Although the SECURE ACT is often discussed as one of the largest retirement-focused legislative reform in decades, it included a number of implications for individuals who are divorced or facing a divorce when it became effective January 1, 2020. While the law isn’t directed specifically to divorcing spouses, it’s important to understand these changes given that retirement accounts are a significant consideration in most divorce matters. Some of the SECURE Act provisions that will most likely impact divorcing spouses include:
Stretch IRA for Non-Spouse Heirs
Perhaps one of the most significant aspects of the SECURE Act impacting divorcing or divorced individuals is the elimination of the so called “Stretch IRA.” Under the old rules, beneficiaries were able to stretch required minimum distributions (RMDs) over their lifetime on inherited Traditional IRAs, Roth IRAs and qualified retirement plans. Under the new rules (with a few exceptions) non-spouse beneficiaries who inherit one of these accounts in 2020 or later are now required to withdraw all assets from the inherited account within 10 years following the death of the original account owner.
Exceptions to the SECURE ACT “10-Year Rule”
- Surviving Spouse
- Minor Children—Only until the child reaches the age of majority, then the 10-year rule applies.
- Disabled Individuals—The beneficiary must meet the strict definition from the tax code stating that an individual is unable to work for a long or indefinite period and prove long-term disability.
- Chronically Ill—The beneficiary must meet the definition from the IRS tax code which requires certification by a professional that the individual is unable to perform at least two activities of daily living for at least 90 days or requires “substantial supervision” due to cognitive impairment.
- Similar Age Individuals—The beneficiary is not more than 10 years younger than the IRA or retirement plan owner (e.g. siblings).
Usually, individuals select their spouse as the primary beneficiary and their children as contingent beneficiaries. However, in a divorce situation, the children are often named as primary beneficiaries.
Distributions may be made in any amount over the 10-year period as long as the IRA or retirement account is entirely depleted by the end of the 10th year. Compressing distributions into a 10-year period creates tax implications for the non-spouse beneficiaries, since withdrawals from traditional IRAs and other retirement plans are taxed at the beneficiary’s ordinary income tax rate.
However, for those who don’t necessarily need to tap into their IRA or retirement plans for living expenses in retirement, there may be tax planning opportunities. Since your income, and thus your tax bracket, typically declines as you enter retirement, there may be opportunities to manage the timing of distributions from retirement accounts to take advantage of lower tax brackets. In addition, the beneficiary’s tax rates may differ significantly from the original account owner’s, but tax rates could also differ between beneficiaries. It might make more sense to designate taxable account assets to heirs in a higher tax bracket and IRA and retirement assets to beneficiaries in a lower tax bracket.
It is also important to evaluate whether conversion to a Roth IRA may make sense to meet the account owner’s goals. Conversion to a Roth IRA allows the taxes to be paid by the account owner while the beneficiary recipient will inherit a non-taxable asset.
Trusts as Beneficiaries
If a trust is a named beneficiary, the two typical types of trusts utilized are conduit trusts or discretionary trusts.
Many conduit trusts are drafted in a manner that only allows for the required minimum distribution to be disbursed from an inherited IRA to the trust each year, with a corresponding requirement that the same distribution be passed directly out to the trust beneficiaries. In light of the changes made by the SECURE Act, for those beneficiaries now subject to the 10-year rule, where there is only one year where there is an RMD, the 10th year results in all the taxable income being pushed to that 10th year!
Conduit trusts drafted with language similar to that referenced above might not allow the trustee to take any distributions of the inherited account until the 10th year after death (because prior to that 10th year, any IRA distributions would be ‘voluntary’). Then, in the 10th year, the entire balance would have to be distributed in that single year to the trust and then be passed entirely along to the trust beneficiaries (as a mandated RMD that under the conduit provisions ‘must’ be passed through). The end result could be a very high tax bill to the heir(s), as the entire value of the retirement account is lumped into a single tax year as a distribution to the beneficiary.
In addition, there is a loss of any protection provided by the trust for such assets, since they are distributed from the trust.
Discretionary trusts may not fare much better, if at all. Such trusts often require that all, or a substantial portion of retirement account distributions, remain in the trust (not distributed to the trust beneficiaries). In such circumstances, amounts retained by the trust are subject to trust tax rates, which are highly compressed as compared to individual tax rates.
In short, any trusts that are named as beneficiaries should be reviewed to make sure the funds are being transferred according to the original account owner’s wishes.
Annuities in 401k and Other Retirement Plans
The SECURE Act increases the availability of annuities in employer retirement plans. This is something to be considered, since some annuities may not be divided between spouses, complicating Qualified Domestic Relations Orders (QDROS) that split retirement plans. Annuities in retirement plans should be considered a separate item when drafting any Marital Separation Agreements (MSA) to avoid the headaches of trying to amend an MSA.
Contribution Age Eliminated for Traditional IRAs
Prior to the SECURE Act, contributions to a traditional IRA could not be made past age 70 ½. That restriction has been eliminated, benefiting those working past age 70 ½ under certain conditions, as long as they have taxable compensation (e.g. wages, salaries, commissions, tips, bonuses, or net income from self-employment). Taxable alimony received has traditionally been treated as compensation for IRA contribution purposes.
However, under the Tax Cuts and Jobs Act (TCJA), alimony received is no longer taxable income as of January 1, 2019. Divorcees over age 70 ½ that have taxable compensation and/or began receiving taxable alimony under the pre-TCJA rules have the option to contribute to either a Roth IRA or a Traditional IRA.
The limit for contributions to Traditional and Roth IRAs is $7,000 if you are older than 50. However, Roth IRA contributions are also limited by the amount of income one earns. Single individuals earning more than $124,000 in 2020 have their Roth contribution limit reduced.
Required Minimum Distribution Age Increased from 70½ to 72
Individuals are taxed at their ordinary income tax rate when they withdraw funds from their IRA or retirement plan. The benefit of this change is that divorcees will have another year-and-a-half for their funds to grow tax-deferred in their IRA and plan for retirement.
What the SECURE Act Means for You
Your situation is unique to you and the Secure Act’s implications can be complex depending on your specific situation. That’s why it’s important to review your situation to understand what these changes mean for you and your financial plan. Fortunately, you don’t have to do it alone; we’re here to help guide you through whatever changes come your way.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Chris has more than 30 years of experience in the financial services industry in the areas of accounting and financial planning. He is well-versed in the financial challenges faced by most individuals.