Investors should be aware that the legacy pension plan must be liquidated in 10 years
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Most people don’t know anything about the Secure Act, yet it has a big impact on their retirement planning.
With little fanfare, the Secure Act (Setting Every Community Up for Retirement Enhancement Act) was signed into law on December 20, 2019. It is an important piece of retirement legislation that includes many reforms that could make the easier and more accessible retirement savings for many Americans.
For example, the law expanded access to employer-sponsored retirement accounts, raised the required minimum distribution age to 72, and allowed families to use 529 college savings plan funds to repay student loans.
These are all good things for individual investors.
However, there is a potential downside: The Secure Act brought a major change for beneficiaries of Individual Retirement Accounts and 401(k) plans.
One of the provisions of the bill requires inherited qualified retirement accounts to be liquidated within 10 years. This means that if you inherit an IRA or 401(k) plan from someone other than your spouse, the Secure Act could impact your retirement savings plans or wealth transfer strategies. to future generations.
Before the law, if you inherited an IRA or 401(k), you could “stretch” your taxable distributions and tax payments over your life expectancy. Certainly, many people have used expanded IRAs and 401(k) plans as a source of reliable income for life. Now, for IRAs inherited from original owners who died on or after January 1, 2020, the new law requires most beneficiaries to withdraw assets from an inherited IRA or 401(k) plan within 10 years of the death of the account holder.
This could result in millions of Americans paying tens of thousands of dollars in additional taxes each year. And the problem? Few investors have any idea this could happen, nor do some financial advisors.
To illustrate the issues, consider a hypothetical newly retired couple. They have $3 million in assets – $2 million from non-qualified accounts and an additional $1 million from an IRA.
Any competent financial adviser would ask them to live primarily on Social Security and their non-qualified investments (which come from already taxed sources) and to use IRA proceeds sparingly (which are tax-deferred).
Assuming the couple own their home and are in good health, this approach would allow them to live comfortably and keep their taxes low. The 10-year drawdown provision, however, might cause some investors like this to be more mindful of their heirs.
For example, let’s say the couple has a sole heir, a single daughter whose annual income is just under $70,000. Before the Secure Act, she could have inherited a $1 million IRA—which is possible depending on the type of account, market conditions, and her parents’ age at the time of their death—without absorbing a large amount. part of the tax. All she would have to do was make sure she didn’t take too much, too soon.
However, after the security law, his taxes will increase. Even if she spreads the mandatory withdrawals evenly over 10 years ($70,000 + about $100,000 = $170,000), she will skip two tax brackets (from 22% to 32%). All told, this could easily represent a six-figure hit.
What about a co-heir in the same situation? Certainly, while the ramifications might not be as dire, their taxes would still go up, possibly complicating their financial planning.
So retirees whose taxable income is lower than that of their heirs – which is the case for most retirees – should at least consider whether it makes sense to approach things differently. If they reduced their qualified assets more aggressively and kept larger non-qualified account balances, here’s what could happen:
Their tax liability could be far less than what their higher earning heirs might pay in the future.
At the same time, they could make strategic withdrawals from unqualified accounts to ensure that their rate does not increase too much (i.e. pushing the limits of one tranche without moving to the next).
Meanwhile, since their qualified accounts benefit from an increase in base, it would further reduce the tax burden on their heirs. This is because earnings on these accounts are taxed based on the value at the death of the benefactor.
Of course, not everyone will agree to a plan like this. You may feel like you’ve been saving and investing for decades, so you shouldn’t have to worry – or, frankly, care – whether your adult child has to pay a little more tax. every year. (After all, they receive an inheritance!)
But, again, we’re not talking pennies on the dollar. Indeed, the stakes for some could well exceed $100,000. So, just as many are implementing estate planning strategies to protect more of their wealth, it’s at least worth sitting down with an advisor to consider whether it makes sense to do the same when it comes to concerns the implications of the Secure Act.