At any given moment there are thousands of sensory inputs flooding our attention. The human brain is hardwired to ignore the vast majority of them to focus on those that matter. To test this phenomenon, watch this video and try to count how many times players wearing white pass the basketball (https://www.you tube.com/watch?v=vJG698U2Mvo).
The basketball passing psychological study confirmed that humans can't pay attention to everything. So, while the media has been focusing on impeachment and escalating tensions with Iran, "the most extensive retirement legislation in more than a decade was passed and signed into law."
The new SECURE Act has several implications for retirement savings and taxation.1 This column will focus on one significant change: elimination of the Stretch IRA.
- What was the stretch IRA?
Before the SECURE Act, heirs could spend down inherited IRAs over the course of their own lifetimes. Because traditional IRAs are taxed when the funds are distributed, this meant the inheritor could spread out taxes for a lesser impact.
- The SECURE Act and stretch IRAs
The SECURE Act has eliminated these stretch IRAs for non-spouses.2 Under the new law, beneficiaries who are more than ten years younger than the account owner now have ten years to distribute IRA funds, unless the beneficiary is a spouse, a disabled or chronically ill individual, or a minor child. This goes for both Traditional and Roth IRAs. Thus, inheritors have far less flexibility on the tax impact of inherited IRAs. In fact, this provision of the new law is predicted to generate $15.7 billion in tax revenue over next decade.3
- Why this matters
Let's say a parent passes away at age 85 with $1M in a traditional IRA, and they pass it on to their 55-year-old adult child who, by the way, is now entering their prime earning years. The child will be required to distribute the $1M over 10 years. Assuming the $1M is still invested and growing at 6% annually, this means they will have to distribute $125,000 per year (if they distribute it evenly over the ten years, which is not required). They would pay taxes on that $125,000 at their highest marginal tax bracket, because it is calculated on top of their normal earnings.
Inherited Roth IRAs also must be distributed in 10 years, but those distributions themselves are tax-free. However, unless the inheritor actually spends all of the funds, they may naturally be inclined to put those funds into taxable accounts. Regardless of whether an inherited IRA is traditional or Roth, the inheritor is likely to increase their tax exposure. Hence, the $15.7 billion described above.
- Minimizing Tax Exposure
Those currently with IRAs, and those who anticipate an inheritance, can act now to minimize their future tax exposure. Individual solutions will differ, so talk to your trusted advisor about what is best for you.
For those who anticipate inheriting an IRA, from their parents for example, talk to them about where the money is held. There is a massive opportunity to minimize taxes now because tax rates are historically low. Also be sure to talk to an advisor about establishing financial vehicles now that will allow for tax-efficient solutions when the funds get inherited.
For those who currently have an IRA that may get passed on to a non-spouse, there are other opportunities to minimize taxes. Again, because taxes are historically low, there may be an opportunity for Roth conversions. A trusted advisor can help estimate current taxes compared to the taxes your child might pay in 10, 20, or more years from now. But perhaps they don't care about the tax implications of the inherited IRAs they will pass on. Nevertheless, it's probably a safe assumption that they would rather control the funds instead of blindly sending a substantial proportion of money they worked hard to save to the IRS instead.
For those who expect to inherit an IRA, or those who anticipate they will pass one to the next generation, there are 15.7 billion reasons why now is a good time to talk to your advisor.
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Footnotes
1J. Mark Iwry, David C. John, and William G. Gale, "The SECURE Act: a good start but far more is needed," Brookings, https://www.brookings.edu/blog/up-front/2020/01/08/the-secure-act-a-good-start-but-far-more-is-needed/, Jan. 8, 2020.
2Simon Moore, "How the SECURE Act Just Severely Limited Stretch IRAs," Forbes, https://www.forbes.com/sites/simonmoore/2019/12/22/how-the-secure-act-just-severely-limited-stretch-iras/#3951285a7a86, Dec. 22, 2019.
3Bill Bischoff, "Secure Act includes one critical tax change 'that will send estate planners reeling,'" MarketWatch, https://www.marketwatch.com/story/secure-act-includes-one-critical-tax-change-that-will-send-estate-planners-reeling-2019-12-30, Jan. 6, 2020.
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Attorney Kyle Zwiren works with Financial Architects Inc., an independently-owned company located in Farmington Hills. Zwiren and his team serve attorneys and other professionals to help them design financial plans in line with their goals and based on optimal efficiency. He practiced law prior to becoming a Financial Architect and left the practice to follow his passion. To talk to Zwiren about other topics featured in The Economic Blueprint, email him at kzwiren@financialarch.com or call him at 248-482-3622.
Published: Wed, Jan 29, 2020
