SECURE Act 2.0
What is it and how does it impact your retirement?
Changes to 529s, increased RMDs, QLAC enhancements and more.
If you want the short version, check out our tweet:
We will expand on the tweet in this post and provide more commentary to help you.
Why should you care about the SECURE Act 2.0?
There are some major changes to retirement accounts and savings vehicles. Overall, the changes are positive for the majority of people.
If you are following the conventional playbook of using 401k, IRAs (Roth & Trad), and 529s to save, something in SECURE Act 2.0 will impact you.
The SECURE Act 2.0 was signed into law last Thursday at the end of December. But some of the changes went into effect only days later on 1/1/2023.
Without further delay, what is in the act?
1) 529s Can Be Converted To Roth IRAs
The change that we are most interested in is the ability to convert some of a 529 plan into a Roth Individual Retirement Account (IRA).
A 529 plan is a college savings plan. You contribute after-tax money and it grows tax-free and can be withdrawn tax-free if used for education. Additionally, if your state has income tax, you may be able to deduct contributions to a 529 plan on your state filings.
Our biggest issue with 529s has been the need to spend it on education. It is very limiting and the only current tax benefit is a small write-off on state income tax. We wrote about our preferred order of investment for children here. And noted that our kid’s 529 plans were solely there as a guilt-free way for relatives to gift ‘cash’ without feeling like they were being inconsiderate.
We are well aware of the deadweight loss of gift giving. And “gift our kid an education” sits better with people than “give our kid $”. A $ given has no deadweight cost.
Well now you can convert $35k of a 529 plan into a Roth IRA for your child. The 529 needs to have been open 15 years, and any rollover is subject to annual Roth contribution limits.
So this isn’t open season on transferring wealth.
However, this is a pretty good start. We think this may become a quasi-backdoor Roth contribution for your kid.
Open 529 when a child is born
Have family gift money into the 529 for 15 years
Max out the contribution to the Roth account by rolling over the 529 for a few years after your kid 15.
Now, granted, you can currently contribute up to the child’s annual income amount to a Roth IRA. And if you own a business and put your kid on the payroll, that allows you to have them invest some of their income elsewhere & you can put money in a Roth IRA for them as a transfer of wealth.
If the above is you, or if your teenager does work, but doesn’t earn up to the Roth contribution limit, you can now roll funds from a 529 to a Roth.
We won’t beat this to death, especially since anyone with younger kids has up to 15 years before they need to worry about rolling the 529 to a Roth.
But to close out this section, if you are able to, gifting your kid $35k+ in a Roth with 40+ years of tax free growth before they hit retirement, is one heck of a good deal. (We don’t like the constant tweets that say “$1k today is $21k in 40 years!!!!” since it assumes 8% annual returns and ignores inflation….but humor us as we do exactly that). $35k can grow to over $750k over 40 years.
If you follow our advice, and ask friends and family to contribute to a 529 instead of buy crappy plastic toys for birthdays, holidays, baptisms/bar mitzahs/quincientas (sp?)/etc, you can likely get most of the $35k funded for you by friends and family.
Imagine instead of toys you used once and forgot, your parents gave you $35k that would grow to nearly $1mm for your retirement. That is a leg up in life and older you would likely take that trade-off. So do it for your kids.
2) Older RMD Ages
Required minimum distributions (RMDs) are one of those things that seem immaterial until you have to deal with them.
Maybe we have a skewed view working in insurance and constantly having the topic discussed as retired people are looking for ways to avoid them. But they can be a real headache in your retirement.
For those who don’t know, RMDs are set by the IRS and tell you a percent of your pre-tax retirement accounts you need to use each year (401k and trad IRA - money you put into retirement tax-free). In short, the IRS let you avoid taxes for a long time, but doesn’t want you to avoid them forever. So they force you to take distributions and when money comes out the pre-tax retirement accounts it finally gets taxed.
So what’s the issue?
The RMD rules are across all accounts. If you have numerous retirement accounts and each is changing with markets, it is an administrative pain to ensure you comply - and the penalty for non-compliance is huge (see #3).
If you are trying to be tax-efficient in your retirement drawdown, these force you to take money you may not need and pay taxes you may not want
RMDs used to start at 70.5 years old, and were recently increased. Anyone who was at least 70.5 in 2019 had to start taking RMDs. In 2020, the age increased to 72 with the first SECURE act. Now the age will be increased to 73 in 2023 and automatically increases to age 75 by 2033.
This allows you more discretion on your retirement drawdowns for a longer period of time. Overall, this is a positive.
3) Lower RMD Penalty
Additionally, the penalty for not taking enough distributions has been reduced.
If you think of a person working at multiple companies in a career and having a traditional IRA and having a spouse with a similar situation, you could have a dozen accounts you need to account for. RMD penalties were far too common.
And the penalty was steep. 50% penalty steep.
Now the penalty was reduced to 25% (still punitive as all get out), but if you correct the mistake the penalty is ‘only’ 10%. 10% aligns it with other penalties for early withdrawals in other accounts, so at least it is getting more reasonable.
3.5) Employer Roth RMDs & Matches
Not really worth its own number on the list, so we will call it #3.5, but Roth 401ks are now exempt from RMDs. If your employer offers a Roth 401k option, you should consider putting some of your contribution into it…likely 1/2 of your contribution, but we do twice as much to our Roth 401k just because we are betting on our taxes being even higher in retirement than now.
(So a 12% contribution rate means we put 8% into a Roth 401k and 4% into regular 401k. We get a 4% employer match meaning the end result is even split 8% into each.)
This change makes the employer Roth even more attractive.
Additionally, your employer match used to be in the pre-tax option. The act allows for employers to match as a Roth 401k. We assume it is going to take a while for most 401k administrators to build this option in, so likely no near-term impact. But longer-term this may be an attractive choice.
Action items - expect to see more 401ks have a Roth 401k option and match and you should consider it to help diversify your future tax risk between after-tax (Roth) and pre-tax (trad 401k and trad IRA) options. That way if taxes go down or up in retirement you have flexibility.
4)QLACs Baby
We are 100% biased as one of our major career accomplishments was working with QLACs and our career is all about risk and modeling long-term liabilities. So we have a 0.00001% type love affair with QLACs.
QLACs are qualified longevity annuity contracts. They are deferred annuities that don’t start paying out until way later in life. You purchase them with pre-tax retirement money and avoid RMDs till they start paying out.
Why would you defer your payout till your late 70s?
It is true longevity insurance. A very real risk people don’t consider is living too long. Sure, on average life expectancy is mid 80s. But if you live to 100 and only planned to live to 85, that is 15 years of additional spending you need to cover. Having a product that covers those late-in-life needs has value
They are cheap. When you price an annuity you discount the future payments based on market growth AND probability of making a payout. The chance a person dies is very high for each year later in life. This means you don’t expect to payout many of those payments. The result for you? You can get a very high relative income stream compared to the price of the annuity.
Completely made up numbers, but lets say a 50 year old pays $100k for an annuity that starts immediately and earns $5k a year. If that person buys a QLAC that starts at age 85 (the oldest you can start), they may get $25k+ a year for each payment (actual number depends on interest rates and product). But the point is, you could get a significant cashflow stream that kicks in later in life for the same price as a small cashflow stream that kicks in earlier.
They defer taxes longer, which is why there is a cap on what you can purchase.
QLACs are not included in RMD calcs. So if you have enough income and don’t want to be forced to take more distributions, BUT want to ensure you don’t run out of money, QLACs are a great fit.
In short, we think QLACs are underutilized and not known about. It is one of the few annuity products we would purchase and likely will for our wife (women in her family almost all live to 100).
[Note - there is no cash surrender in a QLAC, it is a true longevity insurance. Just like if you buy term insurance and live too long, if you buy a QLAC and die before you need it, you get $0, for the most part.]
Previously, the maximum premium you could use for a QLAC used to be the lesser of $125k and 25% of your retirement account balance.
SECURE 2.0 upped the limit to $200k and removed the 25% cap.
This is a complicated and a unique product, so you want to work with an advisor, but it is a niche product that many people may benefit from and now they are even more attractive.
5) Better 401ks
There were a lot of improvements to 401ks that we will group together:
First, employers now get a tax credit for automatically enrolling employees in the company 401k and setting up automatic contribution increases. Now on twitter, 401ks are controversial due to being inflexible and because everyone on twitter is rich or will be super rich and don’t need no stinkin 401k…Better to use that money to start a business (not wrong if you are ambitious).
But for the majority of people, 401ks are their only savings.
We think auto-enrollment and auto-increases will be a big net positive across W2 workers.
This is aligned with the concept of “nudges”. The extra step of opting into your 401k keeps people from doing it. Similarly, making it take an extra step to opt out, keeps people from doing it. So with auto-enrollment and contribution increases, we may see more people hitting a 10%+ savings rate.
Starting people with an auto-contribution of 3% that increases 1% per year up to 10% will at least it make so more people save more money in a 401k. Money in a 401k is better than no savings for the majority.
Second, the employer plan catch-up contributions increased from $6,500 to $10,000 and are now indexed for inflation for workers 62+. Catch-ups from 50 to 62 are unchanged though.
Since many people make more money as they age, and since the cost of living goes down as your kids move out, many people in their 60s have excess money. Now anyone who didn’t save as much as they want, or who wants some more tax-advantaged savings, can put in more money.
Third, many people contribute to a 401k and then change companies and forget about their money. Many 401ks have high fees that employers pay while you are employed there, but get taken out of your account after you leave. So forgetting a old 401k can be expensive. The SECURE act is setting up a ‘lost-and-found’ database for old plans run by the Pension Benefit Guarantee Corporation (PBGC).
This will help people find and rollover their old 401k from plans with high administrative fees.
Fourth, long-term part time workers (3 years and 500hours a year) can now contribute to retirement plans. A benefit for those who have a part-time spouse who takes care of the kids.
Fifth, we already mentioned the employer Roth contribution match above.
Sixth, employers can provide ‘small financial incentives’ for employees to contribute to retirement plans. Currently, this is disallowed, but in the future employers may be able to offer some gift cards to entice employees to enroll and contribute.
Again, for the majority of people, anything that gets them saving more in a 401k is likely a net benefit for society.
Lastly, an emergency savings account. Non-highly compensated employees can start contributing $2,500 a year to an emergency savings account in a designated Roth account. These accounts would be eligible for 4 free withdrawals in a year, no penalty and no fees. This should encourage more people to build an emergency fund.
6) Student Loan Debt Matching
This is also a 401k enhancement, but important enough it was worth splitting out into its own section. Starting in 2024, employers can ‘match’ an employees student loan payment with a 401k contribution.
So you pay $500 in student loans a month and don’t have money to contribute to your 401k. Your employer can ‘match’ your payment by contributing $500 into your 401k.
This isn’t as good as the $10k student loan vote buying…err…forgiveness. But at least recent grads don’t have to choose between paying loans vs saving as they will get some savings built up by their employer while paying down their loans. Especially helpful as higher interest rates means higher APRs on student loans.
7) IRA Catch-up Limit Increases
Similar to the increase in 401k catch-up contributions. IRAs allow for an extra $1,000 contribution for those over 50. That amount will be indexed for inflation going forward allowing for a larger nominal catch-ups over time.
The same logic applies as above, this allows for people closing in on retirement to take advantage of excess income in tax-advantaged accounts.
Wrap-up
There are some other smaller items like tax-credits extended to military spouses and incentives for small employers to offer retirement savings. But the above covers all the major items.
Government doesn’t get much right, but as far as the bills they pass, this one seems like one of the less bad ones for the majority of the population.
We know that the retirement savings industry (financial companies, asset managers, insures, etc) lobbied heavily for many of the recent changes in retirement accounts. So they probably wrote most of these items and congress just signed it. But the end result is pretty not bad.
Many of these changes go into effect this year and the law impacts everyone from new employees to near retirees. There is likely at least 1 piece of this that may effect you.
What do we plan to do?
Continue getting gifts for kids into 529s and in 15 years roll as much of it into Roth IRAs as we can
Elect for our employer match to be in Roth 401k when it becomes available on our 401k
QLAC for Mrs. F’er once we get closer to retirement
Take advantage of additional catch-ups later in life
If Mrs. F’er (who we retired but she enjoys her career helping patients so still works 1-2 days a week by choice) gets the ability to do a 401k at her job, take advantage of it.
Push our RMDs back since we plan to retire with enough money that our issue will be finding tax efficiency in retirement
Depending on the interest in the emergency savings account, we may use that. Right now between our 2 emergency savings accounts we have 3-3.75% APR (Alliant CU and SOFI) so it may be hard to beat. TBD
We already max out our accounts and get the full employer match so auto-enrollment doesn’t help and we don’t need the college payment employer match. But if we were straight out of college and had student loans with high APRs and no chance to refinance cheap, we would use that option to pay loans and get employer matches.
Can a person start a 529 plan for his or herself and then roll this over into a Roth in 15 years?
Great news and write up. Alliant also has embedded optionality for savers who could get preferential access in a future stock offering. And I love 529s! https://seekingalpha.com/article/4566588-best-way-to-compound-the-sp-500