start drawing money out and paying taxes on it in the year you reach 70.5, you won’t have to begin taxable withdrawals until age 72.
Bad news? Most beneficiaries who inherit your IRA will lose the option of stretching out the tax deferral more than 10 years. The IRS needs the tax revenue within 10 years, and it can’t wait for it to trickle in over 34 years. Some minor exceptions apply. For instance, a beneficiary under the age of 18 would have to withdraw only a very small RMD each year until age 18, and then withdraw all that is left within 10 years.
Are IRAs still a good tool? Probably. But for beneficiaries, they’re not nearly as good as they used to be.
Ferguson is an attorney who owns The Estate Planning Center in Salem, Ill. Learn more at thefarmersestateplanningattorneys.com.