A remarkable event took place in Washington last month; Congress passed a substantive piece of bipartisan legislation. In fact, prior to the passage of the SECURE (Setting Every Community Up for Retirement Enhancement) Act on May 23rd, by a margin of 417 to 3 in the U.S. House of Representatives, the only notable piece of recent legislation that was enacted with the blessing of both parties on the hill was the First Step Act, a sensible prison reform bill, signed into law by president Trump on December 21st, 2018. The SECURE Act still needs to be reconciled and voted on by the Senate; but the consensus is that some form of the bill will easily pass.
We commend Congress for passing a bi-partisan bill, an extraordinarily rare feat during this hyper-divisive time. Unfortunately, our lawmakers, the majority of whom have accomplished few things consistently but fail the American people by absolving their responsibility to work together, have failed their citizens yet again. This time, Congress let their constituents down by perversely doing exactly what they’ve been rightfully lambasted for not doing: working cohesively to pass meaningful legislation.
In its current form, the “SECURE Act” is disadvantageous to the tens of millions of working Americans and small business owners who contribute to Individual Retirement Accounts (IRAs). But before we delve into the reasons why, it would behoove us to frame why IRAs, while sometimes used by wealthy Americans, are often a preferred retirement vehicle for small business owners, the self-employed, and working Americans that do not have access to 401k's. For the sake of simplicity, we will focus on the two most commonly used IRAs: Traditional IRAs and ROTH IRAs, named after the deceased Delaware Senator and World War 2 Veteran William Roth, who spearheaded the effort to create the retirement product that has benefited millions of working American's and their heirs.
Each year, single individuals are allowed to contribute up to a fixed amount of money into IRAs. For the tax year 2019, IRS rules dictate that individuals can contribute up to $6,000 ($7,000 if you are over 50 years old). Although similar, there are two important differences between a Traditional IRA and a ROTH IRA. The money contributed to a Traditional IRA is tax deductible, whereas contributions to a ROTH IRA do not qualify for a tax deduction. However, while Traditional IRAs are tax deferred until redeemed and then taxed as ordinary income (the theory being, at retirement, the account holders' tax bracket will be lower than it was when they were working) ROTH IRAs grow and are cashed out tax free.
Second, while many working Americans use Traditional IRAs, ROTH IRAs are particularly favored by middle class Americans. Because of their tax-exempt status, lawmakers (wisely) limited the amount of annual income a person can earn in order to be eligible to make a contribution to a Roth IRA. Specifically, in order to make the maximum contribution to a ROTH IRA, individuals cannot earn over $122,000 per year. After an individual earns over $137,000, a ROTH IRA is no longer available to them and they must use a Traditional IRA or another retirement product.
A boring but important piece of granularity embedded into the SECURE Act changes the guidelines as to how non-spousal heirs (children) can take distributions from IRA accounts bequeathed to them. At present, while heirs are forced to (eventually) withdraw the money from these accounts, they can minimize their taxes by taking distributions over their own projected lifespans. Of course, the longer securities held in an IRA can grow tax deferred, the greater chance those assets have to appreciate. A provision buried in the SECURE Act disallows beneficiaries to take distributions over their lifetime. Instead, the window is much shorter and those assets would be subjected to taxes more quickly.
Financial pundit James Lange of Forbes aptly stated, "On May 23, 2019 the House of Representatives overwhelmingly passed the SECURE Act. A more appropriate name for the bill would be the Extreme Death-Tax for IRA and Retirement Plan Owners Act, because it gives the IRS carte blanche to confiscate up to one third of your IRA and retirement plans. In other words, it’s a money grab…The SECURE Act can mean the difference between your child being financially secure versus being broke, yet Congress is trying to gloss over this provision buried in the fine print.”
If the inherited IRA is a ROTH IRA, the distributions will remain tax free but the tax exempt status of the money will be lost. Hence, if a beneficiary takes a distribution and decides to invest in stocks, bonds or other securities, they will have to pay taxes on any realized gains and dividends those funds produce.
Forbes’ Lange continued, “…This is one of the few truly bipartisan bills that has potential devastating consequences...I wonder how many of our legislators in the House actually read this bill or understood what it was they voted for. Did they realize they are effectively—by accelerating income-tax collection on inherited IRAs and other retirement plans—imposing massive taxes on the families of IRA and retirement plans owners - even those with far less than a million dollars? Or perhaps they did understand it and hoped that the American public wouldn’t...”
The SECURE Act is another glaring example of politicians claiming they want to help the middle class, but voting for legislation that does exactly the opposite. If the SECURE Act becomes law, most working Americans who are being responsible by saving for retirement and doing their best to leave a nest egg for their children, will become less economically well off. Indeed, if politicians from both sides of the aisle continue to talk on the campaign trail about their respective plans to help the middle class, but do nothing substantive to work with their counterparts across the aisle to enact thoughtful legislation to do so, there will not be much of a middle class left to help.
There are certainly provisions in the tax code that aid the lower middle-class and working poor - rightfully, we have a progressive tax code and various carve outs such as the Earned Income Tax Credit benefit those in need. That said, the tax code is rife with loopholes that disproportionately help the wealthy and super-rich. A reasonable aspect of IRA’s and especially ROTH IRAs, is that they are well thought-out retirement tools whose current tax treatment is progressive yet reasonable and incentivizes working Americans to save for their future and for that of their children. Congress should pivot and correct their terrible mistake by shelving the SECURE Act.