Planning your tax strategy? The SECURE Act may have 2020 year-end tax implications that affect you. Now is a good time to refresh your memory about changes brought by the Setting Every Community Up for Retirement Enhancement Act (SECURE ACT). The SECURE Act became law in December of 2019.
Although this particular post is primarily about tax-saving changes that Baby Boomers should consider, the Millennial Generation needs to pay close attention to the ever-changing implications to Solo 401k retirement accounts. A Solo 401k offers retirement security. This is something the corporate world no longer provides through job security nor a path to a retirement pension. A Solo 401k with solid tax planning is the best way to take control of your future retirement.
SECURE Act Recap for Tax Year 2020
You’ll find more details in this previous blog but the main SECURE Act highlights affecting a Solo 401k retirement plan and estate planning are:
- Starting in 2020, you can establish a Solo 401k through tax day (April 15, 2021 or extensions).
- Continue contributing to an IRA beyond the age of 70½
- It extends the required minimum (RMD) distributions from Solo 401ks and IRAs from age 70½ to age 72.
- The SECURE Act provides additional options for lifetime income strategies by allowing you to convert their retirement savings into guaranteed lifetime income through annuities.
- Withdraw up to $5,000 for a new birth or adoption without penalty.
- A consideration of interest to some taxpayers is converting Solo 401k tax-deferred funds into after-tax Roth Solo 401k. More about this in the next section of this blog.
- A not so good change is the removal of “stretch” provisions for beneficiaries of IRAs and 401ks. Previously, all beneficiaries could stretch the distributions over their lifetime to minimize taxes. Now, the stretch provision is limited only to beneficiaries who are surviving spouses, minor children, and those not more than 10 years younger than the deceased.
- You must offer the plan to employees working 500 hours per year for 3 consecutive years. However, the 3 consecutive year period does not begin until 2021.
Pre-Tax Planning Based on the SECURE Act
The SECURE Act might provide an incentive for some people to convert tax-deferred funds to after-tax funds at today’s tax rates. The possible incentive may depend on whether or not your heirs fall outside of the 10-year rule. If this is your situation, you may want to convert some Solo 401k funds to a Roth Solo 401k to reduce your heirs’ future tax obligations.
The 10-year rule requires beneficiaries [that are not surviving spouses, minor children, or within 10 years of your age] to withdraw all funds from the inherited tax-deferred account by Dec. 31 of the 10th year following the year of death.
Withdrawing the funds during that time means the money will be taxed at the beneficiary’s current tax rate. Failure to withdraw within the 10 years is likely to trigger a 50% penalty along with a large boost in taxable income for year 10. Using the Mega Backdoor Roth could very well be your best tax strategy. Of course, no one knows what the tax rates will be down the road but taxes are at uncommon lows today.
Life Insurance as an Estate Planning Strategy
Another tax limiting strategy could be purchasing life insurance through your Solo 401k that is payable to your heirs. You’ll pay policy premiums with pre-tax dollars from the Solo 401k. But tax consequences exist. That’s because the IRS considers the cost of life insurance protection provided under the plan to be an “economic benefit”. Therefore, it is immediate taxable income to the insured (not after retirement).
Each year, the Solo 401k must issue a Form 1099-R stating the participant’s current benefit. This is the “deemed distribution” subject to income tax, but the income is NOT treated as a distribution. You’ll personally pay income tax on that value. However, you won’t pay the 10% penalty tax on retirement plan distributions made to participants younger than age 59½.
Furthermore, you won’t pay income tax on the full premium because of the future investment value. This is a split-dollar arrangement. A permanent life insurance policy owned by an irrevocable trust will ultimately pay an income-tax-free death benefit to heirs and possibly keep the policy out of the insured individual’s taxable estate.
Estate Planning Based on the SECURE Act
You may have noticed there is an overlap between pre-tax planning and estate planning related to the SECURE Act. That is because changes to the “stretch’ provision and 10-year rule have create new challenges for Solo 401k account owners. The challenge is eliminating or minimizing “bracket creep” for heirs. The Roth conversion and life insurance strategies both work towards this goal along with other strategies.
You may choose to work directly with potential heirs to create a strategy for withdrawals from the inherited Solo 401k. You can potentially do this in increments that minimize bracket creep over the 10-years. Another strategy is carefully planning the distribution of your accumulated assets. Tax-deferred Solo 401k assets might be left to beneficiaries in lower ordinary income tax brackets. This leaves other assets (after-tax) to beneficiaries in high tax brackets.
Conclusion
The SECURE Act brings significant changes across retirement accounts and all of the implications are not yet known. Existing plans have until the end of 2022 to make any necessary changes. However, plans will need to begin operating within the new requirements before document changes are completed.
Most of the provisions of the SECURE Act in 2020 tax year apply. Individual investors as well as business owners may need to seek professional advice from their financial advisor or tax professional. Review your existing retirement and estate plans with an advisor. This will help to ensure that you are on track to meet your goals under the new law.
