In “Estate Planning for Retirement Benefits After the SECURE Act,” the author offers up a quick review of traditional retirement plans and notes that withdrawal and transfer planning will need to change with the Setting Every Community Up for Retirement Enhancement (SECURE) Act.
For many years, employees enjoyed defined benefit plans in which employers made regular contributions to pension plans that offered a relatively assured cash stream or lump sum withdrawal at retirement. These plans provided stability and left little decision making to the employee. Retirees benefited from steady retirement income with little withdrawal planning on their part.
Since the late 70s, however, defined benefit pension plans have steadily been replaced by defined contribution plans such as Internal Revenue Code Sections 401k and 403b plans. The author points out that most employees today are retiring with these plans. Defined contribution plans have brought two distinct retirement risks to retirees. First, they rely on the employee making a proactive decision to save a portion of every paycheck into a retirement plan. While some employers provide a minimal match of 3%-6% of pay to encourage employees to save, few employees save the annual maximum allowed of $19,500 per year in 2021 (or $26,000 for employees aged 50 years or older). Due to the need for an employee to proactively reduce their current paycheck for future retirement savings, many retirees today fail to leave their employment with sufficient funds to provide a stable retirement.
The second risk of defined contribution plans is that employees must also proactively choose how their savings are invested. Many plans today offer a default investment choice of a “target date fund” structured to mechanically adjust investments over the years until the participant’s retirement age. These funds don’t adjust to market volatility or economic cycles but rather re-allocate assets on a fixed schedule as the employee ages. Because most employees aren’t schooled in choosing their own investments nor confident in making choices, they either default to the target date fund, or they choose inappropriately, further putting their future retirement at risk.
With both defined benefit plans and defined contribution plans, the author points out the pre-tax contributions are subject to full ordinary income taxes when withdrawn. He further notes that with the passing of the SECURE Act, owners of defined contribution plans benefited from several temporary taxation advantages, including the elimination of required plan distributions in 2020 and the elimination of several early withdrawal penalties for the year as well.
Going forward, the SECURE Act has important elements that will influence how plan participants make decisions about withdrawing their retirement. First, the SECURE Act increased the years that a participant can contribute into a plan. Previously, participants couldn’t contribute after reaching age 70½; that age cap has been eliminated allowing participants who continue to work to put more pre-tax money into a retirement fund. Second, required minimum distributions (RMDs) have been delayed from age 70½ to 72, allowing retirees to keep pre-tax funds growing a little longer in their retirement accounts before being forced to withdraw minimum taxable amounts each year. Both of these new provisions allow participants to potentially grow their retirement accounts even more pre-tax before making retirement withdrawals.
For those who’ve accumulated large retirement accounts—whether pre-tax or after-tax—the author goes on to highlight the single most important change in the SECURE Act for retirement account owners: Although the SECURE Act contains a number of positive enhancements to the rules regarding retirement plans that will increase retiree security, starting Jan. 1, 2020, inheritors of retirement accounts must withdraw all funds within 10 years, with few exceptions. This single change eliminates the extremely valuable estate-planning “stretch” technique and will change the way account holders plan for transfers on death.
Previously, when a retirement account holder died, with the correct planning, the designated beneficiaries could inherit an individual retirement account and the future RMDs would be stretched over their remaining lifetime. During that time, the account might continue to grow with tax-deferred appreciation and still even be passed on to the next generation for further stretched-out appreciation. This is no longer an option.
The author explains the SECURE Act includes an exception to the 10-year withdrawal rule for a deceased’s spouse. A spousal beneficiary can still receive an inherited IRA or Roth IRA and fold it into their own account for the remainder of their lifetime. They can, in fact, choose to combine the IRAs completely or keep the inherited IRA separate, which can be beneficial if the spouse isn’t yet 59½—the age of penalty-free withdrawals. All withdrawals will still be taxed to the spouse at full income tax rates, but the RMDs won’t begin until age 72 and can be stretched over their remaining lifetime.
Minor beneficiaries also are exempt from the new 10-year withdrawal rule. A retirement account holder may choose to name a minor as a beneficiary to extend the life of the tax-deferred growth. Once the minor reaches the age of majority, the 10-year rule kicks in. At that point, however, the minor may be in a very low tax bracket and may be able to withdraw the funds with greater after-tax benefit than other potential inheritors.
For all other designated beneficiaries of IRAs and tax-free Roth IRAs, inherited funds must now be withdrawn over 10 years. The author points out that the message is clear that “retirement accounts should not be used for what are basically testamentary purposes.” With the new rules, account holders and professionals will want to consider carefully the designated beneficiaries of these plans. Depending on the terms, it may no longer make sense to name a trust as the beneficiary of a retirement account if the distributions will result in higher taxes and lower net inheritance. Similarly, there may be increased use of skip-generation beneficiaries if there’s an opportunity to delay required withdrawals or take withdrawals at a lower tax rate.
The SECURE Act has many features that may make retirement more stable and comfortable for many of today’s employees. The author notes that for estate planners and financial professionals, it’s completely changed the transfer planning aspects of these accounts. After a spousal beneficiary, all additional and contingent beneficiaries will likely be considered with tax consequences in mind. For this reason, professionals should be actively contacting clients to review their existing beneficiary designations on all retirement accounts.