Have you ever had the experience of opening up one of your kids’ report cards to see their grade drop in a subject they previously excelled at? In earlier years they had been coming home telling you how much they loved history or science, only to now become disenchanted. Perhaps when you ask them what happened, you find out they have a new teacher this year that puts a much higher emphasis on homework or classroom participation and excelling at tests doesn’t count as much. Jill and I have experienced this from time to time during our girls’ lives, and each time I reach back to the advice that my mom gave me – to step back and adapt to how they are approaching the class. It’s highly unlikely that the teacher is going to change their approach so to get the most out of the class they were going to have to change theirs.
If it was history that my kid was falling out of love with, I might quote the 19th century British statesman and father of the Conservative Party, Benjamin Disraeli, “Change is inevitable. Change is constant.” As a financial guy and someone who helps folks design, develop, and deploy sound retirement systems, this is particularly true of taxes and tax code. A vital part of the annual review process is to take a look at income tax law changes and make the prudent adjustments to existing retirement and estate plans.
The current year is no different and getting educated on the changes is imperative to keep your plan moving forward successfully. So, what are the significant changes to retirement plans this year? Well, this week, let’s go over a few of the more common ones that can have a significant impact on our retirement plans if we don’t prepare accordingly.
We’ll start with Required Minimum Distributions (RMDs) from tax deferred retirement accounts (think traditional IRAs and 401(k) plans). If you were born after June 30, 1949 you don’t have to begin taking RMDs from your IRAs and 401(k)s until you are 72 years old, up from age 70-1/2. You can take money out prior to turning 72. However for the year of your 72nd birthday, the new law requires you to take an RMD of annually-based on the RMD tables prescribed by the IRS. Those who fail to do so will incur a 50% excise tax on the amount you should have taken.
This will give an advantage to people born after June 30, 1949 by allowing them to continue tax-deferred growth in those accounts for an additional two years. Those born before July 1, 1949, must adhere to the old rules, which mandate that RMDs to start for the year they turn 70½.
What are the exact dates that RMDs must be taken? Well, these rules don’t change. Account owners must take their first RMD by April 1st of the year following the year in which they turn the age to start required distributions, or 72 for those born after June 30, 1949. Someone who turns 72 in 2022 must take their first RMD no later than April 1, 2023. The second RMD for that year must be taken by December 31st of that same year—or 2023 in the example cited above. The deadline for all subsequent annual RMDs is then December 31st of each year.
Let’s look at Inherited IRAs and 401(k)s? Under the old rules, people who inherited IRAs and 401(k)s were often permitted to extend required withdrawals and the accompanying tax payments over their own lifetimes. Often referred to as the “Stretch”, this type of planning allowed heirs to maximize growth in these accounts. Those who inherited 401(k)s and IRAs prior to 2020 will still be allowed to continue using the “Stretch” planning method.
However, under the new law for those who inherit retirement accounts after Dec. 31, 2019, the beneficiary of your account must withdraw all funds and pay the applicable taxes on these funds within 10 years of the owner’s death. Some exceptions apply and include surviving spouses and beneficiaries who are disabled; these beneficiaries will be allowed to take distributions over their life expectancies. But for many, this concept will no longer be permitted as a tax-savings strategy.
One group of savers get a little perk. Teachers and school employees with 403(b) plans, state and local government employees with 457(b) plans, and federal government workers with Thrift Savings Plans (TSPs) for federal employees have two extra years in which to comply with the new beneficiary distribution rules. This gives people who inherit those plans from someone who dies prior to January 1, 2022, the ability to use the old Stretch planning method.
So, if you were planning on utilizing the Stretch concept for your retirement plans, what can you do now? The elimination of the Stretch does allow beneficiaries and heirs to decide when, over the 10-year limit to take the money out and make any resulting tax payments. They can decide to do so in installments or a lump sum.
A discussion about how and when to make these withdrawals should be part of an annual review with your financial advisor to explore what’s most suitable for your situation. Part of this analysis will also include looking at how your financial situation might change in the future.
No longer having the Stretch IRA option available may mean exploring options like using the inherited IRA for living expenses, having your spouse inherit your IRA, or using other planning options like life insurance including ILITs (Irrevocable Life Insurance Trusts) if an estate planning issue exists.
There’s another important consideration for those whose retirement plans are held within a trust. Some IRA owners leave their accounts to trusts so that they can maintain some control “beyond the grave.” Many of these trusts restrict annual payouts to only the RMD. The elimination of the Stretch IRA means the money needs to be dispersed within a decade, so owners who want to retain control for longer via leaving their IRA to a trust will need to the take into account the tax treatment of trusts.
One option for traditional IRA owners in this situation is implement a Roth conversion strategy to convert their traditional IRA to a Roth IRA. The account owner will pay income tax on the IRA assets he or she converts, but once the money is in a Roth, the trust can take tax-free IRA withdrawals and retain control over the money.
What’s interesting is that while Benjamin Disraeli talks about changing being inevitable and constant, another Benjamin – Franklin, that is, once said that nothing in life is certain except death and taxes. Oddly enough, I think the Benjamins have it. This year and beyond, we can expect change, especially in how we are taxed now and at our death!
Folks, please be safe out there. All of us at Cutter Financial wish you and your family health and safety during these challenging times.
Have a great week.
Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, Mansfield & Southlake, TX. Jeff can be reached at jeff@cutterfinancialgroup.com.
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