The SECURE Act & Tax Extenders

Over the last week, Congress passed its Appropriations Act, designed to continue to fund the government. To it, they attached the SECURE Act (Setting Every Community Up for Retirement Enhancement) and the extension of multiple expired/expiring tax provisions, known as the “Tax Extenders”. The president is expected to sign the entire bill before departing for the holidays.

The SECURE Act modifies a number of qualified plan (401k, SIMPLE, SEP, etc.) and IRA/Roth IRA rules, along with a couple of 529 plan rules and the treatment of the “kiddie tax”. Below, I highlight the changes along with their likely impact on PWA clients. Virtually all of these changes take place as of 1/1/2020, but unlike the last few tax changes that passed in late December, there is no action that you need to take immediately. If you’re having trouble sleeping, you can read the Secure Act in its entirety on pages 1532-1656 of the Appropriations Act. There are only a few tax extenders that are likely to impact PWA clients. I’ve highlighted those below as well. For the full list, see pages 3-26 of the Division Q amendment to the Appropriations Act.

Secure Act Summary

First a little editorial… the name of the Act (Setting Every Community Up for Retirement Enhancement) and a lot of the press around it is completely misleading in my opinion. The Act’s changes to the retirement system are mostly minor positive tweaks with one somewhat concerning opening of Pandora’s high-cost-annuities-in-a-401k Box (more on that below). It is a far cry from the type of changes that would give everyone access to and the incentive to participate in a tax-advantaged retirement plan. The Act has been sold as “the”, or at least “an” answer to modern retirement issues, but it really doesn’t change a whole lot other than opening a new way for insurers to profit. Call me skeptical, but the insurance industry’s lobby game was strong on this one and when lobbyists step up to the plate in Washington, a home run is rarely a good thing for anyone other than their interest group. So, rather than reading this to see the multiple amazing ways that the Act will help you, please read it to get a sense for the minor positive changes and the couple of things to cautiously look out for in the future. Without further ado, the Secure Act:

· Eliminates a roadblock to Multiple Employer Plans (MEPs) that would allow two or more employers to join a pooled retirement plan, ideally expanding access to plans and reducing costs due to plan size. Pretty self-explanatory and nothing but positives here. Theoretically, this could allow anyone who works for a small business to have a 401k plan available, or a better 401k plan available in the future. Whether or not employers do band together to do this remains to be seen.

· Allows more part-time workers to participate in 401k plans. Specifically those who work 500-1000 hours per year, who were previously excluded from participation, will now be able to participate in the plans. That’s a clear positive for part-time workers and a slight negative for other workers who may see the increased costs to employers as a result of this change passed down to them in some form.

· Increases the business tax credit for new employer retirement plans to $5000 from $500 and adds a $500 credit for auto-enrollment feature. All good incentives that help motivate employers to create retirement plans and get their employees to participate. When compared to the cost of maintaining these plans though (esp. with any sort of matching or profit sharing), it’s honestly still chump change.

· Tweaks the Safe Harbor 401k rules to allow for a higher default employee contribution % while removing notification requirements for plans that make non-elective contributions. Employers can now auto-enroll employees with as much as a 15% contribution level (up from 10%) or with an automatic annual escalation to 15% max. Employees can still opt out though.

· Allows a new exception from the 10% early distribution penalty from a retirement plan for childbirth/adoption within one year after birth, up to a max of $5k per parent. Repayment is allowed to certain types of plans, though the rules are unclear. The increased flexibility is great and maybe more people will participate in employer retirement plans if they can get money back out of them for events like this. But generally, giving people the ability to raid retirement savings for non-retirement reasons isn’t setting anyone up for retirement.

· Eliminates the use of 401k loan “credit card” arrangements. Did you know that some plans adopted provisions that let an employee take out a 401k loan credit card that they could use for any purpose up to the loan limit? That’s not setting anyone up for success in retirement. There are already well-established reasons that loans can be permitted and formal arrangements to make sure participants are taking loans for those reasons only, and are aware of the terrible tax and penalty implications of defaulting on those loans.

· Requires plan administrators to include on quarterly statements an estimate of lifetime income that could be produced at retirement age based on current 401k balance. In other words, if you used your lump sum 401k balance to purchase a straight annuity (series of monthly payments for your life), how much could you expect each month in retirement? I think framing the question in this way is helpful in leading people to realize they may need to save more (or less) based on where they stand.

· Extends the date by which a retirement plan needs to be in place for a tax year from 12/31 of that tax year to the filing deadline of the tax return (plus extensions). This is helpful if you started self-employment or a small business and don’t realize you could benefit from setting up a retirement plan until you prepare your taxes, only to find out that you previously had to open most retirement plans by 12/31 to make a difference. Now you can see the benefit in real numbers and make the decision to open and fund the plan at tax time.

· Allows for portability of lifetime income options in a retirement plan. If the plan decides to eliminate a lifetime income option that was offered, employees enrolled in that option would be allowed to take an in-service withdrawal either by a direct rollover to an IRA or retirement plan or by a distribution to the employee. This is a necessary precursor for the next bullet.

· Provides a fiduciary safe harbor for including lifetime income options using annuities. As long as the cost is “reasonable” and the insurer is thought to be financially capable of satisfying its obligations, the plan sponsor will not be held to the same standards as they are with the selection of other investments in the plan as set forth by the Employee Retirement Income Security Act of 1974 (ERISA). This is the provision that drove the insurance industry lobbying for the SECURE Act. It essentially allows employers (and those they hire to select 401k options) to include annuities in the plan. This is not inherently bad. Some annuities, especially annuities that convert a lump sum into an immediate or future monthly cash flow stream for life, make a lot of sense from some people. But there are also terrible annuity products with monstrous fees that take advantage of consumers with overcomplicated promises dressed up as “guaranteed lifetime income” that really make no sense for anyone, especially not inside an already tax-deferred retirement plan. Now, plan sponsors can be talked into including these options by insurers (who kick back commissions to the plan administrator) and will no longer be held to the same standard as they are for selecting mutual funds. For PWA clients, this isn’t an issue. If you have a new fabulous “guaranteed lifetime income” option in your 401k at some point in the future, we’ll evaluate it like any other option and will likely come to the conclusion that it doesn’t make sense. For those who don’t have an advisor looking out for them as a fiduciary, I fear this new ERISA exclusion is opening up Pandora’s Box just when we’re really starting to get plan fees and mutual fund fees down to something reasonable. I hope I’m wrong.

· Eliminates the maximum age for making an IRA contribution (which used to be 70). This is great as people are generally working longer and if they want to keep saving for retirement past 70, it allows them to do so. But, generally speaking, those who are working past 70 and contributing to their retirement past age 70 aren’t the people who have a retirement savings issue. So, it’s a nice provision, but not sure it really helps a whole lot.

· Changes the Required Minimum Distribution (RMD) starting age to 72 from 70.5 for pre-tax retirement plans (401ks, IRAs, etc.). A nice add, with people living longer, to not have to start withdrawing from their pre-tax money and therefore paying tax for an extra 1-2 years. Not a huge change, but it will have some impact for those that can rely on other sources of money from retirement to age 72 and can use that timeframe to tax-optimize their withdrawals over life (Roth conversions, gain harvesting, minimizing tax on social security income, minimizing Medicare IRMAA surcharges, etc.).

· Ends the stretch IRA. This provision will force inherited IRAs to be liquidated over 10 years in most circumstances, rather than over the lifetime of the person who inherits the account. No RMDs during the first 9 years. You just need to liquidate by end of year 10. Exceptions: surviving spouse, disabled, chronically ill, not more than 10 years younger than the deceased owner, and minor children of the deceased (until they reach the Age of Majority). This is a big negative for most who stand to inherit a 401k or IRA, and that’s intended since this provision is the primary “pay-for” of the bill in its ability to raise tax revenue. It stinks, but it’s hard to argue with it. Deceased people don’t need retirement accounts and therefore the tax benefits that go along with them don’t make a ton of sense for those who inherit them. I’m in the minority of advisors in admitting this, but the change seems fair to me… maybe even generous in giving 10 years. This one has major estate planning implications. If one leaves their retirement accounts to a trust that is directed to pay out only the RMD each year to the trust beneficiary (to minimize tax over their lifetime under the old rules), that trust won’t pay anything out for 9 years and then will pay the entire lump sum in year 10, or worse, will retain it and pay tax at trust rates. Estate plans and the wording of such trusts need to be re-evaluated and potentially re-written. If you have such a trust, or have one that will be created at your death by your will (testamentary trust), and your estate attorney doesn’t contact you shortly, you’ll need to reach out to him or her and evaluate if any changes are necessary.

· Add a new provision that up to $10k (lifetime) can be used from a 529 to pay off student debt without Federal tax / penalty. Another $10k to pay off a sibling’s student debt. State rules differ and will likely follow the same path as they followed on the addition of K-12 private school tuition. Sounds wonderful, but are there really a lot of people who have extra 529 money lying around to pay down their or a sibling’s student loans? It also doesn’t make sense to set up a 529 for this purpose (unless it allows you to game the state tax deduction rules). It would make more sense to just pay down the debt, not contribute to a 529 and hope it grows while the student loans continue to accrue interest at the same time.

· Reverses the Kiddie Tax changes made by TCJA which taxed investment income of minors at estate & trusts tax rates instead of parent rates. Back to parent rates now. This one has nothing to do with retirement. There was just a lot of pushback especially when people realized the Kiddie Tax applies to Military Survivor’s Benefits and the TCJA exposed much more of that to higher tax. Now it’s “fixed” back to the old rules.

Relevant Tax Extenders

· The deduction for mortgage insurance (PMI) expenses returns for those who itemize.

· The threshold to deduct medical expenses for those who itemize is 7.5% of adjusted gross income (down from 10% without the extenders).

· The qualified tuition deduction, which doesn’t require itemizing, is back (max $4k, income restrictions apply as before).

All of the above tax extenders apply for tax years 2019 and 2020. They expire again for 2021 unless further extended by future legislation.

After-Tax 401ks & Rollovers To Roth IRAs

The IRS recently clarified rules surrounding rollovers of qualified plans (401ks, 403bs, etc., all of which I’ll refer to as “401k”s for the rest of this post for simplicity) to IRAs which can have a dramatic impact on a plan participant’s ability to save for retirement in some situations. For those of you who want to read the official IRS notice, it is Notice 2014-54, released on September 18, 2014. For everyone else (which is probably everyone), I’ll summarize what changed and what it means for you. First some background…

Virtually everyone understands the pre-tax portion of a 401k. You defer a portion of your salary as a deposit to your 401k and that amount is not taxed in the period it’s earned. Instead, it grows tax-deferred until retirement, at which time you can withdraw it (usually after age 59 ½ without penalties) and pay tax at withdrawal. Another, newer type of 401k is a Roth 401k. In a Roth 401k, you are taxed on the income that you defer to your 401k, but it grows tax free and is not taxed at all (under current laws) at withdrawal in retirement. If your tax rate is the same at the time of deferral as it is in retirement, then both types of 401ks produce the same amount of after-tax money in retirement. For most people who are into their mid-earning years, the premise that they’ll earn less in retirement and have more ability to control what portion of their retirement savings is subject to tax each year means they’ll probably be in a lower tax rate in retirement. This means they’d favor the pre-tax “Traditional” 401k. While the generalization is true, in general, like much of financial planning, the details of choosing between a Traditional 401k and a Roth 401k are complicated and really need to be evaluated on a case-by-case basis. Regardless of whether you contribute to a Traditional 401k, a Roth 401k, or a combination of the two, the IRS limits contributions at $17,500 per year (indexed to inflation and likely to increase to $18,000 for 2015) + $5,500 more if you’re over age 50. If your employer makes contributions to your 401k via matching, profit sharing, or direct contributions, a second limit applies. That is that your contributions plus your employer’s contributions cannot exceed $52,000 for 2014 (again indexed to inflation).

In addition to the Traditional and Roth 401ks, there is less well-known and less-popular type of 401k called the After-Tax 401k. Many plans do not allow an After-Tax 401k due to the difficulty in accounting for so many types of contributions. For those that do allow it, in this type of 401k, contributions are taxed in the year you earn them (they don’t go into the account pre-tax like a Traditional 401k), but at withdrawal in retirement, you only pay tax on the growth since you’ve already paid tax on the amounts you contributed. This is much less powerful from a tax perspective than pre-tax in (Traditional 401k) or tax-free out (Roth 401k), but is still advantageous in some cases because it means the growth (interest, dividends, and gains) is not taxed each year as it is earned and so that growth can continue to compound tax-deferred until withdrawal. The After-Tax 401k is not subject to the $17,500 employee contribution limit, but is subject to the $52,000 total contribution limit. This means that if you’re maxing out your Traditional/Roth 401k, and your employer isn’t contributing $34,500, and your plan allows an After-Tax 401k, there is room for you to contribute to your After-Tax 401k. Unfortunately, the tax on the growth of an After-Tax 401k is assessed at ordinary income tax rates rather than at lower, capital gain rates as an ordinary taxable brokerage account would be taxed. So, in general, an efficiently managed taxable brokerage can be a better option than an After-Tax 401k, especially when considering the liquidity advantage that comes with being able to access your money at any point for any purpose. This has been the root cause of the limited popularity and use of an After-Tax 401k.

Once you leave your employer, you can withdraw from your 401k and rollover the money to an IRA. Traditional 401ks go to Traditional IRAs and Roth 401ks go to Roth IRAs, all preserving their tax status. With After-Tax 401ks, it’s more complicated. If After-Tax 401k money is rolled over to a Traditional IRA, a portion of the Traditional IRA becomes “basis”, which is not taxed again at withdrawal and every withdrawal will be part growth (taxed) and part return of basis (not-taxed). If it’s rolled over to a Roth IRA though, the tax treatment used to be unclear. Many tax practitioners and plan administrators thought that the IRS would consider Traditional 401k money and After-Tax 401k money together in one rollover, assessing a prorated amount of tax if one were to try to roll pre-tax money to a Traditional IRA and after-tax to a Roth. This treatment would be consistent with the way the IRS taxes conversions from Traditional IRAs to Roth IRAs. If there are both pre-tax and after-tax (basis) dollars in a Traditional IRA, and you attempt to convert a portion of that Traditional IRA to a Roth IRA, you’d be taxed pro-rata on the amount. Others came up with complicated multi-step schemes to try to isolate the After-Tax portion of a 401k in its own account, such that it could be converted to a Roth tax-free. IRS guidance on Sep 18 clarified that effective immediately, After-Tax 401k dollars can be rolled over directly to a Roth IRA without any tax being due as long as it’s done at the same time as Traditional 401k money is rolled over to a Traditional IRA.

I find it hard to believe that this treatment will be around forever, but at least for now, this has opened the door for massive amounts of money to be tucked away in an After-Tax 401k and then rolled directly to a Roth IRA at the time service with that employer is terminated. Here’s an example of how it could work for someone earning $200k per year, maxing out her Traditional 401k with an 8.75% ($17,500) contribution, receiving a 3% ($6,000) employer contribution, and working for three years before moving on to another opportunity at a different employer:

 

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The person above would be able to stash away $85,500 in a Roth IRA after only 3 years while otherwise earning too much per year to be able to directly contribute to a Roth IRA. It’s clearly not for everyone since you need to have a lot of free cash flow in order to take advantage of the large contributions and your plan needs to include After-Tax 401k contributions as an option. If it can work for you, and you’re looking to tuck away large amounts of tax-advantaged money, this is a really big deal.

So here’s what to do: If you’re maxing out your $17,500 401k contribution each year and looking to put more than that away for retirement, send your 401k plan administrator a note (or call) and ask, “Does my 401k plan allow after-tax (non-Roth) contributions after I’ve hit my $17,500 maximum pre-tax contribution each year?” If the answer is “yes”, you can start to take advantage of this immediately.

One final note to keep in mind… tax rules are always changing. There’s nothing to say the IRS won’t change its mind or that Congress won’t pass a law to stop this treatment of After-Tax 401ks. That’s true of any tax law or IRS interpretation of that law. It’s prudent to monitor the tax landscape and adjust decisions accordingly. Contact your financial advisor before and while attempting something like this or if you have questions about it.

401k’s: Just Because You’re Not Writing A Check…

Just because you’re not writing a check, doesn’t mean you’re not paying for administration and access to your 401k. I’ve seen recent polls indicating that 50-75% of 401k participants believe they’re not paying anything for their 401k. They couldn’t be more wrong. There are two broad types of fees that plans participants and/or their employers incur: investment fees and administrative fees. All plans incur investment and administrative expenses, most plans pass those expenses onto investors in the plan as fees, and some plans do it in a way that is very difficult for the average investor to notice.

Investment fees are those charged by the investment funds themselves as a ways of generating a profit on their funds as well as offsetting the cost to create, maintain, and distribute the funds. These fees are passed onto investors in the fund (whether it’s through a retirement plan or an individual investment) through the fund’s expense ratio. You can find the fund’s expense ratio in the Fact Sheet or Prospectus for the fund. If the fund is publicly traded with a 5-letter ticker symbol, you can also look it up at Morningstar.com (snip from Morningstar for a particular mutual fund is shown below with the expense ratio highlighted).

If a fund has an expense ratio of 1%, it means that over the course of each year, 1% of the fund’s total holdings are paid to the investment company and eliminated from the fund. Another way of looking at this is that the fund’s investors each pay 1% of their fund assets each year to the investment company (e.g., if you have $100k in the fund, you pay $1k per year to the fund through the expense ratio). Because this payment takes place inside the fund, it doesn’t appear on any statements or in account histories. It simply erodes the value of the fund over time, either creating larger losses than would otherwise have been incurred or reducing gains. All funds have an expense ratio, but many funds have different classes set up with different expense ratios. The more money a retirement plan has to put in the fund, the better the class they have access to and therefore the lower the cost to participants. As will be explained below though, the lowest cost class of a fund, or the lowest cost fund for a particular type of asset (large cap U.S. stocks for example) is not always the one chosen by the plan administrator.

Administrative fees are those fees charged by a third party administrator (i.e. not you and not your employer) to do the plan recordkeeping, fulfill legal requirements, provide disclosures, file government-required forms, accept payroll deposits, payout withdrawal/loan requests, and likely provide a plan website where participants can interact with the plan. Purely administrative fees paid by plan participants as either a flat amount per quarter/year or as a percentage of account value per quarter/year are usually fully disclosed on account statements and in transaction histories. In some cases, these fees are no bourn by the plan participants, but are instead paid directly by the employer. In this case, the fees are not typically disclosed to participants since they don’t directly pay the fees. In many cases, the administrative fees are not paid by the investor directly or by the employer directly, but are instead paid by the investment companies that provide the funds in the plan in the form of a commission. In these cases, the plan administrator typically selects investment funds that have a fairly high expense ratio for participation in the plan (either higher cost classes of certain funds, or higher cost funds of certain asset classes. The investment companies earn more on these funds than they would if lower-fee funds were selected, so they provide a portion of the difference to the administrator to compensate them. In this case, the administrative fees are not shown on participant statements or in account histories. They’re harder to track, and process is more convoluted (reminds me of the healthcare system of payments – but that’s another blog post for another day), but it should still be clear that the investor is paying the administrative costs nonetheless. As an extreme example, one of the worst 401k plans I’ve seen has only investment funds in it with expense ratios well over 2%. Some of the best plans have funds with expense ratios as low as 0.02%. You could argue that this means 1.98%+ of those fund fees are in excess of what they could be and that the investment company and the plan administrator are sharing those profits. If you use that 401k plan and you slowly build assets to over $500k with an average balance of $100k in the plan over 20 years, you are paying 1.98% in excess fees per year * $100k average annual balance * 20 years = $39,600 in excess fees! In many plans, there are good funds from an expense standpoint and there are bad funds. Cherry-picking the good ones and then using other retirement accounts (a spouse’s 401k/403b, IRAs, Roth IRAs, etc.) to fill in the rest of your retirement asset allocation is a good way to minimize the fund/admin expenses that you pay, and something that any good financial advisor should help you do (or do for you as is the case with PWA clients).

Recent law changes by the Department of Labor have increased the disclosures required by 401k plans so that you, as the plan participant, and your employer as the sponsor of the plan, can get a better idea of the fees that are being charged directly and indirectly. These disclosures become mandatory this month for most employers and quarterly statements will include fee information going forward by the end of the year. As part of the process, many plans are introducing new fund selections and/or changing the way they deal with administrative fees in the plan (e.g. billing them directly per participant rather than using the commission method described above). Please communicate any plan changes and send any fee disclosure documents to your PWA advisor so that we can recommend any changes you should make to your plan investments as a result.

Having access to a very diversified set of investment options in a tax advantaged retirement plan is something that is worth paying for. However, you and/or your financial advisor should know how much you’re paying for it and make sure that you’re not getting ripped off and are taking advantage of the best low-cost investment vehicles available to you.