Effective January 1, 2020, the SECURE Act is in effect. While there are several areas that this new legislation impacts, these four changes may impact you and your friends now:
- Inherited IRA distributions must now be taken within 10 years (in most cases). This effectively eliminates the “Stretch IRA” provision that permitted beneficiaries to use the inherited IRA over their lifetime.
- 529 College Savings Plan Funds can be used to pay down student loan debt up to $10,000. Under the new law, a 529 plan may also be used to pay for certain apprenticeship programs.
- Required Minimum Distribution age now begins at age 72 for individuals turning age 70 ½ after January 1, 2020. If you turned age 70 ½ prior to January 1, 2020, continue your previous RMD schedule.
- Qualified Birth or Adoption Distributions are available up to $5,000 penalty free to withdraw from a retirement account. The 10% penalty will not be applicable for these special distributions.
I want to focus on the first two items in this month’s newsletter.
Non-Spousal Inherited Retirement Accounts*
*Retirement Account (RA) refers to any Qualified Retirement Account including IRA, Roth IRA, 401k, 403(b), 457(b), IRA Annuities
NOTE: If you inherited a Retirement Account prior to January 1, 2020, no changes are required to your current RMD schedule.
New inherited Retirement Account distribution rules are significant and will impact the planning strategies for many of you. Previously, non-spouse beneficiaries of a Retirement Account had the option to distribute the funds by:
- Taking a lump sum
- “Stretching” the RA throughout their lifetime. Thus, minimizing a larger taxable event. For example, if a 47-year-old person inherits an IRA, that persons IRS life expectancy factor is 36 years. In year 1, they will take out 1/36th of the IRA balance, in year 2, the distribution is 1/35th, and so on.
- If the deceased owner had not begun taking RMDs, then the beneficiary could use the 5-year rule to delay any distributions. However, all funds must be distributed within 5 years.
The SECURE Act eliminates the “stretch” option in most situations. It also changes the 5-year rule to a 10-year rule and applies to beneficiaries, regardless of whether the original account owner had begun taking RMDs or not. Beneficiaries can essentially take the money out at any time over the 10-year period following the death of the original RA holder. Choosing what action to take during the 10 years provides flexibility, but it may result in larger taxable income for some beneficiaries.
Example: George dies in 2020 (at age 70) and leaves his $500,000 IRA to his 47-year-old daughter Carrie. Under prior law, the withdrawal amount could have been spread over Carrie’s 36-year life expectancy (about $5,735 in the first year, with subsequent distributions over the next 35 years.) Now, the balance in the inherited IRA must be taken out within 10 years of George’s death, perhaps resulting in a large taxable event over some (or multiple) period(s) during that 10 years at Carrie’s ordinary income tax rate. Potentially even moving her into a higher tax bracket.
529 College Savings Plan Funds
If you qualify for a low rate student loan, would you be better off to use the loan funds for college expenses and then repay the loan with the 529 money?
Conceptually, this is the idea of using leverage or Other People’s Money (“OPM”). While using the loan to fund college expenses, the 529 should be invested for future growth. Given a reasonable time frame to make positive returns, this could potentially result in positive leverage. Qualifying distributions from the 529 are tax free and thus, the idea of preserving the 529 funds for student loan payoff is worth exploring. Other factors such as your state’s adoption of the Federal law and the tax deductibility of student loan interest should be reviewed. Of course, the flip side is also true - if the invested funds lose money, then the leverage worked against you and you could end up needing to pay off the loan with other funds.
Regardless of whether this concept is practical for a family or student, it presents an excellent learning opportunity. The personal impact of credit use is often misunderstood, and, unfortunately, young people are exposed to loans and credit card advertisements on a regular basis. Consider a process for this review, work though the analysis, and perhaps the lessons learned can help a student better prepared to understand the impacts of leverage, risk, and regulatory impacts on financial decisions.
Interested in more changes, certain situational rules and the rule exceptions brought about by the SECURE ACT? This one-page summary highlights some of the key changes as well as some additional detail regarding the specific provisions.
The legislation adopted under the SECURE Act has many benefits and some potential negative side effects. It is IMPORTANT to review how they impact you and your beneficiarys’ unique situations. Reviewing beneficiaries, generational planning, gifting strategies, and even explore how Roth conversions may now make more sense. Let’s chat.