The Secure Act allows contributions to be made to traditional IRAs after age 70 ½ — but that’s now optional for IRA custodians.
Who knew?
The IRS, which recently released
IRA contributions after age 70 ½
The Secure Act eliminated the unpopular restriction preventing those age 70 ½ or older from contributing to a traditional IRA, even if they are still working. Beginning in 2020, individuals age 70 ½ or older were able to make traditional IRA contributions, assuming they otherwise qualify by having earnings.
It came as somewhat of a surprise, then, when Notice 2020-68 stated that financial institutions are not required to accept such IRA contributions — even though it’s unclear why a custodian would choose to refuse this new source of funds.
Nevertheless, any financial institution allowing age post-age 70 ½ or older contributions will be required to amend its IRA contracts and update the disclosure statement that must be given to IRA owners. However, these amendments and updates can be delayed until at least Dec. 31, 2022. Advisors should check their custodian’s policy on this.
There may be more of a two-way street for IRAs, with both money going in as contributions and being forced out through required minimum distributions at the same time.
This change in the Secure Act means that for clients over age 72, there may be more of a two-way street for IRAs, with both money going in as contributions and being forced out through required minimum distributions at the same time.
The IRS notice confirms that any contributions made for a year when an RMD must be taken will not offset an RMD. (For 2020 there are no RMDs since they were waived by the CARES Act.) According to the IRS, contributions and distributions are separate transactions and are handled independently.
Example 1: Fatima, age 74, has an RMD for 2021 of $30,000. She makes a $6,000 IRA contribution for 2021. Her RMD remains $30,000 and is not offset by the $6,000 IRA contribution.
The Notice also explains how making deductible IRA contributions after age 70½ can limit an individual’s ability to do tax-free qualified charitable distributions. Congress was apparently worried that some people might game the system by effectively receiving a back-door type of deductible contribution without itemizing so they created this labyrinth of tax rules to avoid the perceived abuse.
What I call the “QCD tax trap” is really one of the most ridiculous and complex provisions ever created by Congress, but now we have to explain this to clients. That’s why the best advice is to avoid this situation altogether. But for those who have this situation, the Notice gives an example similar to the following of the complicated formula.
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Example 2: Amir, age 75, makes $5,000 deductible traditional IRA contributions for both 2020 and 2021, but none for 2022. He does not do a QCD for 2020 but does a QCD of 6,000 for 2021 and a QCD of $6,500 for 2022.
To determine the tax-free QCD amount for 2021, Amir’s $6,000 QCD is reduced by the aggregate amount of post-age 70½ contributions for 2021 and earlier taxable years. For Amir, these amounts are $5,000 for each year, 2020 and 2021, resulting in his entire 2021 QCD becoming taxable ($6,000 - $10,000 = -$4,000).
To determine the tax-free QCD amount for 2022, Amir’s $6,500 QCD is reduced by the portion of the aggregate amount of post-age 70½ deductible contributions still remaining (i.e., not used up offsetting tax-free QCDs in prior years). Amir has an outstanding aggregate amount of $4,000 post-age 70½ deductible contributions. The tax-free portion of his $6,500 QCD is limited to $2,500 in 2022 ($6,500 - $4,000 = $2,500).
In future years, Amir makes no more deductible IRA contributions, and his $10,000 total post-age 70½ deductible contributions from 2020 and 2021 have been completely used up (offsetting all or a portion of his QCDs in 2021 and 2022). Since he has no amount of post-age 70½ contributions remaining, future QCDs will not be offset and will be fully tax-free.
While the IRS guidance is helpful in explaining exactly how the formula works, the bottom line is that it’s better to avoid this complexity altogether. The IRS was also probably wondering what Congress was thinking when they created this tax law absurdity. IRA owners should not make deductible IRA contributions at age 70 ½ or later if they plan to also do QCDs. Roth IRA contributions are a better strategy as they will not negatively impact a QCD done from a traditional IRA. Or, for married couples, consider having one spouse make deductible IRA contributions while the other does a QCD.
Penalty-free distributions for birth or adoption
The Secure Act added a new 10% penalty exception for birth or adoption. This exception is limited to $5,000 per child, and the exception applies to IRAs and defined contribution plans.
Since Jan. 1, there have been many questions, especially from plan administrators, as participants have attempted to take advantage of the new rules. The Notice confirms that both parents can receive penalty-free distributions. Also, each birth or adoption qualifies for its own eligible distribution.
Example 1: On Jan. 26, 2020, Paul and June became the proud parents of twin boys. Paul, age 35, can withdraw $10,000 penalty-free from his 401(k) and June, 33, can withdraw $10,000 penalty-free from her IRA as qualified birth or adoption distributions. Note that these distributions are still taxable. The only relief is on the 10% early distribution penalty.
Notice 2020-68 clarifies that to qualify for the exception, the distribution must be made during the one-year period beginning on the date on which the child is born, or the legal adoption is finalized. To qualify for this exception, the retirement account owner must include the name, age, and taxpayer identification number of the child or eligible adoptee on the tax return for the year in which the distribution is made.
The Notice also gives more details about who qualifies as “an eligible adoptee.” An eligible adoptee includes any individual who has not attained age 18 or is physically or mentally incapable of self-support. To be considered “physically or mentally incapable of self-support,” the strict standard used to determine eligibility for the disability exception to the 10% penalty under the tax code applies.
Example 2: Mark and Maya are 55-year-old foster parents to two boys: 17-year-old Jack and 24-year-old James. James is mentally incapable of self-support. Mark and Maya decided to officially adopt both Jack and James and the adoption process was finalized June 1, 2020.
Even as they still have to deal with tax season, the service is tasked with handling much of the stimulus packages.
Mark and Maya will each withdraw $10,000 ($20,000 combined total) from their IRAs before June 1, 2021. Since the withdrawals are qualified, Mark and Maya will not have to pay the 10% early withdrawal penalty, but they will be taxed on the withdrawals. Mark and Maya did their homework. Both Jack and James are eligible adoptees since Jack is under age 18 and James is considered disabled under the tax code.
Oddly, the Notice makes it clear that the definition of an eligible adoptee does not include an individual who is the child of the taxpayer’s spouse.
Example 3:Jerry and Wendy have been married for 5 years. In June 2020, Jerry legally adopted Spencer, age 15, Jerry cannot take a qualified adoption distribution from his IRA because Spencer is his wife’s son.
Employer plans do not have to offer qualified birth or adoption distributions to participants. However, if an individual is otherwise eligible for an in-service distribution from the plan and meets the requirements for a qualified birth or adoption distribution, then the individual may treat the distribution as a qualified birth or adoption distribution on the federal income tax return.
Example 4: Miguel’s son was born in April 2020. Miguel’s 401(k) plan does not offer qualified birth or adoption distributions but he is eligible for an in-service distribution. Miguel can treat a distribution of up to $5,000 from the plan as a qualified birth or adoption distribution on his tax return. The distribution would be taxable but not subject to the 10% penalty.
The Secure Act allows an individual receiving a qualified birth or adoption distribution to repay all or part of the distribution at any time to an eligible retirement account. While the new guidance does not give much insight on how repayments will be handled, it does say that more information on recontributions is forthcoming.
It is important for clients to remember that a distribution taken for qualified birth or adoption expenses is still subject to tax. Tapping a retirement account early, even with no penalty, should be avoided unless it is absolutely necessary. The funds will be too hard to replace as retirement arrives.
More areas of guidance
The Secure Act allows foster care workers to make nondeductible IRA contributions and after-tax company plan contributions from “difficulty of care” payments from their employer — even though those payments are non-taxable.
The Notice addresses some issues for employer plans surrounding these contributions and says that further guidance on handling the contributions to IRAs will be issued in the future.
The Notice and 457(b) plans
Notice 2020-68 also addresses two changes made by a separate law —the Bipartisan American Miners Act of 2019— passed at the same time as the Secure Act. The first change allows 457(b) plans for state and local government workers to permit in-service distributions as early as the calendar year in which the employee attains age 59 ½.
The second change permits defined benefit pension plans to lower the minimum age for in-service distributions from age 62 to age 59 ½. Notice 2020-68 makes clear that these changes are optional — not mandatory.
Further guidance needed
Notice 2020-68 does not address one of the most significant Secure Act changes: the new rules for post-death beneficiary distributions. Those rules eliminated the stretch IRA for most non-spouse beneficiaries, replacing it with a 10-year payout period. Many questions on these new rules for inherited accounts remain unanswered. Hopefully, guidance on these critical issues will be released soon.
