How changes to RMDs can boost your client's income

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The Secure Act is projected to have the largest direct impact on retirement accounts since the passage of the Pension Protection Act in 2006. And while the legislation’s repeal of the so-called stretch provision for inherited retirement accounts — at least for most non-spouse beneficiaries — is arguably the biggest headline for advisors, another noteworthy change is the subtle increase in the age at which required minimum distributions must begin.

Admittedly, the majority of retirees will not be impacted by the delayed RMD provision, given most people aren’t able to afford to wait until the age at which RMDs must begin. But for those who can hold off, strategically timed Roth conversions, among other tactics, can be an effective tool to accelerate income in a tax-efficient manner. Such actions also help underline the value planners can provide their clients.

Known officially as the Setting Every Community Up for Retirement Enhancement Act, the legislation undoubtedly raises for individuals nearing retirement age, there are a handful of tactics and new ground rules that planners must bear in mind.

Section 114 of the Secure Act, for example, increases the age at which an IRA owner or participant in an employer-sponsored retirement plan must begin taking RMDs — namely, from the year in which they turn 70 ½ to the year in which they reach 72. Participants in 401(k), 403(b) and similar non-IRA–based employer-sponsored retirement plans will still be able to delay RMDs to a later age, provided they are still working and meet the requirements of IRC Section 401(a)(9)(c)(ii)(I).

Accordingly, the required beginning date for IRA owners and most plan participants has changed from April 1 of the year following the year in which they reach age 70 ½ to April 1 of the year following the year in which they reach age 72.

Mirroring the option available under current rules, individuals will be able to distribute their first RMD at any time during the year in which they turn 72 or in the following year, up until April 1. However, if an individual chooses to take their age-72 RMD between January 1 and April 1 of the following year, they will have to take both that RMD and a second one — the age-73 RMD — by the end of the year, potentially pushing them into a higher income bracket and/or increasing other income-related costs such as the Medicare Income Related Monthly Adjustment Amount, or IRMAA.

Andrew Harrer/Bloomberg

Although the Secure Act delays the age at which RMDs must begin
for many individuals approaching age 70 ½, it does not offer any relief to those who turned 70 ½ in 2019. Such individuals will maintain a required beginning date of April 1, 2020, and must continue to take RMDs in the same manner as before the Secure Act took effect.

More specifically, Section 114(d) of the Secure Act states:

“EFFECTIVE DATE. — The amendments made by this section shall apply to distributions required to be made after December 31, 2019, with respect to individuals who attain age 70 ½ after such date.”

Thus, anyone who reached the onset of RMDs in 2019 — or for those already well into their 70s or beyond — will simply have to continue their current RMD schedule. Even someone only turning 71 in 2020, having turned 70 ½ in the second half of 2019, cannot wait until they’re 72 to begin RMDs. That’s because they already triggered their onset by reaching the age 70 ½ threshold in 2019. Again, only those younger than age 70 ½ at the end of 2019, i.e., those born after June 30, 1949,are eligible for the new, age-72 RMD threshold.

WHEN'S YOUR BIRTHDAY?
For those who delay distributions from their IRAs or other retirement accounts until they reach the RMD age threshold, changes made by the Secure Act to lifetime RMDs actually have twice the impact for those born in the first half of the year, as compared to those born in the second half of the year.

More specifically, those born from January 1 through June 30 will reach their 70^th birthday in the same year in which they reach age 70 ½. Thus, they gain two more years of RMD deferral by virtue of the Secure Act’s changes.

Example No. 1: Sully, born on June 3, 1950, owns a traditional IRA. Prior to the changes in the Secure Act, Sully would have needed to begin taking RMDs in 2020, or as late as April 1, 2021.

In light of the Secure Act’s changes, however, Sully will not have to begin taking distributions until 2022, the year in which he reaches 72, with his first RMD due as late as April 1, 2023. Thus, his RMDs are delayed two calendar years as compared to the current rules.

By contrast, individuals born from July 1 through December 31 celebrate their half-birthdays the year after they turn 70, meaning they turn 71 in the year in which they reach age 70 ½. Such individuals will only see one additional year in which they’re not obligated to take an RMD.

Example No. 2: Mike, born on July 10, 1950, owns a traditional IRA. Prior to the changes made by the Secure Act, Mike would have needed to begin taking RMDs in 2021, or as late as April 1, 2022.

Now, Mike won’t have to begin taking RMDs until 2022, the year in which he reaches 72, or as late as April 1, 2023. As such the Secure Act buys him only one additional year in which he doesn’t have to take RMDs.

LIFE EXPECTANCY FACTORS
A common question regarding the change to the starting age for RMDs has been, “Does this change the life expectancy factors used to calculate those RMDs at all?” The answer, under the Secure Act, is no.

Rather, the current life expectancy factors that apply for various ages will continue to apply when retirement account owners reach those ages. Retirement account owners just won’t have to use the factors for an age-70 or age-71 individual anymore, and will begin at age 72 instead.

Example 3: Randall, who turns 70 ½ on August 21, 2020, owns an IRA. Absent the changes made by the Secure Act, he would have begun taking RMDs in 2020, using the uniform lifetime table, which for a 70-year-old indicates a factor of 27.4.

As a result of the Secure Act’s changes though, Randall will not have to begin taking RMDs until 2022, when he reaches age 72. Therefore, his first RMD will still be calculated using the uniform lifetime table factor for a 72-year-old, which currently stands at 25.6.

Notably, a separate IRS proposal from earlier in 2019 would change the life expectancy tables to be used for all RMDs in coming years. And while the proposed regulations have yet to be made official, they are widely expected to be finalized sometime in the first half of 2020, to be effective for RMDs beginning in 2021.

As such, RMDs that occur in 2021 and later may actually have a different life expectancy factor than under current law, but not as a result of the Secure Act. Consequently, the Secure Act impact remains the same: that the life expectancy tables simply won’t apply at ages 70 and 71, and instead will begin at 72. Yet by the time the first Secure Act new-age RMDs kick in at age 72 in 2022, they will likely do so with new tables.

Given these changes, a funny coincidence is likely to play out. Under the current uniform lifetime table, the factor for a 70-year-old — which admittedly has only been used by half of retirement account owners because the other half have turned 71 in the year they reach age 70 ½ — is 27.4. Meanwhile, the factor for a 72-year-old under the new uniform lifetime table contained in the aforementioned proposed regulations is a nearly identical 27.3.

As a result, assuming the proposed regulations are finalized and effective for 2021, the future age-72-first-RMD for individuals in 2022 under the Secure Act is going to be almost an identical percentage of their IRA as would have been for those born in the first half of the year when turning age 70 ½ under the old rules.

QUALIFIED CHARITABLE DISTRIBUTIONS
Although the Secure Act changes the age at which RMDs must begin, the law made no change to the age at which qualified charitable distributions, or QCDs, may begin. So even though such IRA owners will not have to start taking RMDs from their IRAs until they reach age 72, they will still be able to make QCDs from those accounts once they reach 70 ½.

Such pre-RMD QCDs are entirely voluntary and will not reduce or otherwise impact future RMD amounts, beyond the IRA balance being reduced by the amount of the QCD when calculating those future RMDs.

However, for individuals inclined to give to charity anyway, the QCD can still be attractive, especially if gifted cash — or even appreciated securities — won’t be deductible because total itemized contributions don’t exceed the taxpayer’s standard deduction.

PLANNING IMPLICATIONS
While any delay in the forced distribution of funds from IRAs and other retirement accounts will no doubt be welcome news for some — particularly clients who tend to have sizable retirement account balances — the majority of individuals will see little to no benefit from this change.

And while it’s important to remember that an RMD is a required minimum distribution, that doesn’t prevent people from taking more than the required amount or from taking distributions from their retirement accounts before being mandated. That in practice is what many people do, for the simple fact that they need the money.

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To that end, as part of proposed regulations to update the life expectancy tables that individuals use to calculate RMDs, the IRS indicated that according to its own numbers, only about 20% of people take the required minimum amount. And if someone is already taking more than the minimum, they’ll likely continue to do so regardless of whether the RMD age is 70 ½ or 72.

Thus, the Secure Act’s change to the RMD age is likely to benefit only the one-fifth or so of retirement account owners who, according to the IRS, can potentially afford not to take distributions from their accounts.

For such individuals, pushing back the RMD starting age from 70 ½ to 72 may seem like only a minor change, but whenever Congress cracks open a planning window, it’s best to make the most of it, no matter how small the crack may be.

Note that if an unwanted distribution occurs prior to an advisor being able to connect with a client to notify them about the new RMD age — particularly for those whose RMDs would have begun in 2021 — advisors can check if the distribution is eligible within the 60-day window for an indirect rollover.

PARTIAL ROTH CONVERSIONS
Traditionally, the years between an individual’s retirement and their starting to receive Social Security benefits and take RMDs have been understood as gap years. For those who could afford to delay IRA distributions and Social Security benefits until required to do so, gap years would end when income from both Social Security and RMDs began to flow in — which often would be at around the same time, as Social Security would begin at age 70 and RMDs in the year an individual reached 70 ½.

These gap years can be some of the lowest taxable income years of an individual’s adult life. As such, they often make prime years for accelerating income that would otherwise be taxable in a future, higher-income year — e.g., after Social Security benefits and RMDs kick in. More often than not, this income acceleration is best accomplished via partial Roth IRA conversions. That’s because it’s easy to generate the income, and it also provides further tax benefits in the form of future tax-free distributions of earnings, provided the qualified distribution rules are met.

The Secure Act’s changes will potentially provide an additional year or two where Social Security benefits may begin, but before the onset of RMDs stacked on top that can substantially increase income — for those who did not already need their retirement account distributions — in essence creating one or two semi-gap years where it may still be appealing to do a partial Roth conversion on top of Social Security benefits to fill the void before RMDs.

Yet even with this benefit, such individuals will generally find that these years do not allow for the same volume of tax-efficient Roth IRA conversions as earlier gap years. That’s because the receipt of Social Security income will at least partially crowd out the lower tax brackets, and phasing in the taxation of Social Security benefits — also known as the tax torpedo — can be especially tax-unfavorable.

As a result, continued but slightly lower partial Roth IRA conversions may still make sense during these bonus years in which RMDs are no longer required. That said, this will need to be evaluated on a case-by-case basis to coordinate with the onset of Social Security benefits.

RE-EVALUATING 2020 PLANS
Chances are that long before the Secure Act was passed, individuals turning 70 ½ in 2020 had established their 2020 income game plan with the idea that some or all of their living expenses would be covered by distributions from their retirement accounts.

Now, such individuals no longer have to take those same distributions from their IRAs and other accounts, as they will be permitted to delay these distributions with a new RMD age of 72. Thus, a re-evaluation of 2020 cash flow and retirement distribution sources is advisable.

Perhaps the client has ample taxable dollars in a bank or brokerage account that would make sense to spend first. This might allow the individual to keep income low enough to avoid spikes in their marginal tax rate as Social Security income taxability is phased in. Alternatively, switching funding for 2020 spending from pre-tax retirement dollars to taxable dollars may allow even more dollars to be converted to a Roth IRA at favorable rates, as discussed above.

Bear in mind that in many situations, individuals turning 70 ½ in 2020 may already have completed distribution paperwork or other similar requests, which will trigger early-2020 distributions from their IRA or other pre-tax retirement accounts. Such individuals should be prioritized for communication by advisors to avoid now-unwanted or unnecessary distributions from occurring.

UPDATING TECHNOLOGY SETTINGS
Many advisors use various software solutions to help them plan for and communicate with clients. And in many cases, the workflows and other systematized processes advisors employ are self-built, or at the very least highly customized by the advisors who benefit from them.

It’s likely that many of these systems have some sort of logic built around RMDs beginning at age 70 ½, such as:

• Letters automatically generated to send to clients about their first RMD year;
• 70 ½ “birthday” reminders to send presents, cards, letters, etc.; and
• Inclusion of such individuals on year-end RMD double-check lists.

Advisors should carefully review systems, settings and processes to see what items may need updating to keep them in compliance with the Secure Act’s changes. A good starting point would be to segment clients based on their birthday — where those born prior to July 1, 1949, are subject to the old rules, where RMDs begin or already began by age 70 ½ — while those born after June 30, 1949, wouldn’t have been turning age 70 ½ until 2020 or later, and consequently will all be eligible for the new age-72 RMD rules.

Clearly, the most significant aspect of the Secure Act’s change in the age at which RMDs must begin is the direct impact it has on RMDs. Lifetime RMDs, however, are not the only things impacted by this change. Notably, the change impacts non-designated beneficiaries after the death of the retirement account owner, as well as spousal beneficiaries who choose to remain beneficiaries of an inherited retirement account.

NON-DESIGNATED BENEFICIARIES
Under IRC Section 401(a)(9)(A), when a retirement account owner dies prior to their RMD start date and has named a non-designated beneficiary — e.g., charities, estates, non-see-through trusts — that beneficiary is required to distribute all assets in the inherited retirement account within five years.

Conversely, IRC Section 401(a)(9)(B) provides that when the owner dies on or after their required start date with a non-designated beneficiary, annual minimum distributions are calculated using the decedent’s remaining single life expectancy, had they lived.

The Secure Act made no direct changes to these rules, as the new 10-year rule does not apply to non-designated beneficiaries. However, as a result of the RMD age change, an IRA owner’s required start date is now pushed back to April 1 of the year following the year in which they turn 72. Note that the same age applies to plan participants unless an exception such as the “still working” exception is applicable.

Thus, for non-designated beneficiaries, the five-year rule will still apply if death occurs at an even later age, requiring full distribution of the inherited account within five years of the account owner’s death if they die prior to April 1 of the year after they reach age 72.

SUCCESSOR BENEFICIARY BENEFITS
Another important side effect of the RMD age change is that it potentially enhances two benefits available to surviving spouse beneficiaries who choose to remain a beneficiary of the IRA or employer-sponsored retirement plan account — as opposed to, for instance, rolling the inherited account over into a retirement account in their own name:

Under IRC Section 401(a)(9)(B)(iv)(I), spousal beneficiaries do not have to take RMDs from the inherited account until the decedent would have needed to begin taking RMDs of their own. Furthermore, under IRC Section 401(a)(9)(B)(iv)(II), if the surviving spouse beneficiary dies before the distributions would have been required under IRC Section 401(a)(9)(B)(iv)(I), the surviving spouse would be treated as the original owner of the account. Consequently, their beneficiaries would be treated as the first beneficiaries of the account.

To maintain consistency with the direct change to the age at which RMDs begin, the Secure Act includes language that applies the age change to these important spousal beneficiary benefits. Thus, surviving spouse beneficiaries who establish and maintain an account as an inherited IRA — or, where the plan allows, an inherited plan account — will not have to take RMDs from the inherited account until the decedent would have reached age 72.

Similarly, if the spouse-beneficiary dies before that time, they will be treated as the original account owner, and their beneficiaries will be treated as having inherited directly from them.

The key takeaway for planners is that the Secure Act’s revision of the RMD age rules will materially benefit some clients. This may be taken advantage of in the form of an extra year or two where income may be kept at lower levels, enabling extra opportunities for partial Roth IRA conversions or simply for preventing RMDs from pushing individuals into higher tax brackets, paying higher IRMAAs or increasing other income-related costs. Advisors who deliver more income to clients than they’d otherwise expect are truly offering value in a clear, readily appreciable way.

Jeff Levine, CPA/PFS, CFP, MSA, a Financial Planning contributing writer, is the Lead Financial Planning Nerd at Kitces.com, and Director of Advanced Planning for Buckingham Wealth Partners.