In May, the House of Representatives approved the “Secure Act”,
a bill intended to “reform” 401(k) and IRA rules. The Senate
is now considering its version of these reforms. This legislation, if
enacted into law, will change the way IRA and other retirement plan contributions
and withdrawals will be made and taxed. These changes are a mixed bag
of good and bad for individual taxpayers.
Under separate bills already passed in the House and pending in the Senate,
positive changes include pushing back the age at which you are required
to begin making taxable withdrawals from 70 1/2 to age 72; and expanding
access to 401(k) plans for small employers and long-term part time workers.
Also, taxpayers over age 70 ½ will be allowed to make contributions
to traditional IRAs, as many people continue to work into their later years.
However, other provisions will negatively impact taxes and estate planning
for individual taxpayers who leave behind IRAs, 401(k) s etc. to be inherited
by their children. These changes will mean that the long-term value to
your children of an inherited IRA will be much less.
When someone dies and leaves behind an IRA (or 401(k), etc.) to be inherited
by someone else, we call it a beneficiary IRA. Tax rules then say how
soon you have to start taking money out of the IRA – and paying
taxes on it. Tax day is a bad day! When you have to withdraw money and
pay tax, it causes the value to shrink, and eliminates the value of future
growth, too. The worst taxes are taxes that you have to pay sooner instead of later.
It’s better to have to take the money out and pay taxes on it later,
in the future, and to push back the day when withdrawals and taxes reduce
the value of the account.
The pending changes will drastically shorten the period of time during
which money has to be withdrawn from an inherited IRA. This means taxes
would be paid much sooner and the ultimate after-tax value will be less.
A surviving spouse gets the best opportunity to continue “tax deferral”
– deferring or delaying the time when taxes have to be paid. A surviving
spouse beneficiary can postpone when he or she will have to start taking
required minimum distributions, and can also use a more favorable life
expectancy table that results in smaller minimum required distributions,
using either a “rollover” IRA or a “beneficiary”
IRA (or can even take out all the money! Though it’s then all taxable…).
These are advantages especially for a younger surviving spouse, and the
best option often depends on the age of the spouse and their other financial
circumstances.
Under current rules, non-spouse beneficiaries like your children can generally
stretch out required distributions and taxes over their life expectancy,
which can be a long period of time. We call that a “stretch IRA.”
Compared to taxable investments whose growth is reduced by paying taxes
every year, tax deferred IRAs, 401(k) s, etc. can grow more in the long
term. Tax-deferred growth in an inherited beneficiary IRA can produce
big gains in following decades, which the pending bills would take away.
For example, a 25-year-old child who inherits an IRA can now postpone distributions
over a life expectancy of about 57 years. That year, her required distribution
would be only about 1.75% of the total – and the amount lost to
taxes would only be a fraction of that, depending on her other income
and her marginal tax rate.
The House bill however will limit the stretch duration to 10 years. After
10 years has gone by, the beneficiary will owe taxes on the whole IRA amount.
The Senate bill permits stretch treatment for the first $400,000 combined
of IRA money, but the rest has to be distributed – and taxes paid
– within only five years!
These changes are basically intended to boost revenue by increasing taxes.
There are exceptions for spouses and young, ill and disabled beneficiaries.
Financial planning alternatives could include tax-free life insurance solutions
or charitable gifts or trusts instead. Also, Roth IRA conversions may
be more attractive. (Money in a Roth IRA isn’t taxable, since the
taxes already been paid, but is subject to the same mandatory withdrawal
rules that can lengthen or shorten the opportunity for tax-deferred growth.)
At
Marks Elder Law, we help people every day with issues like these. I invite your questions
and feedback. Please let me know how I can help you and your family.
