By the very name, the SECURE Act – or Setting Every Community Up for Retirement Enhancement Act – is designed to enhance retirement savings. There are several provisions in the new law to help accomplish this goal. Those provisions:
- Loosen the restrictions of “common characteristic” for small employers, allowing for wider pools to share expenses, which may help bring down the cost for plan participants.
- Offer employer tax credit for automatic enrollment in retirement plans including 401(k) plans.
- Increase the minimum distribution age from 70½ to age 72
- Eliminates the Stretch IRA provisions for most by requiring that balances of non-spousal IRAs be distributed within 10 years of the account owner’s death.
- Opens the gates for more employers to offer annuities as investment options within 401(k) plans. Under the SECURE Act, the onus falls on insurance companies, which sell annuities, to offer proper investment choices for plan participants.
As a result of the SECURE Act, the planning surrounding one of the most popular vehicles for retirement saving – the 401(k) plan – has come under renewed focus. Many companies implement 401(k) plans with limited thought and little education about the plan provisions and the potential planning opportunities that are available. While these planning ideas may not be new, they have potentially been underused.
Custodians have prototype plans that are easy to implement and contain “standard” or popular provisions. Taking advantage of the “non-standard” or less popular provisions, may be in the best interest of plan participants and provide more opportunities for flexible, tax effective retirement savings strategies.
Let’s look deeper at the 401(k) planning opportunities that may now have more appeal as a result of the SECURE Act.
1. Allowing for After-Tax Contributions
The annual employee deferral for contribution to a 401(k) plan is $19,500 in 2020, with an additional catch-up contribution limit of $6,500 for individuals 50 and older, for a total of $26,000. The total annual contribution limit to all retirement plans is $57,000 in 2020.
For example, adding $6,000 in employer matching contributions to the $26,000 deferred by the over-age-50 employee totals $32,000. The employee also has an opportunity to defer an additional $25,000 in after-tax contributions to get to the annual limit of $57,000.
Planning Opportunity: When the 401(k) plan is ultimately distributed, the after-tax contribution amount ($25,000 in the example) is eligible to roll over to a Roth-IRA. This allows for traditional 401(k), pre-tax deferral contributions of $26,000, which are excluded from the employees current taxable income and therefore reduces current income tax liability. At the same time, employees are building savings ($25,000) that is eligible for tax-free growth, first by being in the 401(k) plan and also by being distributed into a Roth IRA when employment has ended.
2. Allowing for IRA and Outside 401(k) Plan Rollover Contributions
When you leave a job, many employees choose to roll over their 401(k) plan to either the new employer’s 401(k) plan or to a rollover IRA. The rollover IRA (pre-tax) balances impact the ability to do a tax-free, backdoor Roth IRA contribution.
Having pre-tax IRAs makes a portion of the Roth IRA conversion subject to current income tax.
Planning Opportunity: By allowing the conversion of traditional (pre-tax), rollover IRA accounts into an active 401(k) plan, two results are achieved:
- Pre-tax IRA values may be eliminated by converting them to 401(k) plan assets, leaving only non-deductible IRA values for Roth IRA conversion without creating a tax liability.
- The 401(k) plan balance increases with the associated creditor protection and potential availability of investment or distribution options, discussed below.
3. Ability to Acquire Whole-Life Insurance
With the appropriate provisions, you can purchase certain life insurance policies in qualified retirement plans, including 401(k) plans.
Planning Opportunity: The purchase of life insurance inside a 401(k) plan allows people to use pre-tax dollars to pay the premiums, while creating a potential tax-free death benefit.
However, the cost of insurance (PS 58 table) is included in current year, taxable income. This is treated as an annual “deemed-distribution,” not subject to pre-59½ penalties, reported annually on a Form 1099R.
The total life insurance premiums must be less than 50% of the employer seasoned contributions for whole life insurance and less than 25% for term or universal life policies. The contribution must be in the plan for two years to be considered “seasoned.”
When you leave a job, the policy must be removed from the plan. The policy may be removed in one of three ways:
- The policy may be surrendered for the cash-value. The cash-value becomes cash inside the plan, which may then be invested in stocks or mutual funds.
- The policy may be distributed to the plan participant. The taxable value of the distribution is the cash value received by the employee minus the PS 58 amounts – which were previously included in the employee’s taxable income – in each year the policy was owned inside the 401(k) the plan.
- The policy may be purchased from the plan for the cash value. The plan participant will then have a tax basis in the policy for the cost of insurance (PS 58 cost), which was included in the employee’s taxable income for each year the policy was owned inside the 401(k) the plan.
The beneficiary of a policy held by a 401(k) plan participant inside the 401(k) plan will receive the death benefit, if the policy is inside the 401(k) plan at the death of the employee. Similar to item No. 2 above, the taxable value of the death benefit is the cash value of the policy minus the PS 58 amounts – which were previously included in the employee’s taxable income – in each year the policy was owned inside the 401(k) the plan, when the funds are withdrawn from the plan. The death benefit amount that is greater than the cash value is non-taxable to the beneficiary.
4. Post-55 Distributions
An employee who leaves their job after age 55 (or age 50 for first responders), is not subject to pre-59½ penalties for withdrawals from a 401(k) plan.
Planning Opportunity: Allowing annual distributions from a 401(k) plan, after age 55 provides an opportunity for plan participants to obtain cash flow that isn’t subject to penalty. Many plans offer a one-time withdrawal of plan assets.
However, should the participant need multiple years of cash flow prior to age 59½, it is possible to substantially increase the marginal income tax rate of the participant. The allowance of annual distributions provides an opportunity to manage income tax liability by minimizing withdrawals subject to current income tax.
5. In-Service Distributions
Allowing current employees to take distributions after age 59½ allows an active 401(k) plan participant to withdraw funds from their 401(k) plan while they are still employed, continue to participate in the plan, and continue to contribute to the plan.
Planning Opportunity: An employee who is actively participating and contributing to a 401(k) plan may have an opportunity to invest in securities or strategies unavailable inside the plan.
Allowing for withdrawals while working – aka “in service” – provides an opportunity to create liquidity available for investments outside the plan. The participant may relinquish creditor protection afforded in a qualified retirement plan for the opportunity to create liquidity for diversification outside the plan. This is available for IRA rollovers.
6. Employer Securities
Some 401(k) plans allow for investing in and holding employer securities, especially publicly traded companies. Some private employers also allow for investing in and holding employer securities. (Think about employee stock ownership plans). Net Unrealized Appreciation (NUA) is a tax-advantaged concept that allows for the distribution (in-kind) of employer securities outside a qualified retirement plan.
The cost basis, or amount paid, for the employer securities is taxed at ordinary income tax rates. The appreciation in value (gain over and above the cost basis) of the employer securities is federally taxed at long-term capital gains tax rates – currently 0%, 15% or 20%, plus potentially the 3.8% Net Investment Income Tax (NIIT) rate.
Planning Opportunity: The amendment of current 401(k) plans to allow for acquiring, holding and distributing in-kind, employer securities – even if employer securities do not currently exist – will set up a 401(k) plan for potential future opportunities to benefit from NUA.
The distribution of employer securities in-kind, even if mandatory redemption is required, is an important aspect of the plan strategy. There are many plans that create employer stock units, which mimic the performance of employer securities but may not exist outside the plan and therefore are ineligible for the beneficial tax treatment of NUA.
Should employer securities be issued in the future, the amended 401(k) plan is already set up to provide an additional income tax benefit for plan participants.
The More Things Change …
The relationship between the SECURE Act and retirement savings is complex and far-reaching.
It has changed the way we save for retirement and the way we pass on that legacy, no doubt those ripples will continue.
Your financial advisor can help you review your current portfolio and estate plan to “secure” the future for you and your loved ones. Get in touch today and see how Carson can help you navigate the changing landscape.
For a comprehensive review of your personal situation, always consult with a tax or legal advisor.