With all the news we are bombarded with every day, you may have missed this information which is new and will affect every single person in some way in their life. It is the passage of the new SECURE Act which became the law effective January 1, 2020 and changes retirement plan rules.
The new law has 29 new provisions or major changes, but I want to focus on just a few major areas. Some of this news is good news and some of it could be bad.
The SECURE Act stands for Setting Every Community Up For Retirement Enhancement. With the act come some big changes for individuals and small businesses when it comes to tax and retirement planning.
Even if you are just starting out working now, or you are 40, 50, 60, or even 70 or more, this new law touches you as well as your employer and family. Retirement planning just took a giant leap into the 21st century!
The News About Enrolling in an IRA at Work
Most personal finance bloggers will tell you that enrolling in your employer IRA plan is a wise choice. I have always said that doing so ASAP at your very first job (if it is available) is the way to go. It’s not only smart but essential so you can get the years of building up your retirement plan off to a really great start.
To promote additional savings, the SECURE Act allows automatic-enrollment “safe harbor plans” to increase the cap on automatically raising payroll contributions from 10% to 15% of an employee’s paycheck, while still giving employees an opportunity to opt out of the increase if they chose. Check with your employer now to see exactly how this changes your planning and weekly take home pay.
The BIG Changes in the Distribution of “Inherited” IRA’s
The most important provision of the SECURE Act may be the removal of the “stretch RMD provisions”. This is essentially a tax revenue generator, meaning a tax hike on many Americans.
The act will impact millions of Americans who will inherit or leave behind a retirement account. Beginning this past January 1, 2020, the required minimum distributions (RMD) on these accounts are now being limited to 10 years. In the past, you could stretch the payouts over the beneficiary’s lifetime, but now that period will be shortened and that will affect the taxes of millions of those who receive those IRA distributions.
If you inherit someone’s IRA and are age 40, you have to complete the withdrawals by age 50 now. In the past, you could have stretched that out over 10, 20, 30, or more years until your own passing without any tax penalties.
This change can push higher RMDs into your prime working years and highest tax years of a beneficiary’s life.
You will likely need to adjust how much you withdraw annually as compared to the previous rules. On the other side, if you are doing your estate and retirement planning, you need to understand the tax impact of leaving your IRAs and 401(k)s to your heirs as the rules are changing significantly. Check with your tax advisor to look at your specific plan and the changes you need to make.
How Will SECURE Affect Your IRA Distributions (RMDs)?
Neglecting to withdraw a required minimum distribution (RMD) from an IRA by the due date brings about a painful tax code penalty: 50%. Yes, you read that right. If you are supposed to withdraw at least $4,000 and did not do as such, you have to write the IRS a check for $2,000. But now, keep in mind that on January 1, 2020, the RMD rules were modified.
You need to be mindful of the RMD, because it applies to the majority of retirement accounts. This IRS rule requires you to withdraw a specific minimum amount from any qualified accounts you have when you reach a certain age. Previously it was 70½, but beginning in 2020, it is now age 72.
The push of the RMD beginning date from 70½ to 72 will mostly benefit those who have not yet turned 70½ and are born in the first half of the year. The reason is because if you turn 70½ in the second half of the year, you won’t hit age 72 for two more years. However, for those that hit 70½ early in the year, the change will only push RMDs by one year.
What is the point of an RMD mandatory withdrawal?
Not surprisingly, it’s to be sure that the government gets their tax money. Without the RMD requirement, individuals could live off other income and never pay tax on retirement account gains. That cash could be left to family or friends as an inheritance and the IRS would not receive taxes from it.
Which types of retirement accounts have RMDs?
Qualified retirement accounts like IRA accounts, 401(k)s, 457 plans, and other tax-deferred retirement savings plans like a TSP, 403(b), TSA, SEP, or SIMPLE IRA plan require withdrawals in retirement.
When do you start taking distributions?
For most accounts, you must take your first distribution by April 1 of the year following the calendar year in which you reach age 72. If you retire after that age, you must take your first RMD from your 401(k), profit-sharing, 403(b), or other defined contribution plan by April 1 of the year following the calendar year in which you retire.
Every year after your start date, you are required to take your RMD by December 31. Remember, for Roth IRAs, you do not have to take an RMD because you paid taxes before contributing. However, other types of Roth accounts do require RMDs, but you may be able to avoid them (for instance, by rolling your Roth 401(k) into your Roth IRA).
What happens if you don’t take your RMD?
The penalty for not taking a required minimum distribution—or if the distribution is not large enough—is still a 50% tax on the amount not withdrawn in time.
How much money do you have to withdraw?
To calculate a specific RMD, you must divide your prior year’s December 31st retirement account balance by a “distribution period” factor based on your age. You can use these worksheets from the IRS to calculate your RMD amount.
Why did they change the rules on RMDs?
Due to people working longer, Congress pushed out when required minimum distributions begin. For anyone who has not already reached age 70½ by the end of 2019, the new required beginning date will be 72 for RMDs. *There is an exception to this rule if you are not a 5% owner in the company and continue to work, you can push out your RMDs for that employer’s retirement plan until the year after you retire.
Example of a distribution calculation
Learning about the “distribution phase” is just one aspect of preparing for your nest egg years. Here is an example to help you understand.
Ann is 71 and must take her first RMD in the year that she reaches age 72. Her year-end IRA balance from the prior year was $100,000. Her “distribution period” factor (from the IRS table) is 27.4.
NOTE: The IRS just released in November 2019 proposed updates to the Life Expectancy and Distribution Period Tables, which if finalized, would also provide some relief to retirees by reducing the amount of RMDs owed each year to allow money to last longer in retirement)
The result of dividing $100,000 by 27.4 is $3,649.63 – the amount of the RMD that Ann must withdraw for the calendar year in which she turns 72.
What are the potential tax implications?
One of the critiques of this rule change is that it will mostly only benefit wealthier Americans who do not need all of their required minimum distributions right now, allowing them to have a year or two more of tax-deferred savings. If you retire before 70½, like most Americans do, you likely already will start taking withdrawals from your retirement accounts to meet your retirement income needs. Many Americans withdraw more than their RMDs require each year, so a push back in the year they must start will have a minimal impact.
On the other side, the push back in RMD age could cause negative tax consequences in some limited situations if no planning is done. Because the RMD won’t start for some individuals until two years later, the RMD could be higher than if they started at 70½. If that happens, a higher RMD can mean more taxable income.
By increasing taxable income, the individual could be pushed into a higher tax rate or even trigger increased Medicare premiums. Medicare’s Income Related Monthly Adjustment Amount (IRMAA) is determined by modified adjusted gross income. And $1 over the threshold means you pay the higher Medicare amounts, meaning that $1 extra of taxable income could cost thousands in Medicare premiums. Even just a slightly higher taxable RMD could cause serious problems.
While the bill does smooth out some minor road blocks to retirement savings, like removing the IRA age limitation, expanding the start date for RMDs, increasing annuity options as a new option for IRA’s, and potentially increasing the likelihood of small employers starting a retirement plan, there is still a strong argument that these changes are not all beneficial.
While some may be positive, it doesn’t move the retirement security needle much or at all. Many of the changes can be viewed as only benefiting wealthy IRA owners and is also a benefit to the insurance companies and their lobbying groups who have gained more access to investments into annuity options.
How have you planned your retirement savings and how will you deal with these new retirement plan rules in the SECURE Act of 2020? Will these changes help you? Or will they hurt you?