President Trump recently signed legislation called “Setting Every Community Up for Retirement Enhancement” (SECURE Act). This legislation has 29 provisions in it and will affect many investors saving for retirement.
One of the biggest changes is the removal of the ‘Stretch’ IRA. Prior to this legislation, children or grandchildren that inherited an IRA or Roth IRA could take the distributions over their lifetime. This is where you get the term ‘Stretch’ IRA. A lot of estate planning was done in the past to take advantage of this. For decedents that pass away beginning in 2020, a non-spousal beneficiary like a child or grandchild must withdrawal the inherited IRA or 401(k) by the end of the 10th year following the year of the inheritance.
1. Contribute to a Roth 401(k) plan or Roth IRA
Conventional planning has been to defer income and the attendant taxes into the future. If your employer offers a 401(k) plan and you are participating, this is Exhibit A of how to defer income. Contribute pre-tax through payroll deductions, have the account grow tax deferred and pay taxes when distributions are made.
In 2020 an employee can contribute up to $19,500 into their 401(k) plan. For investors over age 50, they can contribute an additional $6,500 in a so-called catch up contribution for a total of $26,000.
Some employers will also offer a Roth 401(k) plan. This allows employees to contribute on an after-tax basis. The annual contribution limits are the same as the 401(k) plan mentioned above. Employees can contribute to the 401(k) plan, Roth 401(k) or some combination of the two plans.
Investors with earned income can contribute to an IRA or Roth IRA. Earned income is from working as an employee or income earned from a trade or business you are involved with. The contribution limit for 2020 is $6,000. If you are age 50 or older, there is a catch-up contribution of $1,000 for a total of $7,000.
There are income limits to contribute to a Roth IRA. In 2020, a single taxpayer can fund the Roth IRA fully if their modified adjusted income is below $124,000. They are not eligible if their modified adjusted gross income is over $139,000. There is partial amount allowed if their income is between these amounts. For a married couple filing a joint return they can fully fund the Roth IRA if their income is below $196,000. They are not eligible if their income is over $206,000. There is also a partial amount allowed if their income is between these amounts.
The Roth IRA is not income tax deductible. However, distributions from a Roth IRA can be income tax-free if you meet these two requirements:
- The Roth IRA account needs to be open for 5 years.
- The account owner taking a distribution needs to be over age 59 ½.
Meet these two requirements and all of the distributions are tax-free. Another advantage with the Roth IRA is that it is not subject to the Required Minimum Distribution Rules (“RMD”) that IRA’s and 401(k)’s are. These RMD rules require taxpayers to take out a certain amount annually when they turn age 72. Roth IRA’s are not subject to the RMD rules during the account owners and surviving spouse’s lifetime, which is a huge benefit to a Roth IRA. This could allow the account to grow tax-free for decades. With this new legislation, non-spousal beneficiaries who could be children, grandchild or other beneficiaries must empty the account by the end of the 10th year following the year of the inheritance. Interestingly there are no distribution requirements within this 10-year period.
While there are income limits concerning who is eligible for a Roth IRA, there is a possible strategy for some investors around these limits. This is called a ‘Back Door’ Roth IRA. To fund a ‘Back Door’ Roth IRA you fund a non-deductible IRA and immediately convert this into a Roth IRA.
Investors need to be cautious however with this strategy. If you already have investments in an IRA, SEP – IRA or SIMPLE IRA this approach may not work for you. If you have assets in these accounts, the ‘Pro-Rata’rule comes into effect. Essentially, having assets in these accounts will diminish the tax advantage, as not all of the conversion from the IRA to the Roth IRA will be income tax-free.
3. Do a Partial Roth Conversion
A Roth Conversion is when you take a distribution from an IRA, tax it and rollover the proceeds within 60 days into a Roth IRA. Instead of getting a check however, have the funds sent from the IRA to the Roth IRA in a trustee-to-trustee transfer. A partial Roth Conversion here means you may only want to convert a portion of your IRA in any one year.
It is important to have additional funds to pay the tax on the conversion from another source. For example, if you wanted to convert $100,000 from your IRA to your Roth IRA, and your income tax bracket was 30%, you would want to have $30,000 ($100,000 * 30%) of funds available to pay the tax so as the entire $100,000 distributed from your IRA could be converted into the Roth IRA.
Doing a Roth Conversion accelerates the income tax. For some, this is very counter intuitive. One reason to consider this is due to the income tax rate cuts from the Tax Cuts and Jobs Act (TCJA) passed in 2017. The highest income tax rate was cut from 39.6% to 37%. We will have these income tax rates until 2025. For some perspective, President Reagan cut the highest income tax rate from 70% (not a typo) to 50% in 1981.
4. Contribute to an IRA
Prior to the SECURE Act investors could no longer contribute to an IRA after age 70 ½. Interestingly enough you could contribute to a Roth IRA at any age assuming you had earned income. Starting in 2020, the IRA is now treated the same as a Roth IRA, there is no longer any age restriction. Again, you will need to have earned income to contribute to an IRA or Roth IRA.
5. Consider delaying taking your Required Minimum Distribution
Prior to the SECURE Act, investors needed to begin taking their Required Minimum Distribution (“RMD”) from their IRA’s and 401(k)’s when they turned 70 ½. With this legislation, the age is now increased to age 72. For anyone that has not already reached age 70 ½ by December 31, 2019, the RMD date will now be age 72. While this is not a game changer, it will however allow investors another 18 months to allow the funds in their IRA to grow.