Co-produced with Beyond Saving
The “Setting Every Community Up for Retirement Enhancement Act of 2019”, called the “SECURE Act” makes significant changes to retirement account rules and brings up new considerations for retirees.
At High Dividend Opportunities, our priority is on building a large immediate income stream with a portfolio that yields in excess of 9%. This significant cash-flow makes our portfolios very flexible, allowing us to adapt to changes in tax laws, as well as in the market.
The new law has made some changes that will impact retirees, such as delaying the “Required Minimum Distribution”, making some major changes in how inherited IRAs are treated, and making modifications that will change what is offered in 401(k)s.
Investors who have followed our Income Method and have portfolios yielding 9%+ have no problems generating enough cash to meet the RMD requirement in their 70’s, but will now have the option of reinvesting that cash-flow for a couple more years, taking advantage of deferring taxes. Everyone’s situation is different, so we cannot offer advice on what retirees should do, but we can take a look at some of the factors that should be considered when evaluating whether withdrawing from an IRA should be delayed.
One of the largest impacts of the new law is that it extends the age at which a retiree is required to begin taking “Required Minimum Distributions” out of a traditional IRA from 70.5 to 72 years.
From a portfolio standpoint, our income method nullifies one of the largest drawbacks of RMDs – potentially having to sell stocks to get cash at a time when prices are depressed. With portfolios yielding 9%+, there is more than enough cash for retirees to take their RMDs out of dividends without selling a single share of stock. Since the RMD amount grows each year, it is inevitable that eventually, the portfolio has to be liquidated, but our high-yield approach can hold off that necessity until the late 80’s. Providing plenty of time for retirees to find profitable times to sell their holdings. At age 70 or 71, a portfolio following our approach has no difficulty producing enough dividends to cover the RMDs.
So let’s discuss some of the tax implications. The benefit for retirees is that it allows for leaving the money to grow tax-deferred for an additional year and a half. On the other hand, when retirees turn 72, the distribution period will be shorter, so the RMDs will be larger. Here is the current RMD table for 2020, the IRS will be updating it in 2021 and is expected to assume a longer life expectancy (longer distribution periods).
You can calculate your required distribution by dividing the total sum of your combined IRAs and dividing by the “distribution period”. So for someone with $1 million in IRAs, the RMD at age 70 would be $1,000,000/27.4 = $36,497. At age 72, the same sized account would require a distribution of $1,000,000/25.6 = $39,063. Assuming that the portfolio would likely grow over the two years, then the RMD might be even higher. (Note that the RMD rules are different for some retirement accounts, such as Roth IRAs and inherited IRAs).
More income is generally considered a good thing, but there are a few vital considerations a retiree should think about before deciding whether to leave the money to grow, or to start taking the income tax hit.
One major, but perhaps overlooked factor, is Medicare premiums. If your income is high enough, you might have to pay a surcharge on your Medicare part B and part D.
Keep in mind that the adjusted gross income is behind a year. So for 2020, it is your AGI for 2018 that will determine if you must pay the monthly surcharge. When considering when to take money out of an IRA, retirees should keep in mind the impact on their taxable income. Large withdrawals could trigger a large tax, move you to a higher bracket and cause a surcharge on Medicare two years after the withdrawal.
On the other hand, it might be better to have a significant tax and surcharge for one year if your RMDs might increase your income into the higher tax brackets indefinitely.
Roth IRAs are exempt from RMDs, and withdrawals are tax-free, so many retirees might consider rolling a portion or all of their traditional IRAs into Roths. This is a taxable event, but it can be done a little at a time to spread the tax burden across multiple years, or it could be done all at once.
So while investors can leave their funds in their IRAs longer, there are situations where it is more beneficial to take it out earlier. It is important to consider the impact that taxable income will have on your federal taxes, state taxes, Medicare, and other benefits.
No Contribution Age Limits
A second major change from the SECURE act is the removal of age limits for contributing to an IRA. As long as a person has earned income, they are now allowed to contribute regardless of age. Previously, contributions were no longer allowed after age 70.5. With many workers continuing to work into their 70’s, this will allow them to continue to invest in an IRA.
This creates an interesting situation where a 75-year-old could contribute and be required to take an RMD in the same year. Anyone looking at taking advantage of this in their 70’s will have to be careful to consider that any new investments into their IRA will also increase their required RMD.
“Stretch” IRA Eliminated
The “stretch IRA” took advantage of the ability to efficiently pass along large amounts of capital to children and grandchildren. Previous rules allowed for an inherited IRA to be paid out over the life expectancy of the designated beneficiary. As an estate planning tool, this would allow a young beneficiary to realize the benefits over a long period of time.
The new law eliminates this practice by requiring most non-spouse beneficiaries to withdraw the entire amount within 10 years. It can be taken out in one lump sum, periodically or in regular payments – but it has to be completely taken out by year 10. This new rule will not impact spouses, chronically ill or disabled heirs.
For those who have an estate plan in place, they should be aware that any IRAs designated to go to a beneficiary might not be as tax efficient as initially envisioned. This could have a particularly large impact on beneficiaries who are receiving Medicare and having to liquidate the IRA in 10-years might also cause the surcharges discussed above.
Anyone with an estate plan should definitely review it and see if this is one of the techniques being used and consider an alternative.
For investors who are still contributing to a 401(k), starting in 2020 they will likely see new options. Retirement plans will now have “safe harbor” from getting sued if an annuity company goes under or fails to make payments. Therefore, it is likely that many 401(k)s will start offering annuities as an option.
Annuities are not an investment, they are an insurance product. Like any insurance product, many mathematical minds have been put to work to ensure that the insurance company comes out ahead. They provide guaranteed payments over a period of time, and some will provide guaranteed payments for your entire life. It is the appeal of providing a “guaranteed income” that draws many into buying annuities. With few employers offering pension plans, an annuity could be seen as a possibility to provide a fixed income stream and to ensure that you do not outlive your income.
Investors should keep in mind that while these products are often pitched as no or low-risk, they are not without risk. They are subject to counter-party risk – if the insurance company goes under the contract might not be honored. You could be putting a significant amount of money in the hands of a single company, and given the nature of the product you are counting on the health of that company for decades.
With current interest rates so low, the rate of return on most annuities is also very low. The insurance company is betting that they can get a higher return investing the funds than they will have to pay out, and they tend to build in a very large margin of safety for themselves. Odds are very high that any particular annuity product is going to under-perform average returns for the stock market over time. Annuities tend to have high fees and will usually have surrender charges that make it unfeasible to move the money.
Anyone considering an annuity needs to conduct due diligence, understanding it is a large decision that cannot be reversed. We are big proponents of diversification, suggesting that investors have their capital spread among at least 40 companies.
If annuities are going to be part of a retirement plan, we suggest taking the same approach and ensuring that you are not overly dependent on the continued existence of any one company. It is relatively easy to determine if a company is likely to continue for the next 3-5 years, it is nearly impossible to predict which companies might be around in 20, 30 or 40 years. A lot of things can change over the decades.
The SECURE Act makes several changes, most of them we consider positive. It is good that the government has recognized longer average lifespans and that many people are still working into their 70’s. Whether retirees choose to delay withdrawing money from their IRAs or not, it is good to have the option.
Flexibility is perhaps one of the most underrated considerations in retirement planning. In a previous article, we highlighted the benefits and drawbacks of traditional IRAs vs Roth IRAs vs taxable accounts, and we emphasized ensuring that your retirement plan is flexible and can meet unexpected changes.
The government will change laws, unexpected expenses will crop up, interest rates will change and the market will do what the market does. There is no guarantee that these changes will be beneficial.
One of the reasons we believe our Income Method is superior to other investment strategies is that a significant cash stream allows us to be more flexible. With our model portfolio targeting a +9% yield, this allows us to redirect that cash stream anywhere we need it to go, it can be reinvested in the same investments, it can be reinvested in different investments, it can be withdrawn as income, it could be converted from one account type to another, or it could be allocated among all of the above!
Action To Take
- Do the math: if you are retired or near retirement, figure out what your income stream will be as you approach your 80’s. Everyone’s tax situation is different, just because you can delay RMDs does not necessarily mean you should. Questions to ask yourself are:
- How much income do you need now? How much might you need later?
- Are you going to be at risk of triggering the Medicare surcharges?
- What tax bracket will you likely be in?
- Would withdrawing early reduce your tax burden?
- Should you convert a portion or all of your traditional IRA to a Roth? It may inflate your income significantly in one year, but federal tax rates are relatively favorable right now.
- Review your estate plan with a qualified professional, especially if your previous plan utilized IRAs. The plan might not be as tax efficient as it was when it was devised. If you don’t have an estate plan, make one. Whether you are 20 years old, and it involves only a simple will printed off the internet to ensure that a handful of assets go to where you wish. Or a complex plan allocating millions of dollars in assets in a tax-efficient manner. It will make things much easier for your loved ones in a time of distress if your financials are in order and decisions don’t have to be made by a court. Have a written plan, and make sure that the beneficiaries know where that plan is or have a copy.
- 401(k)s will have additional options and thanks to provisions that expand “multiple employer plans”, many small businesses that previously did not offer 401(k)s will now be able to do so. We are frequently asked whether our Income Method is appropriate for younger investors, we strongly believe that it is. It is never too early to build an income stream, younger investors have the advantage of having many more years where most or all of the income can be redeployed into more investments. Certainly, any 401(k) that an employer offers matching on should be taken advantage of to the full extent that the employer will match. Younger investors should also keep an eye on the future and diversify their investments into Roth IRAs and taxable accounts, providing the flexibility to adapt to any tax law changes. With many brokers now offering $0 commissions and no or very low brokerage account minimums, the days of having to invest with large enough sums to absorb trading costs are gone. The markets are more accessible than they have ever been before.
A little bit of planning can go a long way and can help you avoid running into unnecessarily large tax obligations.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.