For a myriad of reasons, the traditional public and private pensions have been declining since the late 80s, which has pushed the responsibility of saving for retirement onto the individual.   In today’s do-it-yourself savings environment, most professionals are forced to use 401(k) plans and IRAs. Clearly the current systems is not working for everyone, because according a survey from WSJ “one-fourth of working Americans have no retirement savings at all”—including 13% of workers age 60 and older.  But help may be on the way. Although according, Philip DeMuth, who wrote an opinion piece titled “Congress Is Coming for Your IRA” thinks it may have negative consequences.  His opinion piece is sparking debate among the retirement planning industry.  Recently the House passed the Setting Every Community Up for Retirement Enhancement Act, (SECURE Act) in May. The vote was 417-3 in House.  The Secure Act is widely expected to pass the Senate by almost unanimous consent. According to Philip DeMuth, “While ostensibly helping Americans save for retirement, the bill would actually reduce the value of all retirement savings plans: individual retirement accounts, 401(k)s, Roth IRAs, the works.”  Forbes contributor Jamie Hopkins who wrote “8 major ways the secure act could impact your retirement plan” says “The SECURE Act would be the first real major retirement legislation since the Pension Protection Act in 2006.”  According to reporting from CNBC, “here’s how the House proposes paying for it: There’s a revenue provision that will require most nonspouse beneficiaries to distribute inherited IRAs within 10 years of the original owner’s death.”

Basically, this kills a strategy wealthy IRA owners use to pass large retirement accounts to heirs, known as the “stretch IRA.”

The Stretch IRA Elimination 

Mr. DeMuth finds that one of the main issues with the Secure Act is that it would get rid of something called the Stretch IRA, which has been a popular estate planning instrument in the financial-planning world since the early 2000s.  The stretch IRA allows people who save for retirement to leave their retirement to kids, grandchildren, or other beneficiaries.  So under the current legislative rules, the recipients can take small required minimum distributions from the accounts over the course of their actuarial lifetimes. Payouts are usually pretty modest for children but they can they grow in size over several decades until the inherited or passed down IRA may pleasantly provide for the child’s retirement thru the power of tax-deferred compounding. So this gives parents the peace of mind that if they were to suddenly pass away, that worrying about their retirement will not be one of the issues. The new rules would apply to account holders who die after 2020, are a few people with significant money, this could upend years of careful estate planning.  

Currently up to ⅓ of an inherited IRA gets eaten up by taxes under current tax rules.  When the individual tax breaks from the TCJA expire in 2025, taxes are predicted to go up. And if Trump signs the Secure Act into law, it could pave the way for a so-called “taxpocalypse” in the next 10 years.  Now The Senate version, known as RESA, is slightly less punitive and may instead call for a five-year payout period for inherited IRAs over $400,000 per heir. Details have yet to be hashed out, but both bills call for changes to inherited IRAs after Dec. 31, 2019.

Age Limits Change 

While some of the act’s provisions are administrative in nature or intended to raise revenue, most of the proposed changes are taxpayer-friendly measures designed to boost retirement savings. One of the compromises in this bill is that Congress will push back the age which retirees must take their first required minimum IRA distributions from 70 ½ to 72. Which means you could let your retirement funds grow an extra 1½ years before tapping into them. Required minimum distributions (RMDs) from 401(k) plans and traditional IRAs are a thorn in the side of many retirees.

Phil DeMuth feels that this was not what American workers were promised two decades about building a retirement nest egg for yourself and children.       

Most estate planners used to suggest the strategy for parents to leave their IRAs to their children or grandchildren and stretch the payouts over decades. Now under the new proposed Secure Act legislation, an owner of an IRA account can leave it to the surviving spouse, who would be exempt from this 10-year clock.  The problem is that the widow would be subject to paying taxes in higher “filing single” tax bracket. Mr DeMuth notes that “The bracket can easily jump from 12% to 25% or from 24% to 35% as the mandatory payout ratios automatically increase with age. For example, the required minimum distribution for a 70-year-old is 3.7% of the retirement-account balance; for a 90-year-old it is 8.8%.”    

 $1 million IRA account example   

As an example, say a someone who makes a high paying salary inherits a 1 million IRA account, in the best-case scenario under this Secure Act, would mean the person would be forced to take payouts that add $100,000 of annual income on top their salary for a whole decade. And they lived in a high tax state such New York or California, half of the annual payout’s value could be lost to taxes by the government. Think this is bad well it gets worse. 

Mr. DeMuth feels that this make it harder middle-class parents who want to save for their kid’s College. Marketwatch noted in a recent article that Senator Ted Cruz (R-Texas) announced opposition because the bill no longer includes a provision that would allow tax-free Section 529 college savings account withdrawals to cover homeschooling costs.     

Another example could be, what if the parents of an 18 year bound for college inherited a $500,000 IRA, with the proposed higher-taxed distributions, say $50,000 a year for 10 years—it would make them appear richer on paper than they really are. It will wipe out their ability to qualify for financial aid.  And say for argument’s sake, that these parents delayed taking the payout distributions for the first 4 years to get around the financial-aid effect, they then would be forced to double up on the payouts once their child graduated, which could bump them into a higher tax bracket.  

Now even if the grandparents took a different route and left the IRA directly with the college-bound grandchild, the “kiddie tax” would require the distributions to be taxed at the parents’ rates. Whichever way the family turns, its a lose advantageous scenario than what is currently in place now.    

Estate Planning for high amount IRA accounts will be harder

Many of the estate planning strategies will be changed. So in recent years an IRA owner might have set up a trust if his intended beneficiaries were young children.  Under the new proposed rules of the Secure Act, IRAs will no longer be subject to annual required minimum payouts, so for example, so a IRA of $1 million placed in a trust for the benefit of an 8-year-old could conceivably receive nothing for nine years. 

Then by year 10, by law, the IRA would have to pay out everything.  Under current laws when the young beneficiary turns 18, he suddenly would get a windfall. Having an extra decade of compounded growth, the original IRA could have doubled in 10 years to $ 2 million or more. 

 So under the proposed Secure Act, all is delivered in one year, so most of it gets taxed in higher brackets. Now depending what the trust rules are set up as, at it allowed to keep the money in the trust, it would get taxed at a federal trust tax rate of $37 on income over $12,500.  And don’t forget California state taxes.   

Annuities 

In Mr. DeMuth’s opinion, the insurance industry will benefit from the Secure act’s mandate, that annuities must be offered as a payout option in all retirement plans. Financial advisers sold more than $230 billion worth of annuities in 2018, and the insurance industry would like to push that sales figure higher.  He went on to say “annuitizing retirement-plan assets is generally a bad idea unless the retiree needs all the cash for living expenses and can find a very low-cost annuity that is indexed to CPI-E—the inflation rate facing senior citizens that includes their increasingly expensive medical care. Unfortunately, such an annuity doesn’t exist.”   

The mandatory offer of an annuity is a first step that could lead to the mandatory ‘annuitization’ of all retirement accounts. This would force the distributions into higher brackets, accelerate the collection of tax revenue, and eliminate the “problem” of the inherited IRA. Best of all, politicians would get to accomplish all this without voting to raise taxes.  Win win for them, not for you.    

Conclusion 

While the goal of the Secure Act is to increase the ranks of retirement savers and the amount they save, it also would throw a wrench into financial planning by changing the rules that apply to inherited retirement accounts.  Not everyone agrees with Philip DeMuth’s perspective, Wayne Chopus, Insured Retirement Institute president and CEO said in Think Advisor that “Most IRAs will likely be used by the original retirement account owner as income — exactly how Congress intended when the IRA was established — not as estate planning tools,”   The WSJ’s editorial board wrote, however, that “maybe there’s an argument that IRAs weren’t meant to be used as vehicles for inheritance. Nevertheless they are, and the figures can be large.”

Ted Cruz of Texas is the Senate’s main holdout against the Secure Act. His concern is that the House version dropped a niche provision that would allow tax-advantaged 529 Plans to pay for homeschooling. He might be able to hold out, but it’ll be a stretch. We shall see what unfolds.