In December 2019, a new law was passed named “Setting Every Community Up for Retirement Enhancement Act” or “Secure Act” for short. While the new law brings a few positive changes to the IRA landscape, I would say the positive changes are overshadowed by a very negative change for taxpayers related to inherited IRAs.
Before diving into the changes, let’s take a minute to review the rules for IRAs before the Secure Act. There are two main types of IRAs: Roth and traditional. Traditional IRA contributions are made from pre-tax dollars meaning that traditional IRA contributions reduce your taxable income in the year contributions are made (subject to certain limitations). The money inside the IRA gets to grow (tax free) until retirement. The government had set the age at 70½ as the age at which one must begin withdrawing assets from a traditional IRA. So, in the year in which one turned 70½ there was a “required minimum distribution” (RMD) that must be taken that is computed using life expectancy tables and the overall value of the IRA. When cash is withdrawn from a traditional IRA it is taxed like income in the year withdrawn. The Roth IRA is a more recent innovation that was created as part of the Taxpayer Relief Act of 1997. Roth IRAs are different than traditional IRAs in that contributions are made with after-tax money and, consequently, withdrawals in retirement are not taxed. The main similarity with Traditional IRAs is that the Roth IRA also has tax-free growth. Roth IRAs also have the distinct advantage of not being subject to RMD rules so withdrawals can be delayed indefinitely for the owner.
The Secure Act brings a few positive changes for traditional IRA owners. For one, the age was changed for RMDs—moving it from 70½ to 72. This change applies only to IRA owners that turn 70½ after 2019. So, this is some good news for traditional IRA owners who can delay taking distributions for bit longer if no distributions are needed. It’s also noteworthy that the law removed the age limit on making traditional IRA contributions. The previous limit was 70½ and now there is no restriction, thereby allowing IRA owners to continue contributing indefinitely if desired. These changes don’t affect Roth IRAs as Roth IRAs have no RMD and already permitted contributions after 70 ½. In my opinion, while these changes are positive, their impact is not expected to be material. More specifically, moving the RMD age back 18 months allows for a bit more tax-deferred growth but isn’t expected to materially change a taxpayer’s financial circumstances. Moreover, it doubtful that the removal of the age restriction on contributions will have a significant impact given that IRA owners are more likely to be withdrawing than adding at that time.
While there are a few positives, the Secure Act also contains a HUGE negative related to inherited IRAs which applies to both traditional and Roth IRAs. Prior to the Secure Act, if someone inherited an IRA, they effectively were able to stretch the payments over their lifetime—often referred to as a “Stretch IRA.” In other words, distributions were required upon inheriting the IRA, but the recipient was able to use their life expectancy to compute a distribution amount. This rule allowed heirs to receive payments for a lifetime and enjoy years of tax-deferred growth. The Secure Act generally requires inherited IRAs to be fully withdrawn within 10 years. This change has enormous tax implications as billions in IRA money is expected to be passed down by baby boomers in the coming decades leading to substantial withdrawal requirements and tax bills. The 10-year withdrawal requirement does have some exceptions. Thankfully, the rule does not apply to spouses of IRA owners. Also, it excludes disabled beneficiaries, beneficiaries who are fewer than 10 years younger than the IRA owner and minor beneficiaries for as long as they are minors.
In my opinion, this change hurts taxpayers, or taxpayer heirs, more than it helps. Effectively eliminating the Stretch IRA is very clearly an effort to expedite the liquidation of traditional IRAs in order to yield tax dollars more quickly. While IRAs remain an excellent tool for saving money for retirement, this change makes IRAs substantially less effective as a wealth transfer tool. If the goal is to pass a substantial nest egg to children that can be used over many years, other estate-planning tools will need to be deployed.