Here’s What It Will Mean for Your 401(k) and IRA.
This article is by Reshma Kapadia from Barron’s. Updated Dec 20, 2019
The first major retirement legislation in a decade.
Congress passed the first major piece of retirement legislation in a decade this week. The vote, tied to the spending bill needed to keep the government open, was passed by Congress Thursday. That means a spate of changes for retirees related to their required minimum withdrawals, the way they use IRAs, and rethinking estate planning options.
The Setting Every Community Up for Retirement Enhancement—better known as the Secure Act—has been in the works for roughly three years and has enjoyed bipartisan support, despite being stalled for years. As of last week, many policy watchers didn’t expect it to get passed given the flurry of other issues consuming Washington, D.C. But different pieces of legislation often are attached to must-pass appropriations bills at the last minute, and that is what has happened. “It is always good to be attached to the last train leaving the station in Washington, which is what this budget bill is. It has to be passed by Friday, when there will be a government shutdown,” says Shai Akabas, director of economic policy at the Bipartisan Policy Center. “Even amid impeachment debates, this will be an extremely huge priority for Congress.”
Some of the biggest features of the bill for individual investors include removing the age limit restricting IRA contributions; raising the age at which people need to start taking required minimum withdrawals; provisions that could encourage annuities in work-based retirement plans; and closing a loophole that allowed affluent investors to stretch the tax advantages of IRA across multiple generations. For younger investors: $10,000 of 529 plans can be used to pay off student debt and people can take out $5,000 from 401(k) plans without penalty to help with the costs related to a child’s birth or adoption.
Among the more controversial features is a safe harbor for plan sponsors that clears the way for more companies to include annuities in their retirement plans by taking employers off the hook for assessing an insurer’s financial health. Academics have long advocated the merits of incorporating low-cost, simple income annuities to offer a guaranteed income stream and decrease longevity risk, but consumer advocates and financial planners worry that it will also open the door to more complicated and pricey annuities that could lead savers astray.
The bill cobbles together a lot of small changes but doesn’t tackle the largest problems, including shoring up Social Security and the federal agency that backs pension programs, and significantly increasing access to retirement savings. Though not much legislation is likely to pass next year ahead of the election, Akabas says getting the bipartisan bill passed could focus attention on laying the groundwork for tackling the thornier retirement issues.
In the meantime, Barron’s checked in with three financial advisors to see where savers and retirees need to reassess their retirement and estate plans, possible tax minefields and why younger savers may want to favor a Roth IRA over a 401(k).
Finding a Plan B for the Stretch IRA
Under the bill, beneficiaries of an IRA will need to draw down the account—and pay income tax on the money—over a decade, rather than a lifetime. As a result, the IRA becomes a “lousy estate planning vehicle,” says Ed Slott, a retirement expert and founder of IRAHelp.com. Here are the steps to consider now:
• Check beneficiaries and reassess trusts—Stat. With the stretch IRA no longer an option under the bill, Slott suggests possibly naming a spouse as the beneficiary so that the assets can be stretched across the spouse’s lifetime and then passed on to a grandchild, who would have 10 years before having to draw it down completely.
Instead of designating a trust as the beneficiary of an IRA that would then distribute it to heirs, one way to minimize the tax hit for a family with five heirs, for example, is to name each a beneficiary so that the tax bill can be paid over a decade by each—or 50 tax returns, says Christian Cordoba, a financial planner and founder of California Retirement Advisors in El Segundo, Calif.
Often affluent families use a conduit trust as a beneficiary for a stretch IRA to manage the required minimum withdrawals over an heir’s lifetime. But if they had left it to a five-year-old grandchild, the bill would mean that the IRA would have to be drawn down by the time the child is 15, potentially creating a major tax headache, says Jeffrey Levine, a certified financial planner who writes for Michael Kitces’ Nerd’s Eye Blog.
• Life insurance as an alternative to stretch IRAs. For affluent clients who don’t need access to the money, Slott says a cash value life insurance policy that pays out to a trust. “They can take the money out of the IRA, pay a low tax rates on the withdrawals and put it into a life insurance policy that will pay off many multiples of the IRA value and be tax-free,” Slott says. “Insurance is more stable than tax law.”
• Roth conversions may become more popular. One alternative for those who have saved roughly $1 million to $5 million in IRAs to pass it on to heirs is to take advantage of very low tax rates, at least until 2025, to do piecemeal Roth conversions over a number of years to build a tax-free account you can leave to your beneficiaries, Slott says. That’s especially enticing given that heirs may are likely to face higher tax rates, especially if they are in high tax brackets.
Considerations for Near- and Recent-Retirees
• With the bill lifting the age cap for IRA contributions, those who are working longer can continue saving for retirement. That gives them more time to consider doing a Roth conversion, which could give them a larger kitty of tax-free assets to draw from.
• The bill also delays required minimum withdrawals until the age of 72, instead of 70.5, simplifying a rule that often tripped up retirees. But it also gives retirees more time to use a Roth conversion before withdrawals may push them into a higher tax bracket, Levine says.
For Younger Savers
• Think twice about using the bill’s provision to raid a retirement plan penalty-free for up to $5,000 for the birth of a child or adoption. The withdrawal will still trigger a tax bill, which will come due just as child care costs kick up. Retirement experts see this as a possible slippery slope for early savers.
• For younger savers who still qualify for a Roth IRA, it may be worth splitting retirement savings, putting enough into a 401(k) to get the match and the rest in a Roth account. The tax deduction for a 401(k) contribution isn’t as meaningful at a lower tax rate and the benefits of tax-free income in the future may continue to rise. “Tax rates have to go up; you have to look at the math of the deficit. Money in tax-free vehicles—like a Roth will be more valuable every time Congress raises tax rates,” Slott says.