The SECURE Act and its Impact on Widows and Widowers, Part I

Setting Every Community Up for Retirement Enhancement (SECURE) Act was signed into law December 20, 2019 by President Trump. The SECURE Act (“Act”) affects many and includes numerous provisions. In this first post on the SECURE Act I’ll focus only the details and rules of two major provisions that will most likely impact widows and widowers and their immediate family members. In a future post we’ll look at a number of financial and estate planning strategies around the SECURE Act.

NOTE: As with any change to the law, financial advisors, tax professionals, attorneys and taxpayers have a way of coming up with or discovering scenarios the IRS did not anticipate or did not fully clarify in the original change to the law. No doubt the IRS will come out with answers to future questions and clarifications on how to apply the new law to unanticipated scenarios. If future IRS answers and clarifications affect the content of this post, I’ll make every attempt to update the post appropriately.

The first major provision of the SECURE Act changes distribution requirements for inherited Individual Retirement Accounts (IRAs) and defined contribution accounts and is known, unofficially, as the 10-Year Rule.  The second major provision extends the age at which mandatory distributions must be taken from a retirement account such as a 401k or a traditional IRA and is known as the Age-72 Rule.

The New 10-Year Rule for Inherited IRAs and Defined Contribution Accounts

What does the 10-Year Rule affect? The 10-Year Rule affects inherited retirement accounts including Defined Contribution accounts (e.g. 401k, 403b) and IRAs (traditional and Roth). Inherited accounts may also be known as beneficiary accounts. Also, if you inherit a Defined Benefit account or “pension”, and you select a payout option which allows you to roll a lump sum to an IRA, this new IRA will also fall under the 10-Year Rule. The 10-Year Rule has no effect on non-retirement accounts (Individual, Joint, Community Property, Trust, Tenants in Common), only on retirement accounts that are passed along to beneficiaries.

When does the 10-Year Rule effect these retirement accounts? It affects many beneficiaries of these retirement accounts if the original account owner passes away January 1, 2020 or later. If the original account owner passed away in 2019 or earlier, this new 10-Year Rule does not apply. The date when an inherited retirement account is opened or established does not determine use of the 10-Year Rule; what matters is the date of death of the original account owner. For example, if a beneficiary’s inherited retirement account is opened on Feb 12, 2020, but the original account owner died in 2019 or earlier, the beneficiary does not fall under the new 10-Year Rule. Also, this new 10-Year Rule does not affect every beneficiary…

Who does the 10-Year Rule affect?  It might be better to cover those who the 10-Year Rule DOES NOT affect. It DOES NOT affect the following designated beneficiaries of retirement accounts:

• Surviving spouse
• Disabled (within the meaning of section 72(m)(7))
• Chronically ill (for the most part, within the meaning of section 7702B(c)(2))
• Individuals who are up to 10 years younger than the deceased account owner
• Minor children until they reach age of majority (47 states and the District of Columbia use age 18 as age of majority while Nebraska and Alabama use 19 and Mississippi uses 21). Once the Minor reaches age of majority any remaining account balance must be distributed over the ten years after the age of majority date.

Was there an old rule, before this 10-Year Rule, and if so, what happened to this old rule? Yes, for anyone who inherited a retirement account from the original account owner who passed away 12/31/2019 or earlier, the beneficiary follows the old rule. The old rule allows the beneficiary to “stretch” their inherited retirement account over their lifetime by taking only the smallest required distribution each year. The smallest required distribution is called the Required Minimum Distribution (RMD). Some of you may hear this called the MRD or Minimum Required Distribution. Just know that RMD and MRD are the same thing.

Each dollar taken out of the account as a distribution from an inherited retirement account is taxed as ordinary income to the account beneficiary. Any cost basis distributed from the account is not included in the ordinary income amount. Cost basis is the portion of contributions made by the original account owner that were deemed nondeductible. This cost basis is carried over to the beneficiary’s inherited retirement account. Ask your tax or financial advisor if there was any cost basis in the original account owner’s retirement account and whether your portion was carried over to your inherited retirement account. The important point about taking just the RMD each year is that the bulk of the IRA stays intact and continues to grow tax-deferred, for years and even decades! Over a long lifetime of a young beneficiary, this long-term, tax-deferred growth may result in more, sometimes many more, dollars collected.

The new 10-Year Rule requires beneficiaries, except those listed above, to distribute all the contents of that inherited retirement account by the end of the 10^th year after the year the original owner passed away. If the original owner passes away in 2020, that year does not count. Required to follow the 10-Year Rule, the beneficiary has until 12/31/2030 to distribute the entire inherited retirement account (unless they meet one of the five exceptions listed earlier). Distributions can be evenly distributed over the ten years or randomly distributed. The beneficiary can choose to take no distributions the first nine years and then distribute the entire account balance in the tenth year (with a potentially bigger tax bill than taking ten smaller annual distributions). There is no formula, law or requirement on how to split up the distributions over this ten-year period. It’s up to the beneficiary (and hopefully their financial and tax advisors are involved and helping to devise the best strategy for the beneficiary).  

How does the 10-Year Rule affect you? Because a surviving spouse meets a listed exception and does not have to follow the 10-Year Rule, she still has two options for a retirement account inherited from her spouse; she can choose to roll her deceased spouse’s retirement account into her own retirement account (normally this is an IRA), or she can keep the account as an inherited retirement account. If she rolls her deceased spouse’s retirement account into her own retirement account, the new retirement account is no longer considered an inherited or beneficiary account, it’s just her account, in her name, and it has no ties to her spouse. If she follows the second option and keeps the inherited retirement account as an inherited account, it stays tied to her spouse but is now for her benefit. Each strategy has pros and cons depending on the surviving spouse’s age and financial situation.  Determining which option is better for a surviving spouse requires thought and analysis by a qualified financial advisor within the context of the widow’s entire financial situation.   

If the surviving spouse in the previous paragraph also happens to inherit an IRA from an elderly friend (let’s say her friend was more than 10 years older than the surviving spouse) who passes away after 12/31/2019, the surviving spouse must follow the 10-Year Rule. In this case, the surviving spouse does not meet any of the exceptions in the listed above. However, if the friend is less than 10 years older than the surviving spouse, the surviving spouse meets the 4^th exception listed above “Individuals who are up to 10 years younger than the deceased account owner“. In this case the surviving spouse does not have to follow the 10-Year Rule. If the friend passed away in 2019, we learned earlier that the 10-Year Rule does not apply.

For a widow’s minor children, the new 10-Year Rule requires vigilance. The 5^th exception listed is for minors until they reach the age of majority. Let’s say a child, age 8, inherits $200,000 from her father’s IRA. Her father passed away on Jan 10, 2020. In the child’s state, age of majority is 18. Because the child is 8, she falls under the exception to the 10-Year Rule and may take RMDs based on her life expectancy using a factor taken from Table 1 – Single Life Expectancy, Appendix B, in Publication 590-B. The factor for this eight-year-old is 74.8. Avoiding some details, her RMD under the pre-10-Year Rule (“old rule”) is $200,000 divided by 74.8 which is roughly $2,674. She can let the remaining $197,326 continue to grow tax deferred. Next year, let’s assume the account does not shrink, she takes a slightly larger distribution, but not much larger than the first. If the IRA grows due to good investments, her annual RMDs over a life expectancy of 80 or 90 years would grow larger and larger until at some point later in life her RMDs would outpace the investment growth. If using the old rule for the rest of her life, this would allow the IRA to could grow tremendously. However, this will not be the case for her. When she reaches age 18, age of majority in her state, she is forced to switch to the 10-Year Rule. Let’s assume her inherited IRA account balance has grown by about 5% annually to $320,000 by age 18. Instead of taking an RMD of roughly $4,900 using the old rule, she must now take the entire $320,000 over the next 10 years. If she splits distributions evenly, she takes the first of ten distributions, equal to $32,000 at age 18, and pays income taxes on that $32,000. If she doesn’t need all $32,000, she is paying taxes unnecessarily and her account is not growing as efficiently as it could under the old rule. If she forgets to take the larger 10-Year Rule distribution at age 18 and beyond, the IRS could get nasty and penalize her a very high amount. So, knowing when to adjust the RMDs to the new 10-Year Rule is critical!  

Sometimes the original account owner will decide to nominate a trust as the beneficiary of the retirement account with children as beneficiaries of the trust instead of direct beneficiaries of the retirement account. This arrangement is done when an adult child has questionable money management skills or an addiction or potentially may lose assets in a legal settlement. After the original account owner passes away, the successor trustee manages the trust assets, including the retirement account, and doles out money to the challenged adult child as needed or when appropriate. The details in the SECURE Act do not make it clear as to how the 10-Year Rule impacts such trusts.  If you have such an arrangement, stay tuned for further guidance on the SECURE Act and its application to trusts. On to the second major provision of the SECURE Act…

The New Required Beginning Date for Original Owners of IRAs and Defined Contribution Accounts (Not Inherited Retirement Accounts)

The old rule for an account owner who attained age 70 ½ by 12/31/2019, requires mandatory distributions from their own retirement account such as a traditional IRA, 401k, or 403b (but not an inherited retirement account) during the year they reach age 70 ½. The account owner, under this old rule, must take their first Required Minimum Distribution (RMD) any time during the year they turn 70 ½ and as late as April 1^st of the year after they turn 70 ½. If they wait to take their first RMD in the year after they turn 70 ½, they must take a second RMD by 12/31 of that same year. For ease of planning, and to minimize potential taxes, we normally recommend taking the first RMD by 12/31 in the year age 70 ½ is reached so as to avoid taking two RMDs the following year.

The SECURE Act extends the age 70 ½ requirement to age 72, but not for everyone! Let’s call it the Age-72 Rule. Why did the US Government make this change? Most likely because life expectancies have increased and many Americans are now working longer. Some account owners may have sufficient cash flow from other sources and don’t need to take an RMD (and pay the income taxes on that distribution), so any relaxation of this rule is welcome.

How does the Age-72 Rule work? For those who have already reached age 70 ½ by 12/31/2019, there is no change. They follow the same “Age 70 ½ Rule” described above. The Age-72 Rule impacts those who reach age 70 ½ on 1/1/2020 or later, or put another way, if you were born on or after 7/1/1949, you will fall under the Age-72 Rule and will not need to take any RMD until the year you turn 72. 

As an example, Jill inherited an IRA from her husband three years ago in 2017. She rolled this IRA into her own IRA and thereby owns the IRA as her own. Her husband is no longer tied to this IRA and it is no longer considered an inherited IRA. Jill turned 70 on November 10, 2019. Because she did not reach age 70 by 7/1/2019, she falls under the new Age-72 Rule and does not need to take an RMD in 2020. Her 72^nd birthday will be 11/10/2021, so it’s recommended she take her first RMD by 12/31/2021. She could wait and take her first RMD in 2022, as late as 4/1/2022, but then she must also take a second RMD by 12/31/2022, thereby doubling the amount of taxable income that year from her two IRA distributions.

If Jill turned 70 on June 30, 2019, she will reach age 70 ½ six months later on 12/30/2019. This puts Jill under the old rule, and she should take her first RMD by 12/31/2019, but she has until April 1, 2020 to take it. If she waits until 2020 to take that first RMD, she’ll need to take a second RMD by 12/31/2020.

Under the Age-72 Rule, the extra year or two of delayed RMDs may give the widow an extra year or two for other tax strategies like making additional Roth IRA conversions. If Social Security is delayed until age 70, don’t forget to add that income into any analysis for possible Roth conversions or other strategies. We’ll cover these strategies in the next SECURE Act blog post.

Other SECURE Act Tidbits:

• For all IRA account owners with earned income after age 70 – as of 1/1/2020 you can now make IRA contributions up to the current annual contribution limit or amount of earned income, whichever is less, no matter your age. The old rule only allowed IRA contributions up to age 70 ½. The new rule also creates the potential for an odd occurrence; you might be in a situation where you are allowed to make an IRA contribution, due to earned income, at, let’s say age 75, but also are required to take a RMD the same year!
• College Saving Plans (“529 plans”) consider fees, books, supplies or equipment required for apprenticeship programs as “qualified higher education expenses”. Also, up to $10,000 can be used from a 529 Plan account to repay student loans for the account beneficiary (the student using the account). Not to be outdone, the Act also allows $10,000 to be used, from this same 529 account, to repay student loans for each sibling of the beneficiary!
• There are many more smaller tidbits, but most will not impact many widows or widowers.

To summarize, the two big provisions are the 10-Year Rule affecting distribution requirements for inherited retirement accounts and the Age-72 Rule affecting the distribution start date for your own retirement account. Note the exceptions to the 10-Year Rule and get good financial and tax advice regarding these changes.

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Jim Schwartz is a Scottsdale, AZ fee-only financial planner with an expertise and interest in financial planning and education for widows and widowers.  Years of working with and advising widows, widowers, and surviving partners has provided a wealth of experience and knowledge in this complicated financial arena.  He is particularly skilled in his ability to guide his clients through difficult decisions while ensuring the stability of their finances. 

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Jim Schwartz, CFP®, RICP®
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