The Grinch who stole Christmas is alive and well this year—in the US Congress. Our Representatives and Senators passed a bill that negatively affects the middle and working class by changing the rules of passing on an IRA. Now adult children who inherit IRAs will be required to drain them within 10 years and pay all the taxes on the distributions and future earnings.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act, which changes many of the rules of US retirement laws, was approved almost unanimously (417-3) by the House of Representatives and the Senate (81-11). South Dakota’s Representatives Dusty Johnson and Senators John Thune and Mike Rounds all voted for the bill. Despite its name, many of the new law’s provisions are anything but retirement “enhancements.”
I wrote about the SECURE Act in June, as did other financial journalists, but it hasn’t received widespread attention. Despite its heavy bipartisan support, it isn’t necessarily a retirement boost for middle and working class savers.
This revision of long-standing IRA rules is especially unfair to parents who banked on the reliability of those rules. Many of them did Roth conversions and paid the tax due on a traditional IRA, with the intention of leaving the portion of the IRA they did not use themselves as a tax-free gift that could grow over the years and support their children’s retirement.
The amount of taxes raised by forcing inheritors to liquidate IRAs early is estimated at $15.7 billion over 10 years. The main trade-offs for this tax grab were (drum roll) extending by 18 months the age at which an IRA owner must begin taking distributions, increasing incentives to employers who set up 401(k)s, and allowing people over age 70 ½ who are working to contribute to an IRA (mic drop).
New strategies will need to address how an inheritor distributes the IRA to minimize the tax hit. Taking all of an IRA in one year could result in an heir in the peak of their earning years paying 50% of it in taxes.
If you counted on passing on an IRA to your children, you need to reexamine your estate planning. It may be better to name a spouse as a beneficiary rather than children, as a spouse still can inherit the IRA without being forced to liquidate it over 10 years.
The strategy of letting IRA assets accumulate and spending down taxable accounts may change completely. You now may want to spend down IRA accounts, with any balance going to charities, and pass on the accumulated taxable assets to children who will get a step-up in basis (tax free).
If you have made the beneficiary of your IRAs a trust, often created at death in your will, that whole strategy needs reconsidering. “Some types of IRA trusts make no sense under the new law,” says Laura Saunders in a December 21, 2019, Wall Street Journal article, “Inheriting IRAs Just Got Complicated.”
The new law gives a great boost to favoring life insurance over IRAs as a tax-efficient way to move assets to heirs. It also paves the way for high fee and commission annuities to be sold to sponsors of 401(k) plans.
Why did Congress vote so overwhelmingly to penalize IRA inheritors and open up investors’ 401(k) plans to insurance products? Perhaps many of them didn’t fully understand what they were voting on. Or perhaps the insurance lobby did their normal amazing job of selling the alleged benefits of insurance and annuities.
In any case, don’t assume the SECURE Act is a gift that will enhance your retirement security.