What the SECURE Act Means If You’re Divorced

THE SECURE ACT

WHAT THE SECURE ACT MEANS

IF YOU’RE DIVORCED

CHRIS SCHIFFER Senior Vice President, Financial Advisor

Although the SECURE Act is often discussed as one of the largest retirement-focused legislative reforms in decades, it included a number of implications for individuals who are divorced or facing a divorce. 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 are as follows.

“10-Year Rule” for Non-Spouse Heirs

Perhaps one of the most significant impacts the SECURE Act has on divorcing or divorced individuals is the elimination of the so-called “stretch IRA.” This allowed beneficiaries to stretch RMDs over their lifetimes on inherited Traditional IRAs, Roth IRAs and qualified retirement plans. Under the new “10-year rule,” 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 10-YEAR RULE INCLUDE:

1. Surviving spouse

2. Minor children—only until the child reaches the age of majority; then, the 10-year rule applies

3. 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 4. 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

5. 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 tenth 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.

Additionally, 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 RMD 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 tenth year results in all the taxable income being pushed to that tenth 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 tenth year after death—because prior to that tenth year, any IRA distributions would be “voluntary.” Then, in the tenth year, the entire balance would have to be distributed in that single year to the trust and 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 401(k) 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 Agreement (MSA) to avoid the headaches of trying to amend an MSA.

The SECURE Act eliminated the age limit of 70 ½ for making contributions to a Traditional IRA. Now, as long as a person has taxable compensation (e.g. wages, salaries, commissions, tips, bonuses, or net income from self-employment), they can make contributions. Taxable alimony received has traditionally been treated as compensation for IRA contribution purposes.

However, under the TCJA, alimony received is no longer taxable income. 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 you earn. Single individuals earning more than $124,000 in 2020 have their Roth contribution limit reduced.

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.

This article was originally published on February 13, 2020.