But the ugly truth about taxes is that many people hate giving up income to provide for services that make their lives and those of others better.
Enter the collective public good of encouraging people to save for retirement by giving them tax breaks.
If you save in a 401(k) or similar workplace retirement plan — referred to as a defined contribution plan — you can divert untaxed income into an investment account that grows tax-deferred. Employees pay taxes when earnings and contributions are withdrawn. The added benefit is that money put into a 401(k) lowers a worker’s taxable income.
Or maybe you qualify to invest in a Roth IRA or Roth 401(k). You make after-tax contributions to this type of account, but returns are not taxed upon withdrawal.
In either case, upfront or later, the intent was for people to pay taxes on the money they invest for retirement.
But what about the folks who inherit these retirement accounts? Do they deserve to benefit from a favorable tax treatment?
This is where the Secure Act comes in. Starting Jan. 1, a new provision affects IRAs or 401(k) accounts left to beneficiaries. There’s now a 10-year window for beneficiaries to draw down the inherited account.
To help pay for other provisions of this legislation, Congress decided to close a loophole that allowed people inheriting a retirement account to stretch out required minimum distributions (RMDs). Under the old rule, if you inherited an IRA or 401(k) from a non-spouse, you had to take RMDs, but you could extend the withdrawals over your lifetime to minimize the tax hit. In many cases, the tax deferral could go on for decades.
During a recent online discussion, I received the following complaint about the new rule.
“Regarding your recent article about inheriting IRAs, folks seem to think the inherited IRAs are for the wealthiest of the wealthy,” a reader wrote. “What would the same people think of a single parent who saved diligently her entire career and then dies the day before retirement? The retirement accounts are at their max and untouched. The kid(s) inherit the retirement accounts and are in their peak earning years in high tax states. Does the prudent family deserve to pay lots more in taxes because of an untimely death?”
However, the law allows for exceptions that would take care of minor children, spouses and disabled or chronically ill beneficiaries. So, this issue really comes down to a discussion about intergenerational wealth transfers.
Let me ask you this: Why should the next generation get such a generous tax break if they don’t need the money?
“My husband and I saved diligently in 403(b)s with the expectation that we could pass them on to our children who could stretch out the RMDs over their lifetimes,” one reader wrote. “The 10-year rule will decimate my children’s tax obligations and lead essentially to tossing our hard earned and saved money out of the window.”
Saying the new provision will “decimate” an inheritance is a bit overwrought. This money was always going to be taxed at some point. Beneficiaries can defer paying taxes for a decade, which is still a long time for folks to get a tax break for money they neither saved nor earned.
Let’s keep in mind why these savings vehicles were created in the first place: to promote retirement savings. And let’s not forget that the taxes go to serve the public good. (You can argue about how the government wastes money, but that’s an argument for another time.)
I’d like to point out again what Aron Szapiro, the director of policy research at Morningstar, told me recently when we discussed this part of the Secure Act.
“These accounts were not designed to be large intergenerational tax avoidance vehicles,” he said.
Darian Qureshi of Tucson summed up nicely the hand-wringing about inherited retirement accounts, writing: “I believe that there are too many tax avoidance vehicles already, and they have at least two pernicious effects. First, they deprive the tax pool of needed funds. Of course, no one likes paying taxes, but we all expect decent roads, universal education, functioning governments and law enforcement, etc. The less money there is for these public goods the worse shape our society will be in. Second, these vehicles put the emphasis on the individual to save for retirement, health care costs, and so on. This means that those who have the means can take advantage of these programs, and those who do not, cannot. This arbitrarily exacerbates inequality and perpetuates an already unfair society. The Secure Act’s provisions help to decrease intergenerational inequality.”
A number of readers wondered how the Secure Act treats inherited Roth IRAs. The following are typical questions I’ve been receiving specifically about Roths.
Q: Does the Secure Act require inheritors of a Roth IRA to draw proceeds over 10 years, or does it apply only to regular IRAs and 401(k) accounts?
Q: It sounds to me like a Roth IRA passed on to my kids will have to be emptied no later than 10 years after they inherit it. Are there any tax issues associated with the withdrawal from an inherited Roth IRA? My assumption is that my heirs would get the money free of taxes. Is that correct?
The answer comes from Fidelity Investments: Correct, they would have to take distribution within 10 years of the death of the original Roth IRA owner. There is no tax implication as the taxes on the income are paid upfront and any investment growth is tax free, which is the beauty of the Roth. Also, if someone inherits an IRA (Roth or Traditional) they are not required to make yearly withdrawals — as long as the inherited IRA is emptied out within 10 years, they are complying with the law. They could wait to take one lump sum on the last day possible.
Reader Question of the Week
Q: I just learned I had a 401(k) plan from a previous employee that I forgot about. It is now being transferred to Fidelity, where I have my current 401(k). Is it possible to roll over the money to a 529-college savings plan, and, if so, are there any penalties?
Meghan Murphy, vice president at Fidelity Investments, answered this week’s question.
Murphy: Technically, the reader would have to take a full distribution and pay taxes and penalties if applicable and then deposit the balance into a 529 plan. And various state and local rules may apply to 529 contribution limits. Fidelity would never recommend cashing out retirement savings — even a small amount can grow significantly over one’s career. Also, in general, we position saving for retirement as a “must have” and saving for college as a “nice to have.” Though taking loans for college isn’t ideal, there are no loans for retirement!
I agree with Murphy about not cashing out the retirement money to fund a 529 plan. If the person is younger than 59½, he or she may be subject to a 10 percent penalty for the early withdrawal. Many people see saving for retirement and college as an either/or situation. It doesn’t have to be this way.
Yes, you should prioritize retirement, but you don’t have to sacrifice saving for college for your children. As I wrote in a newsletter about four pieces of retirement advice you should question, save for retirement and do your best to also put away money to eliminate or reduce the amount of student loans you or your child take out.
My husband and I were able to save for retirement and our kids’ college funds. Here’s how.
Please join me on Thursday, Jan. 16 at noon (Eastern time) for a live discussion about your money. My guest this week will be Aron Szapiro, director of policy research for Morningstar. He’ll take your questions about the Secure Act.
You can participate in the online discussion with Szapiro here.
I’m live every Thursday from noon to 1 p.m. (Eastern time).
Retirement Rants and Raves
Your thoughts: With the passing of the Secure Act, what plans are you making to adjust to the new rules?
I’m also interested in your experiences or concerns about retirement or aging. You can rant or rave.
Send your comments to email@example.com. Please include your name, city and state. In the subject line, put “Retirement Rants and Raves.”
Last week I asked: How do you feel about the change in the treatment of inherited IRAs and 401(k)s in the Secure Act?
Tim Weiss of Wauwatosa, Wis. wrote, “I appreciated your thoughtful comments on the recent closing of the stretch IRA loophole. You hit the nail on the head when you said the purpose of deferred tax treatment was to help individuals toward retirement goals — not protecting intergenerational transfer of wealth. I get the desire people have to protect their money from taxation, but at some point the bill needs to be paid and the stretch IRA ends up creating generation inequity in the form of greater deficits. And as is stated, in many instances, the people benefiting from this favorable tax treatment are not the people who need the tax break.”
“I generally support the IRA changes in the Secure Act but there is a down side to the changing of the rules on inherited IRAs,” wrote Rose Young from North Carolina. “I considered the previous ability to stretch an IRA across generations as one of the best ways for average people to leave a lasting legacy for their heirs. I understand the rationale for eliminating this but it was one ‘loophole’ that ordinary wage earners could take advantage of. There are many richer targets for loophole elimination. Too bad Congress didn’t pick one.”
Glenn R. from Davidsonville, Md., wrote, “My wife and I will turn 65 in 2020, have one child (31 years old), and have both contributed to traditional IRA, 403(b), and Roth’s for more than 40 working years. We both also have pensions. We consider ourselves very fortunate; however, we worked hard to accumulate this retirement saving. We always figured, with good health, there would probably be some IRA money left for our child to inherit. Then our child could do the RMD thing based on his age. Certainly I know that the government wants the tax revenue generated by the 10-year clause. However, the Secure Act requirement to exhaust inherited IRA accounts in 10 years will be a tax disaster for many beneficiaries, especially if they inherit trusts with withdraw clauses. Hopefully, everyone will revisit their trust/wills and understand how this law changes things.”
Gwen from Oregon had a retirement rave. “Never carried debt other than the mortgage, and I paid off that mortgage back in 2000 by applying all my raises to the principal,” she wrote. “As a result, I could afford to retire from federal service at the minimum retirement age before my body succumbed to the repetitive physical stresses of my job and working the night shift for 30 years. Can’t recommend getting out of debt to retire earlier enough! I’m happy, pursuing my passion, living exactly where I want to, and young enough to enjoy it all.”