About two months ago, I gave a presentation to a group of CPAs, attorneys, and financial professionals on the use of trusts as beneficiaries of retirement plans. I spent about an hour explaining the complicated rules for timing distributions and the identification of beneficiaries, of the requirements for see-through trusts, and what it meant for a beneficiary to stretch their inheritance.
Well, please let me apologize to the attendees, because Congress passed the Secure Act, blowing it all up effective Jan. 1. Sorry.
The Secure Act, which was signed by President Trump in December, does a number of things that change the rules around retirement plans. I keep seeing estimates that there are 29 provisions, but they really boil down to five major items.
1. Barriers to entry to 401(k) and 403(b) plans for small businesses and part-time workers are reduced;
2. Retirement plan participants don’t have to take their first required minimum distributions (RMDs) until age 72, instead of age 70;
3. The age limit on contributions to your traditional IRA, formerly 70, has been removed;
4. There are more options to purchase annuities inside 401(k) plans; and
5. The rules for distributions for inherited IRAs have changed.
Keep in mind, these changes went into effect on Jan. 1. If you inherited an IRA before 2020, or turned 70½ in 2019, you’ll still be subject to the old rules.
Now, I’m an attorney with significant experience working side-by-side with financial advisers and I even spent about two months once studying for securities licenses, though I never took the test, so while I know a lot of the vocabulary I’m a jumping off point on the first four points rather than the end-all be-all. Let’s deal with them quickly.
The age of the pension has been sunsetting ever since the 1980s when Congress went all in on advantaging retirement accounts like 401(k)s and 403(b)s, shifting responsibility for our financial well-being in retirement from our employers to ourselves. Still, if you work for a small business, the entry costs for establishing a 401(k) plan could be prohibitive, leaving you holding even more of that responsibility to seek out SEP IRAs, Simple IRAs, and other more niche markets.
Secure tries to increase access to retirement plans in three concrete ways. First, it provides modest tax incentives for small employers to establish new 401(k) or 403(b) plans. Second, it provides a legal framework for multiple employers to get together to establish pooled plans. There are a few interesting hypotheticals in that world that we just don’t have answers for yet. Finally, it requires that employers allow part-time employees who work 500 hours per year access to the company’s plan. If you are an employer, consult with your attorney for what these changes may mean for you. If you are an employee, consult with your HR representative to see if your workplace will be changing any of its policies, or else to start the enrollment process if you are newly eligible.
New RMD age
Did you know that, even if you don’t need it, you will have start taking out some of your qualified retirement money once you reach a certain age, and pay tax on it accordingly? There’s a good chance that if you are under 60 or 65, no one has gone over that with you.
Despite what some of my clients have doggedly insisted, you have not yet been taxed on money in your qualified retirement plans (except for Roth IRAs). When you pull that money out, then you may owe Uncle Sam, and Uncle Sam wants his cut. Therefore, the law requires that once you hit a certain age, you have to take out a minimum amount each year. Before Secure, your required minimum distributions started in the year in which you turned 70½ years old. Failure to take an RMD resulted in a 50% penalty, the steepest the IRS can levy.
Good news. Now you can wait to take your first RMD until age 72, provided you weren’t already 70½ years old by 2019. You may take money out, but you don’t have to.
No age limit on contributions
Before Secure, you were unable to contribute to your traditional IRA plan once you hit age 70. The law basically said that you were done saving at that point. Secure removes that requirement. Now you can continue to contribute wages to a traditional IRA for as long as you are working. Now, how much this will matter will vary based on how long you plan to keep working.
Annuities in 401(k) plans
Out of the five major items I identified, can you guess which one the insurance industry lobbied hard for? If you guessed opening up trillions of dollars in employer-sponsored retirement plans to invest in annuities, while forgiving the employer from a fiduciary responsibility in managing the same retirement plans, give yourself a pat on the back. That should go nicely with a newfound paranoia that you’ll find your 401(k) investment options to be a warren of indecipherable annuity options with unclear growth options, hidden fees, and sizable commissions to the sales people that managed to convince your company that this was a good idea.
Fun times. And sure, not all annuities are always bad. There are circumstances in my practice where I have to recommend specific annuities for my clients because they are the only tools that work. But for every Medicaid-compliant, spousal income annuity I’ve set up, I’ve seen several clients with products that won’t pay what they expect to at death or whose method for calculating interest requires a scorecard and a thaumaturgist dissecting Nasdaq ice core samples.
If you’re an employee, keep an eye on your 401(k) and 403(b) plans and talk to your attorney and financial adviser if you start seeing annuities as options. If you’re an employer, please review any proposal with your attorney and an independent financial expert before signing up with an insurance company to manage your company’s plan.
Inherited retirement plans
Ah, now we’re talking my language. You may also want to call your estate planner, because your children (probably) will not have the same options available as if you had passed in 2019 or earlier. If you have a trust set up for your kids, let me say this delicately — call your estate planning lawyer to review it.
See, based on the old rules, if I had inherited an IRA from my parents, I would have to take out a minimum amount each year. I could take as much as I wanted, even cashing out the entire account, but had to take out a minimum amount (and get taxed on it) based on my age. At 36, I would have to fully exhaust the inheritance in a little less than 50 years. For a lot of that time, a good market would return more than I would have to pull out.
Compound interest and deferred taxation made this a real benefit. Here’s a few examples from my presentation. Assume a $100,000 inheritance, the beneficiary lives to 85 and only takes RMDs:
• A beneficiary inheriting at age 10 with a 10% annual yield would get over $14,000,000
• A beneficiary inheriting at age 20 with an 8% annual yield would get over $2,500,000
• A beneficiary inheriting at age 50 with a 6% annual yield would get over $325,000
A popular tool in the estate planner’s arsenal has long been the stretch trust. Parents have often used these vehicles to benefit their children without giving the child too much direct control. By leaving qualified accounts to a stretch trust, parents gave structure to and exercised control over the inheritance. It also allowed additional protection from creditors.
Well, Congress has changed the stretch. Since January 1, most beneficiary must now withdraw the inherited funds within 10 years of the death of the plan participant. Good news — gone are the required minimum distributions. You could take it out whenever you want in those 10 years (some now, the rest in year 8; all in year 9; whatever you want!). Bad news — depending on your age, you have now lost some of the possible deferred tax benefits. In fact, the government expects to collect $15 billion more in taxes over the next 10 years as a result of this change.
If you have a stretch trust, or stretch language as part of your estate plan, if it is imperative that you review it with your attorney. Stretch provisions are typically either conduit or accumulation in nature, either distributing the required minimum distribution each year directly to the beneficiary, or else at the trustee’s discretion. So, what happens if you have conduit language with a mandatory distribution and no RMDs until year 10, when it’s 100%? Not what you the settlor intended, that’s for sure.
There are four primary exceptions to this rule.
• Surviving spouse. My wife won’t have to withdraw my 401(k) within 10 years of my death;
• Disabled or chronically ill individuals;
• Minors (until they reach the age of majority); and
• Any other beneficiaries who are within 10 years of age of the decedent (a sibling, for instance).
I have implemented many stretch trusts over my career. This change severely limits the benefit that my clients were seeking. It does not do away with them — there is still a lot of value in structuring distributions or providing protection against creditors — but the tax savings and compounding growth of 10 years is a disappointing fraction compared with 30 or 40.
If you have a stretch trust now and want to review your plan, or are just hearing about them now, I recommend calling your estate planning attorney to discuss your options.
Keith Stevens is an associate at law firm Isaac Wiles.