Most of our clients own some form of qualified retirement account such as a traditional individual retirement account (IRA), 401K, 403B, SEP or Keogh. Such an account provides significant benefits to the account owner because the deposits into the account are made with pre-income-tax dollars and the assets in the account grow “tax-free” until withdrawn by the owner or received as a mandatory distribution which begins when the owner reaches 70½ years of age. The owner of such an account can name one or more beneficiaries to receive the account upon death and they, too, are entitled to tax-free growth of the assets in the account. Under the present law, the spouse of an account owner can “roll,” or transfer, the account into their own retirement account and take required minimum distributions beginning when they reach 70½ years of age and continuing based upon their own life expectancy. A non-spouse beneficiary cannot roll the account into their own account, they receive it as a separate “inherited” retirement account. They begin to withdraw minimum distributions annually based on their own life expectancy beginning in the year following the death of the original account owner. But they, too, receive the benefit of tax-free growth for all of the time the assets remain in the account.
Recently, the House of Representatives passed, by a 413 to 3 vote, the “Setting Every Community Up for Retirement Enhancement Act” also called the “SECURE Act.” Similar legislation is currently pending in the Senate and is called the “Retirement Enhancement Securities Act” (RESA). Both bills significantly affect qualified retirement accounts.
There are some positive aspects of these bills. First, both bills postpone the age at which required minimum distributions must be taken. The SECURE act requires minimum distributions to be taken beginning when the account owner is 72 years old. Under RESA, minimum distributions need not be taken until age 75. Secondly, under current law, people who continue to work past age 70½ are penalized because they cannot continue to make income contributions to a traditional IRA after that age (although income contributions can continue to be made to a Roth IRA). The SECURE act eliminates this limitation by repealing the age cap for traditional IRA contributions. Finally, withdrawals from retirement accounts prior to age 59½ currently incur a 10% penalty tax while under the new proposed legislation, an aggregate of $5,000.00 can be withdrawn from a retirement plan without incurring a penalty if the withdrawal is taken within one year of the birth or adoption of the account owner’s child.
Unfortunately, there are also some changes that will be detrimental to account owners. Most significant is the change in required distributions to non-spouse beneficiaries. Currently, non-spouse beneficiaries are required to take minimum distributions over their life expectancy. Under the SECURE act, the entire account must be distributed over a ten-year period which will accelerate the depletion of the inherited account. It is anticipated that this will have a greater affect on large qualified retirement accounts as small accounts are more typically withdrawn within a relatively short time after inheritance. The RESA bill requires non-spouse beneficiaries to take distributions over a five-year time period unless the account is less than $400,000.00.
If the legislation passes, the impact on a beneficiary will be profound. For example, a 40 year old non-spouse beneficiary of an account worth $500,000.00 has a life expectancy, under the current tables, of 43.6 years. Her required minimum distribution would be approximately 2% or $2,147.00 in the first year. As the life expectancy of the beneficiary decreases each year, the required minimum distribution increases. Assuming annual growth of 5%, it will take approximately 26 years, when the beneficiary reaches 66 years, before the required minimum distribution equals the 5% growth. By that age, despite having taking minimum distributions for 26 years, totaling $615,147.73, the account will still have grown to $818,905.40. Under the SECURE Act, the same beneficiary will be required to withdraw and deplete the account within 10 years over which time she will have withdrawn a total of $660,339.36 and the retirement account will be totally depleted. Proper estate planning will be essential because of the increased tax burden that will result from the quicker distributions. Roth conversions may be utilized to minimize this impact.
Clearly, because of the differences between the SECURE act and RESA, further changes are anticipated. We will revisit this topic in a later newsletter after the differences between the two bills are reconciled and it is signed into law by the president.