New for 2023 – Secure Act 2.0
As part of the $1.7 trillion omnibus spending bill, changes are coming to retirement plans beginning next year. The idea is to get more people to save more for retirement, which is a good thing, but be careful, saving too much in retirement accounts can have a downside, too. Here are some key points about Secure Act 2.0.
- Provides ways to save more in retirement plans and becomes more inclusive
- Reductions in penalties for inadvertent errors
- Larger catch-up contribution opportunities for older workers
- Mandatory distributions will start later
But use caution when funding very large retirement accounts
- Distributions will become larger, potentially propelling savers into higher tax brackets
- Retirement plans are among the worst ways to leave wealth to heirs
- It may be time to consider a Roth conversion for some of your retirement assets
Some of the key provisions of the Secure Act 2.0 that are now effective:
Increase Required Mandatory Distribution Age
The original Secure Act increased the age for Required Minimum Distributions (RMDs) from traditional IRAs, 401ks and 403bs, to age 72. Secure Act 2.0 increases the age for starting RMDs to 73 beginning in 2023 and will be gradually increased to age 75 in 2033.
The 50% Penalty for not taking an RMD is reduced
Failure to take an RMD in timely manner has historically been hit with a punitive 50% penalty. Secure 2.0 reduces that tax to 25%, and if this is corrected in a timely manner, the penalty is reduced from 25% to 10%.
Automatic disaster relief
The bill automatically makes disaster-related distributions and loan relief available upon the issuance of a federal disaster declaration. Distribution relief waives the 10% early withdrawal penalty for up to $22,000.
Provisions Effective January 1, 2024:
Age-Based Catch-Up Contributions Must be Roth Contributions, based on income.
Employees with wages of over $145,000 (to be indexed for inflation) must make any age-based catch-up contributions to Roth accounts, that is, on an after-tax basis. Roth account contributions are made with post-tax dollars that can be withdrawn tax-free after retirement.
For those with wages below $145,000, any age-based catch-up contributions can be made on either a pretax or Roth basis.
Currently, not all plans allow Roth catch-up contributions, but this effectively mandates that plans that want to permit catch-up contributions must offer Roth catch-up contributions.
Student Loan Payment Matching
In an effort to help those burdened with student loans to save for retirement, Secure 2.0 allows employers to make matching contributions to retirement plans based on employees’ student loan payments. Vesting for these contributions is the same as other matching contributions.
The Act includes two optional provisions to give employers a choice of different approaches for emergency savings and unforeseeable financial needs
Provisions Effective January 1, 2025 and later:
Catch-Up Contributions for workers 60 to 63 years of age
Secure 2.0 increases the annual catch-up amount from $7,500 to the greater of $10,000 or 150% of the regular catch-up ($11,250 in 2023) for participants ages 60 through 63. This new limit will also be indexed for inflation.
Saver’s Match Program
The Match program would incentivize retirement savings by providing a 50% matching contribution on up to $2,000 in retirement savings annually for low- and middle-income Americans, without regard to whether an individual has a tax liability. This would replace the current tax credit.
Mandatory Automatic Enrollment
Secure 2.0 also requires employers establishing new 401(k) and 403(b) plans to enroll eligible employees automatically at a 3% pretax contribution level. This level is also mandated to increase annually by 1 percentage point up to at least 10 percent, but not more than 15 percent of the employee’s pay. Employees are still able to override this amount and elect a different contribution level. This does not apply to small businesses with 10 employees or less, or business established for less than three years.
Be Aware of Avoidable Post-Retirement Tax Problems
Congress encouraging savings for retirement is a huge need because so many fail to save anything for retirement. However, it isn’t for everybody!
Remember that the idea of saving for retirement in tax advantaged plans is based on the assumption that you save when you are in a high tax bracket and you take distributions when you will be in a lower tax bracket. If that is not your situation, you may be better off savings on an after-tax basis, especially if you anticipate leaving a large portion of your retirement savings to your heirs.
Remember that when distributions are taken for IRAs and 401ks, those distributions are taxed as ordinary income, meaning they are exposed to the highest tax rates. If you have a large balance in your retirement account, your RMD’s are more likely to push you into higher and higher tax brackets.
Here is a view the projected RMDs of a 60-year-old with current retirement plan assets of $2 million and an account that earns 6% per year. Note that this example does not account for the passage of Secure Act 2.0. Beginning next year, RMDs are delayed, which will only increase the RMDs in future years. It is not difficult to imagine that this person is likely to be in the maximum tax bracket for a long time.
So, while you have the advantage of having saved pretax, your distributions will be roughly cut in half by taxes. If you save on an after-tax basis, you obviously save less, but if invested properly, much of the gain can be taxed at a much lower capital gains rate in the future.
By itself, that may not be enough to justify saving on an after-tax basis, but it goes long way to evening the playing field. The potential coup de grace is how your estate is left to your heirs. There is probably no worse way to leave money to your heirs than in a retirement plan.
Here is a look at that same 60-year old’s projected account balance to age 100. If that person dies in their mid-80’s, they will leave over $4 million to their heirs in that retirement plan. The bad news for the heirs is that they are required to remove and pay taxes on that money within 10 years. That could easily push the heirs into the maximum tax bracket, if they are not already, with no possible way to manage that tax liability. However, if left to the heirs in a taxable account, those assets transfer tax-free and have an adjusted tax basis taken on the date of death. They now have wealth that they can more easily manage to their advantage.
The lesson is that saving via a retirement plan is obviously beneficial, but there are limits to its usefulness for the wealthy. In many cases, a Roth conversion can make sense. If you have questions, give us a call.
Happy New Year!
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