Congress is changing the rules for IRAs

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The pending changes will drastically shorten the period of time during which money has to be withdrawn from an inherited IRA.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.