While Republicans and Democrats in Congress have been unable to agree on almost anything since President Obama was in office, something happened on May 23, 2019. The House of Representatives voted 417-3 to approve the Setting Every Community Up for Retirement Enhancement (SECURE) Act. While the Senate has not yet voted on its version of this act, called the Retirement Enhancement Securities Act (RESA), this legislation seems destined for passage using the same or very similar provisions.

So, what is this miraculous legislation that Congress is finding the resolve to so easily enact? It has been billed as the most significant retirement planning legislation since 2006, and I would agree with this assessment, but not for the obvious reasons.

This article will review the background of the SECURE Act (the ugly), summarize what it means (the good, the bad, and the ugly), and provide possible planning steps to be considered in light of this significant proposed legislation.

I. Background of the SECURE Act (The Ugly).

As an estate and tax planning attorney, I read a lot. Our professional world is constantly changing and we need to keep up. I tell you this since I read an eye-opening article in the May 25, 2019 edition of Barron’s written by Leslie P. Norton. The title of the article was, “The Annuity Trap That Teachers Need to Avoid.”

As an estate planner, I have had many clients with 403(b) accounts. These accounts are the equivalent of 401(k) retirement accounts for those working at non-profit and government organizations. Over the years, I have noticed that they often have an annuity benefit component, and I always thought that it was part of the 403(b) plan requirements. Sadly, I was naïve. According to the Barron’s article, it is not that 403(b) plans require annuity components; rather, they are not subject to the same strict fiduciary liability rules under ERISA. Therefore, non-profit and government employers are not as concerned with potential liability if they allow the sale of annuities. Instead, these employers can offer annuities as a 403(b) investment option, and then the consultants/salesmen directly educate about/sell this option to the employees. The bottom line is that these more lenient 403(b) fiduciary rules result in our middle class teachers and others working for non-profits and government agencies too often being sold annuities that have up-front loads (commissions) and relatively high annual costs. The financial services and life insurance companies selling these annuities to those with 403(b) accounts argue that the employees are risk averse and love the annuity guarantees, and as a result, are willing to pay for these higher cost annuity options to avoid investment risk. Fee-only financial advisors and consumer advocates argue that these employees are generally not financially savvy, and the price paid for these investment guarantees is way too high for what is being purchased. As I said, eye-opening!

Now comes the supposedly wonderful SECURE Act (likely soon to be followed by the Senate’s RESA Act). Does the SECURE Act provide some retirement planning benefits? Absolutely! However, many of the benefits should be provided regardless as they improve our existing retirement planning laws at relatively little to no cost in lost tax revenue. Other benefits are somewhat costly, but provide no real benefit to most and little benefit to those it helps. On the other hand, and as discussed below, the cost for these benefits will be the inability to stretch distributions over a non-spouse beneficiary’s lifetime, which is a very real, and potentially significant, loss of tax deferral benefits under this new legislation.

So why is Congress so willing to enact this legislation? You could call it a slight of hand. Congress is talking about updating our retirement planning laws, but the selling point is really giving access to financial services and insurance companies to sell annuity investment products to those with 401(k) accounts, a market of over a trillion dollars.

II. Summary of the SECURE Act. The SECURE Act is long and complex legislation, but the following is a summary of some of its most significant provisions.

A. Benefits of the SECURE ACT (The Good).

1. Change Required Beginning Date (RBD) from age 70½ to age 72. One of the most publicized beneficial changes is postponing the age at which Required Minimum Distributions (RMDs) must begin for an owner of an Individual Retirement Account (IRA) or Qualified Retirement Plan (QP) account, such as a 401(k) account, from the year the owner turns age 70½ until age 72. The general belief is that this change may provide some benefit because people are living longer. However, this benefit will likely be relatively insignificant for most people, as they will need to access their retirement savings before either age 70½ or 72. It should be noted that this one provision accounts for more than half of the tax revenue losses in this Act, according to the Joint Committee on Taxation. The Senate’s RESA bill proposes to extend the RBD until age 75, which would be a more significant change, but also much more expensive. Please note that IRAs and QPs will sometimes be referred to hereinafter as Retirement Plans.

2. Improve Access to Retirement Plans. Several of the provisions improve access to QPs or otherwise encourage Retirement Plan savings. For example, these changes: (i) enable groups of employers (likely smaller companies) to combine for purposes of offering QPs to their employees in a manner that is likely to be simpler, cheaper, and subject to less liability risk; (ii) simplify 401(k) plan safe harbor rules; (iii) increase the tax credit to employers to offset retirement plan set-up costs; (iv) provide a small credit of up to $500 if the 401(k) or SIMPLE IRA plan provides for automatic employee enrollment (note: this feature has been shown to increase employee participation even though employees are able to elect out); (v) allow for long-term, part-time employees to be eligible to participate in QPs, with the effect of employee eligibility being met by either working at least 1,000 hours in a single year or working between 500 – 1,000 hours a year for three years; and (vi) enable retirement plans to be adopted before the due date for filing the applicable tax return rather than by the end of the tax year. The bottom line on these changes is that they are likely beneficial administrative modifications to our Retirement Plan laws, and their loss in tax revenues is fairly insignificant.

3. Major Kiddie Tax Fix! While the Kiddie Tax provision of the 2017 Tax Act went mostly unnoticed, tax professionals knew this provision was a bona fide disaster waiting to happen. Prior to the 2017 Tax Act, the Kiddie Tax provided that a child’s unearned (non-compensation) income, over a fairly low threshold, would be taxed at their parents’ tax rates rather than their own. The 2017 Tax Act, based on the premise of tax simplicity, changed the tax rates from the parents’ tax rates to the tax rates of a non-grantor trust. The tax rates of a non-grantor trust are the highest tax rates we have in our country beginning with income of about $12,000. Lo and behold, it turns out that it was not a good idea to tax young children and students at our highest tax rates. Those affected include, for example: (i) children receiving government benefits after their parent dies, including among others, children of deceased military personnel and first responders; and (ii) students selling long held securities and those receiving various types of financial aid or scholarships to pay for college. The great news is that this 2017 Tax Act change is being repealed under the SECURE Act. Those previously affected will also have the option to file amended tax returns for the 2018 tax year and elect to use the pre-2017 Tax Act Kiddie Tax rules.

4. Miscellaneous Improvements.

  • Ability to contribute to traditional IRAs after age 70½.
  • Distributions of up to $5,000 will be permitted from Retirement Plans for qualified expenses related to the birth or adoption of a child without incurring the 10% early distribution penalty.

B. Reduction in Potential Income Tax Deferral from Life Expectancy to 10 Years Under the Required Minimum Distribution (RMD) Rules for Non-Spouse Beneficiaries (The Bad). The RMDs are the Retirement Plan rules that require minimum annual distributions by force of a 50% penalty for non-compliance. Hence, these rules are important and need to be taken very seriously.

Under the RMD rules, a beneficiary of a deceased owner’s Retirement Plan account is normally able to use their life expectancy in determining the annual RMD amount, which is often referred to as a “stretch” IRA or Retirement Plan account. The proposed change will move from life expectancy (minimal annual amount beginning in the year after the owner’s death) to a 10-year cliff (the entire Retirement Plan account must be fully distributed by the end of the 10th calendar year after the owner’s death). Exceptions do exist for a surviving spouse, minor children (but only until the child becomes age 18), individual beneficiaries who are less than 10 years younger than the deceased owner, and individuals who are disabled or chronically ill. The Senate’s RESA version would limit the RMD period to five years for accounts over $450,000.

C. Life Income Options (The Ugly). These are the series of provisions that remove the practical impediments from providing life income investment options (i.e., annuities) to participants in 401(k) plans, which is primarily accomplished by providing plan sponsors with safe harbor rules to shield them from potential liability if all does not work out for the employee participants as planned. In addition, plan sponsors are now required to provide annual disclosures to the employee participants as to how much they should reasonably expect to receive in annuity type payments for life based on the savings in their plan account. As discussed above, these provisions are likely the primary driver behind the SECURE Act legislation. Financial services and insurance companies are eyeing more than a trillion dollars of assets in 401(k) plans that could be ripe for investment in annuity type products.

III. What Should You Do Now or After This Proposed Legislation Becomes Effective?

A. Can you do something today to lock in current law as to future RMDs for non-spouse beneficiaries? The simple answer is no. In order to lock in a current law, you need to do something irrevocable, and in this case, that would entail the Retirement Plan account owner passing away. So, at this point, we just need to be in a position to deal with whatever the law eventually becomes, if Congress elects to change it. In our legal practice, this has caused us to slightly modify some of our will and trust language. What anyone else will need to do will depend on their particular situation and their particular estate planning documents.

B. What steps can be taken to reduce the effect of this potential change to limit income tax deferral on Retirement Plan assets for non-spouse beneficiaries?

1. Convert Traditional IRA account assets to Roth IRA account assets. The strategy to convert assets from Traditional IRA to Roth IRA status has been a current tax bracket management strategy encouraged by financial advisors and CPAs, but this strategy will now be even more important. This conversion of IRA assets is an income taxable event to the extent the assets are converted to Roth IRA status during the tax year. This strategy entails converting some amount of Traditional IRA assets to Roth IRA assets each year to take advantage of your lower income tax rate brackets. For this strategy to have maximum effect, you need to be able to pay any resulting income tax liabilities with assets outside the Traditional or Roth IRAs. For those who still want to undertake this strategy but need to use some of the Traditional IRA assets to pay the resulting tax liability, the conversions should generally not take place until you are at least age 59½ to avoid any early distribution penalties. The benefits of this conversion to Roth IRA status during the owner’s life include: (i) avoiding any RMDs during your life, which may provide direct and indirect tax benefits on your income tax return; (ii) possibly lower Medicare insurance premiums in future years; (iii) tax rate arbitrage by paying tax at lower tax rates than what you may expect in future years; (iv) increasing the net of income tax value of the IRA assets by paying the conversion related income taxes with assets outside any Retirement Plan account; and (v) enabling longer, post-conversion, potential income tax deferral by avoiding RMDs during the owner’s life.

2. Utilize a Charitable Remainder Trust (CRT) as beneficiary. For those who are at least somewhat charitably inclined, you could use a CRT to serve as the beneficiary in order to force distributions (and thereby continue income tax deferral) over one or more lifetimes or up to a 20-year term. The downside to this strategy is the loss of distribution flexibility since the distribution requirements are locked in and not just the minimum amount that must be distributed each year. The possible terms of the CRT must also be considered in your particular situation since the remainder to pass to charity must be at least 10%, based on the applicable IRS actuarial tables, among other restrictions.

3. Name one or more charities as beneficiary. For those who are seriously charitably inclined, you could name one or more charities as the beneficiary of any remaining Retirement Plan account assets. In this case, charities will get the tax bill but charities do not pay income tax on these type assets, so the full amount will benefit the desired charitable beneficiaries. In addition, the charitable beneficiary can be a Charitable Family Foundation, including a Donor Advised Fund, Supporting Organization or Private Foundation. By using a Charitable Family Foundation, you are providing for charitable purposes and then your selected individuals will have the ability to effectively direct the ultimate charities that benefit from these funds, including as to timing, amounts, and any desired charitable conditions or limitations. If you like this idea but still want to provide significant additional assets to family beneficiaries, you could purchase life insurance to provide tax-free funds to your family beneficiaries. Having both your charitable and family beneficiaries essentially receive tax-free funds could be a true win-win if the cost of the life insurance is acceptable to provide these significant benefits.

4. Utilize specialized trust planning. Consider setting up and naming a specialized non-grantor trust as the beneficiary. The specialized trust could, for example, be structured to name multi-generational family members and, possibly charities, as beneficiaries. The trust could also be set up in a state that has no income tax on the accumulated income of trusts. The income earned in this type trust, including any distributions it receives from Retirement Plans, would be taxed to whoever effectively receives the trust’s income that year and any accumulated income would be taxed to the trust. The effect is the power to control who pays tax and at their tax rates, subject to the Kiddie Tax for younger trust beneficiaries. By setting up the trust in the proper way in a state that does not tax a trust’s accumulated income, you may also be able to avoid any state level income tax on any of the trust’s accumulated income.

5. Decant or otherwise modify an existing trust to account for changes in the law. In some cases, you may need to decant or otherwise modify an existing trust to account for the changes in the income tax laws related to Retirement Plans.

6. Purchase life insurance in a Gifting Trust (ILIT). For those who still have a significant risk of a future estate tax, distributions from Retirement Plans could be used to fund the purchase of life insurance owned in a Family Gifting Trust (ILIT) to convert Retirement Plan distributions into income and estate tax-free insurance proceeds.

We are here to help you navigate through changing legislation and how it may impact you. If we can assist with a review of your estate plan, the execution of any estate planning documents, or share our expertise with you, please contact us today to set up an appointment – 678.720.0750 or info@morgandisalvo.com.

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