Two Big Retirement Rule Changes From the SECURE Act ⁠— and What to Know About Them

It’s been almost two years since the SECURE Act was signed into law. The SECURE Act, or “Setting Every Community Up for Retirement Enhancement Act,” offers several major adjustments to how we save, prepare for and enjoy retirement. If you’re at or near retirement and have a considerable amount of before-tax savings in IRAs or 401k plans, there are two big rule changes the SECURE Act affects that are worth some strategic financial planning – that’s the former concept of a “Stretch IRA” and required minimum distributions.

Change #1: Reduction of the “Stretch IRA”

With the right estate plan in place, people have had the ability to transfer an IRA account to a beneficiary after their death. While we’re still able to do so, one major change after the passing of the SECURE Act is affecting our beneficiaries in a big way.

If someone has died before December 31, 2019, the inheritor can choose to take withdrawals from the account over the remaining span of their life expectancy. This offers the beneficiary a chance to minimize their yearly tax obligation by receiving smaller amounts over a longer period of time. 

With the SECURE Act changes, this concept of a “stretch IRA” (meaning the withdrawals are stretched over a lifetime) is eliminated for some. For those who have died after December 31, 2019, their beneficiaries (with the exception of a spouse) are now required to withdraw the entirety of the account within 10 years of inheriting the account.1 For most, this means withdrawing larger sums of money during a smaller period of time - leading to a higher yearly tax obligation. Depending on the amount, these withdrawals could even push a beneficiary into a higher tax bracket.

It’s important to note, however, that there is no limitation to how the money is distributed. For example, the beneficiary could choose to withdraw the entire amount during year 9, or they could evenly withdraw the amount each year for 10 years.

Example: Tony is married with three children. Tony and his wife had adjusted gross income of $300,000 in 2020 and expect a little more in 2021. Tony also inherited a $1,000,000 IRA from his father.

If Tony made 10 equal withdrawals, those required withdrawals might add $100,000 per year or more in additional income. A onetime withdrawal might mean $1,000,000 in additional income. The extra income will impact Tony’s taxes now and may push them from the 24% federal marginal tax bracket into the 32% or higher tax bracket in 2021. So, the effective tax rate on that IRA money may be relatively high. The Nebraska tax rates would add up to 6.84% in additional taxes in 2021.

Exceptions to the Change

There are certain individuals who are exempt from this new 10-year rule. The spouse of the deceased, for example, can continue withdrawing from the account over the remainder of their lifetime. 

Others who are exempt from this rule include:

• Beneficiaries who are disabled or chronically ill
• Minors (unless it is a grandchild of the deceased)
• Those who are less than 10 years younger than the original account owner (for example, a sibling)¹

Change #2: Required Minimum Distribution Age

Before the SECURE Act passed, the required minimum distribution age was 70 ½. That means that for anyone who turned 70 ½ in 2019 and before is required to withdraw the minimum amount from their retirement accounts, such as a 401(k) or IRA. With the new law in place, that age has jumped to 72.1 While it doesn’t sound like much of a difference, that 18 months of additional saving and delayed withdrawal can create a significant impact on a retirement account. Plus, this allows retirees to delay the tax obligations of withdrawing this income from their accounts.   

Example: Tony’s father, Lucas, was waiting to withdraw his IRA money until RMDs were required. To pay for his retirement expenses, he was using his cash savings. He heard it was better to allow his before-tax savings to grow.

Lucas was in a very low tax bracket early in retirement. By using his cash savings, his income was limited to the small amount of interest he was receiving from his bank savings. As a result, he was paying no Federal Income tax.

Tax Planning for Nebraskans in Early Retirement

It might make sense to increase taxable income early in retirement in order to reduce the tax rate on the pre-tax savings later in retirement. It’s counterintuitive to choose to pay taxes early, but, strategically, it may make sense.

Delaying withdrawals from pre-tax savings increases the potential value - the result is the amount of the Required Minimum Distribution may be greater. This may come at a time when other income such as Social Security benefits have been maximized – further compounding the potential for higher tax rates. That bigger account balance may also increase the tax burden on a beneficiary when inheriting an IRA. Given that current Federal Income tax rates are scheduled to sunset on Dec 31, 2025, and Congress is considering tax increases for high income families, early retirement may be the time to strategically plan for increased IRA distributions.

One way to do this is to create a strategic tax plan that estimates the income tax rates later in retirement and gauge the tax rate a beneficiary might have if the IRA is inherited by a high earner. The next step is to target IRA withdrawals early in retirement up to the tax rate that matches the later retirement tax rates or those of a beneficiary. Although it is not a guarantee, this strategy could better balance the tax rates applied to withdrawals from a big IRA.

Example: If Lucas had not passed away and left his IRA to Tony, he could have opted to begin IRA distributions in early retirement rather than use his cash savings. To be conservative, Lucas targets withdrawals that put his income at the upper end of the 22% Federal Marginal tax bracket.

Lucas estimated his Social Security income and RMDs after Age 70 would subject his income to a Federal Marginal tax rate of 28%, which is when rates are scheduled to return to the tax rates in 2017. He’s also concerned with Tony’s much higher tax rate if he were to inherit his IRA at that time.

Because Lucas doesn’t need the full amount to cover his retirement expenses but wants to take advantage of the relatively low tax rate of 22%, he decides to convert a portion of his IRA to a Roth IRA. The benefits of which are left for another article.