A hefty piece of federal legislation passed by Congress and signed into law by President Trump in December has been hailed as one of the most far-reaching retirement savings reforms in at least a decade — a package that will broaden the reach of workplace 401(k) plans.
While the legislation makes several important tweaks to Individual Retirement Accounts, too, it’s not likely to enhance their popularity all that much.
Granted, IRAs already are popular, accounting for $9.7 trillion, or 33%, of all retirement assets as of a mid-2019 tally by the Investment Company Institute, a mutual fund trade group.
But relatively few people contribute new money into IRAs, including Roth IRAs, which allow for tax-free withdrawals. The growth of IRAs has been fueled by their role as repositories for money pulled out of workplace 401(k)-style retirement plans.
That is, when people leave an employer, they typically have the option to transfer the money into an IRA rather than leave it in the 401(k) account. Rollovers provide a number of benefits: They preserve the tax-deferred status of the account, open up new investment options and allow investors to consolidate their accounts. None of that will change with passage of the SECURE Act.
New contributions lacking
The bigger impact of the SECURE Act is with 401(k) plans, where the legislation makes several changes that could encourage their expansion by making it easier and less expensive for small employers to offer them.
One new rule will allow these businesses to reduce costs and paperwork hassles by banding together to offer joint plans. Another change provides tax incentives to defray plan-startup costs and more. Small businesses are the places where employee retirement benefits are most likely to be lacking.
But the legislation doesn’t address what might be the fundamental problem with IRAs — they are complex, with rules on who can qualify, how much they can contribute, how withdrawals are taxed, whether penalties apply and so on.
Only about 12% of American households contribute on a regular basis to traditional IRAs (which allow front-end tax deductions) or to Roth IRAs. The percentage hasn’t changed much for more than a decade, according to data compiled by the Investment Company Institute.
Most eligible investors don’t contribute the yearly maximum dollar amount, and most don’t make catch-up contributions despite studies showing Americans have fallen behind in retirement preparations. Catch-up contributions allow people 50 and older to sock away a bit more money each year than younger workers are allowed.
Tweaks affecting IRAs
Complexities aren’t the only reason that most people don’t contribute new money into IRAs. Compared with workplace 401(k) plans, IRAs don’t feature employer matching funds. Nor is it as easy to put money into IRAs using money diverted directly from a paycheck, as it is with 401(k)s. Plus, nobody will enroll you automatically in an IRA, as increasingly happens with 401(k) programs.
The SECURE Act provisions were a mixed bag for IRA investors.
One beneficial change is that the act increases the age at which mandatory required distributions apply, raising it to 72 from 70½ previously. This will help retirees who don’t currently need the money to live on yet to delay, a bit longer, the date when they must begin withdrawals from traditional IRAs and start paying taxes (Roth withdrawals typically aren’t subject to taxes nor to mandatory withdrawals).
A lot of people need to live off their IRAs, but plenty don’t. About 40% of retirees who make IRA withdrawals simply move the money, after paying taxes, to other investment accounts, according to the Investment Company Institute study. The higher age threshold will help them.
Another positive is that people who keep working can continue to contribute money to traditional IRAs regardless of age, repealing a prior limit at 70½ (there’s no age limit on Roth contributions). But you still would need employment-related income to do this.
Demise of the stretch IRA
Conversely, the bill makes it harder for investors to keep an IRA going – and continue delaying taxes – for decades after they die. From now on, the money in an account inherited by non-spouses generally must be withdrawn fully within 10 years of the owner’s death, eclipsing a strategy known as the “stretch” IRA.
“In the context of financial advisors and the clients they serve, the first and probably most notable change resulting from the SECURE Act is the elimination of the so-called “stretch” provision for most (but not all) non-spouse beneficiaries of inherited IRAs,” said Michael Kitces, a financial adviser, in a recent blog.
Then again, setting up a stretch IRA and getting adult children or grandchildren to keep their hands out of the cookie jar are two separate issues. It can be highly tempting for a beneficiary to tap into an account sooner than necessary, rather than let it compound for decades.
David Jacobsen, a vice president-investment officer with Wells Fargo Advisors in Tempe, said stretch IRAs have been popular among his affluent clients who don’t need to live off the money. But most beneficiaries, he added, won’t leave their inheritances alone for long.
For an IRA investor bequeathing money to five adult grandchildren, for example, “Four out of five will liquidate (their portion) fairly quickly, even if it means paying the tax,” Jacobsen said.
Fred Schenck, a retiree living in Sun City, decided not to establish a stretch IRA for this reason. He liked the idea of letting the money build up tax-deferred for three or four decades, but he was concerned that his beneficiaries might splurge now and then on all that cash.
“I never could figure a way to prevent that from happening,” Schenck said in an email. “And now, thanks to Congress, I don’t have to worry about it.”
