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Job Optional* Update

One of the tricky things about financial planning is that just when you think you understand the rules, regulations, and laws, they’re changed. So, sure enough, there were a few important changes to the laws regarding retirement accounts that took place at the end of 2019. Here is a summary of big changes that affect the information presented in Job Optional* (which was published prior to the changes in laws).

Stretch IRAs

With the SECURE Act, passed by Congress in December 2019, Stretch IRAs changed dramatically. As you’ll read in the book, a Stretch IRA allowed the balance of your IRA to pass to your beneficiary and then be taxed based on that beneficiary’s required minimum distribution. The change with the SECURE Law basically did away with that, except in the case of a spouse who is the beneficiary, who then has 10 years to take a full distribution of account funds.

Please consider the following as a substitute for what you will find on pages 129-130.

One of the biggest liabilities most retirees will face is the tax-deferred benefit accounts they have accrued over their lifetimes. This mainly consists of individual retirement accounts (IRAs) and 401(k)s, in addition to other employer-sponsored retirement plans. These assets are not only taxable upon distribution to yourself, but also to your heirs upon death. Some of the most basic planning starts with determining how to best distribute these tax-deferred accounts upon your death.

IRAs, often retirees’ largest assets, can be troublesome for survivors because of their precarious tax situation. As deferred assets, IRAs have never been taxed, and Uncle Sam is determined to get his portion. For a surviving spouse, inheriting an IRA is as easy as replacing the original owner’s name with your own or even rolling those assets into your existing IRA.

Until recently, it was possible to designate a child or grandchild as beneficiary and take minimum distributions based on their life expectancy over the course of their lives—a technique known as a “Stretch IRA” — effectively preserving the tax-advantaged nature of the account for an additional generation or more; however, the passing of the SECURE Act in 2019 eliminated this option for non-spouse beneficiaries. Now these beneficiaries are required to distribute the full amount of the inherited IRA within ten years of death. This further reinforces the need for tax-planning for your estate.

Take for instance a sixty-year-old couple with a million dollar Traditional IRA growing at 7.2% per year.  Without consideration of any Required Minimum Distributions, the value of that IRA would double twice by the time they reached the age of eighty, bringing it to four million dollars. Assuming no growth in the value of the IRA over the ten-year distribution period, there would be an annual distribution of approximately $400,000 per year. Assuming a 30% effective tax rate, the total taxes paid over the ten-year period would be $1.2M, more than the value of their IRA at sixty. It could be enraging to imagine that the current value of your IRA could go entirely into Uncle Sam’s pocket without implementing a strategy to avoid it. Enter the value of the Roth conversion.

Roth IRA Conversions

Another change to the laws has to do with Roth IRA conversions. Please consider this a substitute for what you will find on pages 130-131.

You may be saying, “Wait a minute, Casey, I thought Roth IRAs didn’t have RMDs.” You’re right. During the lifetime of the owner, Roth IRAs don’t have RMDs. Yet, after the original account owner has passed, the beneficiaries must withdraw the full value of the account over ten years in accordance with the SECURE Act. Unlike traditional IRA distributions, though, Roth IRA distributions are still income-tax-free. If you recall in a previous chapter, we discussed converting as much of your traditional IRA into a Roth IRA as possible before RMDs kick in. When it comes to legacy planning, another question to ask is: even after you are 72 and have begun taking RMDs, are you still in a lower income tax bracket than your likely heirs? If so, it might still be worth converting your traditional IRA—even at a higher tax bracket for you—into a Roth account, saving taxes for your beneficiaries down the road.

Here's another way to think about it. Think of a home loan. When you take out a long-term mortgage, you know the interest rate that will be paid and cumulative amount of interest to be paid over the life of the loan. If you are like me, you would never take out a long-term loan with a variable interest rate without a cap on the maximum rate that could be charged. However, with a tax-deductible retirement account, that is exactly what you have done. You have borrowed money in the form of taxation without knowing what tax rate you or your heirs will be charged at some distant point in the future. If your goal is to retire debt free, don’t forget about your loan from the IRS in the form of tax deferral. It could be the most expensive loan you have ever taken.

And, as you may have guessed, the ability to stretch Roth IRAs has also been eliminated, like it was with traditional IRAs. Nonetheless, distributing a tax-free account over ten years to your beneficiaries upon death could be substantially better than a tax-deferred account, taxed at their highest marginal tax rate.

Required Minimum Distribution Age Change

Yet another change brought on by the SECURE Act in December 2019 is the change to the minimum distribution age, which went from 70 ½ to 72 years old.

Please consider this section a replacement for the “Meet Steve and Barbara” section on pages 80-81.

MEET STEVE AND BARBARA

Steve and Barbara were retiring early from the same company at age sixty. Their company offered a variety of pension benefits. The most beneficial, after thorough analysis, was a 10-year, period-certain option guaranteeing all their income needs would be satisfied until age 70. This allowed for a few different planning opportunities. One opportunity, and the most obvious, was their ability to get the highest monthly Social Security check by delaying filing to age 70.

The second and less obvious opportunity was with their taxes. An often-overlooked feature of Social Security is that since 1983, a portion of many retirees’ Social Security benefit is subject to federal income taxes. Due to Social Security originally being an untaxed benefit altogether, many people forget things have changed. Today, depending on your income sources and their taxability, up    to 85 percent of your Social Security benefits can be taxed during retirement. With appropriate planning, however, you may be able to eliminate these taxes altogether, as Steve and Barbara did.

They retired with a substantial amount of pre-tax assets in their 401(k)s, which they would not require for retirement income needs. It essentially became an overblown emergency fund. Unfortunately, due to required minimum distributions on 401(k)s, Steve and Barbara came across an issue. After age 72, they would be forced to begin taking taxable distributions from their traditional retirement accounts, regardless of whether they needed the income. Failing to take RMDs could result in a 50 percent tax penalty of whatever the missed RMD is. But, as we looked down the road, we saw that Steve and Barbara’s RMDs would push most of their Social Security income into taxable range in addition to pushing them into higher marginal tax brackets.

Thankfully, with the passing of the SECURE Act in late 2019, the Required Minimum Distribution age was pushed back to 72, giving them over a decade before RMDs kicked in, and allowing Steve and Barbara even more opportunity to create a tax efficient retirement in their later years. They are using this period to convert most of their tax-deferred retirement dollars to after-tax retirement accounts, which will grow tax-free via Roth IRA conversions. Roth IRAs can grow tax-free without the requirement for distributions until the death of the owner. This almost eliminated the taxes Steve and Barbara would have paid on their Social Security benefits, and minimized the amount of federal, state, and local taxes they would pay over their lifetime. It may even save them on Medicare premiums over their lifetime.

When it comes to Social Security planning, the rules are always changing. As you can see from the previous examples, though, there are many potential landmines, and many opportunities to avoid them if you plan. If you view your retirement as a puzzle, you should see that Social Security is one very large piece!