The final installment of this blog series discussing changes made by the Setting Every Community Up for Retirement Enhancement Act of 2020 (“the SECURE Act”) focuses on modifications to the required minimum distributions rules (“RMDs”).
Two of the most widely reported changes made by the SECURE Act relate to the requirements in the Tax Code that require individuals to receive annual RMDs.
72 Is the New 70½
The tax law generally requires people to begin receiving distributions from employer retirement plans and individual retirement accounts (“IRAs”) by the April 1st following the year in which they reach age 70½.[1] Under the SECURE Act, effective for people who attain age 70½ after December 31, 2019, age 70½ is replaced with age 72.
In order to assure that people are aware of their obligation to begin receiving distributions on a timely basis, financial institutions that act as trustees or custodians of IRAs are required to send a Form 5498, IRA Form Contribution Information, telling IRA account owners that they have reached the age when they are required to begin receiving RMDs. Because of the short amount of time between the date in late December that the SECURE Act was enacted, and January 31, 2020, the date that Forms 5498 were required to be sent out, the Internal Revenue Service (“IRS”) and the Treasury Department were concerned that some financial institutions would be unable to avoid incorrectly informing people who turn 70½ in 2020 that they have to start RMDs. To deal with this timing issue, the IRS issued Notice 2020-6 on January 24, 2020, giving financial institutions until April 2020 to provide corrected information.
Those interested in deferring taxation of their retirement savings got a further assist from recently proposed changes to the IRS regulations that are used to calculate each year’s RMD.
The amount of each year’s RMD is determined under IRS tables on the basis of life expectancy. On November 7, 2019, the IRS issued proposed regulations to update the tables to reflect the fact that people are living longer.
Although the modifications to the IRS tables, which are scheduled to take effect in 2021, will not have a dramatic effect, they will, by increasing the payout period, decrease the amount of the distributions that an individual must take from retirement plans and IRAs. Coupled with the new RMD commencement age, the changes will not only reduce income taxes, but also, by lowering modified adjusted gross income, may help avoid the 3.8 percent tax on net investment income and avoid or reduce Medicare premium surcharges and taxes on Social Security benefits.
The Demise of the Stretch IRA
RMDs are also required after a person’s death. The SECURE Act alters the provision under current law rule that permits the beneficiary of an IRA or the beneficiary of an employer retirement plan benefit (to the extent the employer plan permits this form of post-death distribution) to receive payments over the beneficiary’s life expectancy. Well-heeled individuals relied upon this rule to name grandchildren or other younger beneficiaries to maximize the period of deferral of their retirement savings, a technique that earned the name “stretch IRA”.
The SECURE Act provides that beneficiaries of an employer retirement plan benefit or an IRA must receive a payout of all amounts no later than 10 years after the individual’s death. A beneficiary need not receive payment of any particular amount during any one year in the 10-year period but may, for example, defer the entire payment until the 10th year.
Judgments will need to be made, based upon the amount of the inherited retirement savings, age, and income tax bracket of a beneficiary as to whether it is better to defer payment of the inherited amount or take periodic payments. Thought will also need to be given as to whether it makes sense to convert all or a portion of the assets of an IRA or an employer retirement plan benefit to a Roth IRA,[2] and pay the tax on conversion, to enable the IRA beneficiary to maximize the beneficiary’s tax position by deferring any payment from the IRA for the full 10-year period and then receive the payment tax-free.[3]
There are a number of exceptions to the 10-year payment rule, including most importantly, that it does not apply if the beneficiary is the spouse or minor child, but not the minor grandchild, of the plan participant or IRA owner.
[1] A participant in an employer retirement plan, who is not a 5 percent owner of the employer, may defer the commencement of plan distributions until the April 1st of the later of the year in which they turn 70½ or retire.
[2] If the terms of the plan so permit, it may also be beneficial to convert a pre-tax 401(k) plan account to a Roth 401(k) account, which can be rolled over to a Roth IRA.
[3] Although the Act makes Roth IRAs subject to the 10-year, post-death payout limitation, it does not modify the tax treatment of Roth IRA distributions