As part of the 2019 year-end domestic appropriations bill, a significant package of rule changes for IRA and 401(k) based retirement plans known as the Setting Every Community Up for retirement Enhancement Act (SECURE ACT) was included.
This act passed the House of Representatives in August of 2019, but stalled out in the Senate. It suddenly came back to life through inclusion in this must-pass spending bill.
As a result, some impactful changes to the way IRA plans operate have become law.
While the law makes changes in a range of areas related to self-directed IRA and 401(k) plans, we wanted to focus this article specifically on those changes that may affect holders of a self-directed IRA.
Age for Required Distributions Is now 72
The age at which one is required to start taking distributions from a tax-deferred IRA has been pushed back from 70½ to 72.
For those individuals who would choose to not take a distribution, this slight deferment of the start timing for Required Minimum Distributions (RMDs) is a bonus.
Perhaps the bigger benefit is simplicity, as it was somewhat complex to determine when the first date of required distributions would be on a half-year basis. Knowing the calendar year in which one turns 72 is pretty straightforward.
As with the current law, there is an option for when the first distribution must take place. You can take it by the end of the year when the taxpayer turns 72, or you can delay it until April 1 of the year following. This means that someone turning 72 in 2021 can delay taking their first distribution until April 1, 2022.
The first distribution will be taken using the age 72 life expectancy factor, even if delayed. When the first payment is delayed, you’re still required to take a distribution for the 73 year, so there could be two separate distribution events in the first year.
This change takes effect after December 31, 2019, with respect to individuals who turn 70 ½ after that date. People born before June 1, 1949, will still fall under the old rules.
Repeal of Maximum Age for IRA Contributions
The prohibition against making new contributions to a Traditional IRA after age 70½ was removed. This change allows individuals to continue making contributions to the IRA indefinitely if they continue to have earned income.
Considering that many people are living and working longer, this ability to continue to set money aside in a tax-sheltered IRA may provide a benefit for some savers.
Once one reaches age 72 and is required to start taking distributions, this ability to still contribute may soften the blow to some degree.
If you’re required to distribute $3,000 but can contribute $7,000, you still get a $4,000 net reduction taxable income.
Elimination of RMDs and “Stretch” Concept for Inherited IRAs
Probably the most significant change to IRA based plans in the new law surrounds requirements for distributions from non-spousal inherited IRAs.
Prior to the SECURE Act, an inheritor of an IRA could choose to take a full distribution of the account within a 5-year period or stretch distributions over their life expectancy with calculated required minimum distributions based on their age.
The ability to stretch an IRA over a longer term has been eliminated and replaced by a new 10-year rule. The entire inherited account must be emptied by the end of the 10th year following the year of inheritance. Failure to fully distribute the account results in a tax penalty of 50% the amount that should have been distributed.
This rule applies to any account inherited after December 31st, 2019 and will not impact existing non-spousal inherited IRA plans.
The following types of account beneficiaries are exempted from this requirement and are termed “Eligible Designated Beneficiaries”:
- Disabled beneficiaries (as defined in IRC Section 72(m)(7))
- Chronically Ill beneficiaries (as defined in IRC Section 7702B(c)(2))
- Individuals not more than 10 years younger than the decedent
- Certain minor children of the original account owner, but only until they reach the age of majority
For these Eligible Designated Beneficiaries, the old rules allowing for the use of a life expectancy based required minimum distribution apply.
$5,000 Early Distribution for Birth or Adoption
A new exception was created that allows for a small early distribution from an IRA without a 10% penalty in the case of a new child.
Within a 1-year period from the birth of a child or the adoption of a child under the age of 18, a distribution of up to $5,000 may be taken penalty free. Any normal taxable amount would still be owed.
If both parents have an IRA, each can take up to the $5,000 amount. This same type of distribution may be taken for each child born or adopted and is not a one-time exception like a first-time home purchase.
The unique thing about this exception is that in the future you can replace the distributed amount taken via this method. If you distributed $5,000 in 2021, you could in the future make an IRA contribution up to your allowable maximum as well as that $5,000, without it being considered an excess contribution.
How do These Changes Impact Investors?
The delay in a need to take RMDs will likely benefit many investors in a small way. Designing a portfolio that will meet the liquidity needs of RMDs is always a concern once someone is in their 60’s, and this delay will create a bit of extra flexibility.
The benefit from being able to continue to make contributions should be somewhat limited to a handful of investors still working and creating earned income into their seventies. This option will perhaps mitigate the impact of required distributions, but will not likely change how one chooses appropriate investment assets for their account.
The focus in these later years should still be principal security and production of consistent income capable of meeting the liquidity requirements of distributions.
The change in how inherited IRAs are treated is considerably more significant. With alternative asset investing, one is typically dealing with larger, less liquid assets such as properties, limited partnership interests, mortgage notes and the like.
Having a fixed date by which such assets need to be either liquidated or distributed in-kind to liquidate the entire account could be problematic. Those who are newly inheriting an IRA and considering making it self-directed will need to think carefully about asset selection and a timeline for taking distributions.
For those investors utilizing a self-directed IRA as part of a broader estate plan and a means to pass wealth to the next generations, a reconsideration of those strategies may be in order.