Article by: Jeffrey Skolnick, CPA, M.S. Taxation
On December 20, 2019 President Trump signed into law the SECURE Act and a series of tax extenders. The law has some significant provisions that you should be aware of and I will highlight what I believe to be the most pertinent to taxpayers’ and businesses’ retirement plans.
RETIREMENT PLANS
Some of the most notable provisions of the new law occur in the retirement arena, let’s explore the most significant ones.
The Secure Act eliminated the stretch provision on inherited retirement accounts. For individuals that passed away before 2020, beneficiaries were able to take Required Minimum Distributions (RMDs), based on their life expectancy. If these individuals were young these distributions could have been taken over many years, thus stretching the period when the individual would pay income taxes.
RMDs are amounts required to be taken by individuals from retirement plans in a year. The way most retirement plans are structured is an individual or a Company takes a deduction for a retirement contribution when made (let’s say in 2019), while the individual employee or self-employed individual will not pay income tax on this money until sometime down the road when they withdraw the principal and any earnings associated with the account. The tax code has a provision that stated, until the Secure Act, that minimum required distributions, in most cases, must start at age 70 ½ (this has now been changed to age 72 more on this a little later). The distributions are taken by dividing your retirement accounts by your life expectancy (there are tables that provide your life expectancy). Let’s say your retirement plan has $100,000 and your life expectancy, according to the tables is 25 years. In this case you would be required to take a $4,000 distribution and pay income tax on this amount. Keep in mind you can always take out more than the minimum amount but many individuals like to leave as much as possible in retirement, let it grow tax deferred and take it as needed. The penalty for failing to take an RMD is 50%. This makes this provision one to watch very closely.
As I stated earlier, prior law allowed non-spouse beneficiaries to stretch the retirement fund distributions over their lifetimes. If the person inheriting the funds was young the RMDs could stretch over many years (over 50 years for someone age 33 and almost 68 years for someone 15 years of age). This results in the government waiting many years to collect income tax on retirement funds.
The new law requires non-spouse designated beneficiaries, in most cases, to take all of the retirement funds within 10 years. This can have a significant affect on the beneficiary. If the beneficiary is young, not only are they paying tax on all the inherited money within 10 years but, in addition, they are very possibly working a full time job and therefore the additional income may be taxed at a higher rate.
There are some beneficiaries not subject to this new legislation, they are:
- A surviving spouse
- A child that has not reached the age of majority
- An individual considered disabled
- A chronically ill individual
A couple of positive outcomes in the retirement area are RMDs will now begin at age 72 instead of age 70 ½ and there is no longer an age limit for allowable IRA contributions. Prior to this law taxpayers were not permitted to contribute to a traditional IRA after age 70 ½.
I do want to provide a warning here. As you know I have previously covered taking your RMD from your IRA and directly donating it to a charitable organization, called a Qualified charitable distribution (QCD). If done properly you would avoid picking up your RMD as taxable income and reporting your contribution as an itemized deduction. The advantage to this is you receive the deduction whether you itemize your deductions or not and you also keep your Adjusted Gross Income (AGI) lower and AGI is used in certain other calculations such as medical expense deductions which must exceed 7.5% of your AGI in order to be considered deductible or the taxability of social security benefits received.
If you make traditional IRA contributions after age 70 ½, then you must reduce the amount of QCD allowed. A quick example would be a taxpayer made IRA contributions of $6,000 per year for each of 2 years after reaching age 70 ½. If that same taxpayer withdraws a $10,000 RMD and wants to donate it using a QCD, the deduction would have to be reduced by the $12,000 down to $0 (never below $0). This would require the taxpayer to show $10,000 as retirement income and a $10,000 itemized deduction for the charitable contribution. If the same taxpayer has another $10,000 RMD that they wanted to donate in the next year, it would have to be reduced by $2,000 (the amount of IRA contributions after age 70 ½ still remaining). This would result in the taxpayer excluding $8,000 of the RMD from income and as an itemized deduction. The remaining $2,000 would be shown as income and a charitable contribution.
ELIMINATION OF 10% PENALTY FOR BIRTH OR ADOPTION WITHDRAWALS
In most cases when taxpayers withdraw retirement funds before age 59 ½, they incur a penalty of 10% on top of paying Federal income tax. The new law allows up to $5,000 to be excluded from this penalty if used within one year of the date of birth of a child or the date of legal adoption becomes final.
NON-TUITION FELLOWSHIP AND STIPEND PAYMENTS TREATED AS COMPENSATION FOR IRA PURPOSES
Prior to the Secure Act taxable stipends or other amounts received by graduate or postdoctoral students were treated as taxable income but not allowed as earned income for purposes of allowing an IRA or Roth IRA contribution. This was changed with the new law.
SMALL-EMPLOYER AUTOMATIC CONTRIBUTION TAX CREDIT
Businesses that establish, or have previously established, 401k or SIMPLE plans that cover 100 or fewer employees and implement an automatic contribution arrangement for the non-highly compensated individuals are eligible for a $500 tax credit for three years.
EXPANDED TAX-FREE SECTION 529 PLAN DISTRIBUTIONS
529 plans have been around for quite a while and the are can be withdrawn tax-free for qualified higher education expenses. These expenses include fees, books, supplies and required equipment. The Tax Cuts and Jobs Act expanded allowable expenses to include up to $10,000 per year of expenses for an elementary or secondary public, private or religious school.
The Secure Act allows for more tax-free distributions. These include an expanded definition of qualified higher education expenses to include an apprenticeship program registered and certified with the Secretary of Labor. The law now also allows a maximum of $10,000 lifetime limit to be used to repay the principal or interest payments of any qualified education loan of the registered beneficiary or his/her siblings. The $10,000 limit is per person, therefore an individual with 2 siblings can withdraw $30,000 as a lifetime maximum to pay off $10,000 of principal and/or interest of a qualified education loan of the beneficiary and $10,000 for each of the siblings.
QUALIFIED DISASTER DISTRIBUTIONS
If you reside in a Federally declared disaster area that suffered economic loss, the you will be allowed to withdraw up to $100,000 from your retirement account for each disaster and you will not be liable for the 10% early withdrawal penalty and you will be treated as taking this money ratably over a 3 year period for tax purposes. You are also able to repay the distribution within a 3 year period and thereby eliminate the income tax on the distribution.
EXTENDED PLAN ADOPTION DATES FOR EMPLOYERS
Most retirement plans adopted prior to 2020, although not required to be funded before yearend had to be established before yearend. The new law allows employers to the due date of their income tax returns (including extensions) to establish a retirement plan.
CONCLUSION
The Secure Act provided many changes to retirement plans for employers, employees and self-employed individuals. This is a recap of what I feel are the most significant of these provisions. There are others and because of that, I urge you, as always, to consult with a tax professional well versed with the new law.
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