In December 2019, the Federal Government enacted the SECURE Act, a bill that dramatically alters financial planning for most Americans. The section of the new law that is drawing the most attention and affects the most people relates to beneficiary IRAs.
Under the old rules, you could take distributions over the remainder of your life expectancy. And most people did, allowing the money to grow and pay little tax along the way. However, the new rules force you to withdraw the balance within 10 years, as well as pay all of the taxes associated with the distributions at ordinary income rates, which for most would lead to higher taxes paid and lower net account balances from their IRA inheritance.
But what if you are the smallest of businesses? A solopreneur? Or a freelancer? Are you in a unique position to use one or more of these changes to your advantage and minimize the issues that arise from the legislation?
Consider the following:
You are a solopreneur who has been saving exclusively in a traditional IRA and show earnings from your business of about $100,000 per year. To this point, you are currently saving the maximum $6,000 per year in your IRA ($7,000 if you are over 50). Unfortunately, a relative dies leaving you an IRA valued at approximately $200,000. Under the old rules, you could take distributions over the remainder of your life expectancy. However, the new rules force you to withdraw the balance within 10 years, as well as pay all the taxes associated with the distributions at ordinary income rates.
So, what can you do?
Well, if this applies to you, you may be able to defer taxes on more of the inherited IRA, or perhaps even pay no taxes at all while the IRA is being distributed!
How?
The answer for these solopreneurs is to open a different retirement plan; either a solo 401k or a SEP IRA. In either a solo 401k or a SEP IRA, the solopreneur can use the plan to make higher contributions than their traditional IRA. These increased contributions can offset the income received from beneficiary IRA withdrawals.
In our case, the solo 401k investor can put up to $57,000 (up to $63,500 if over age 50) in contributions into their plan, potentially keeping the money tax-deferred. Alternatively, the solopreneur can begin to move money into a SEP IRA. If our solopreneur from above earns $100,000, he can put approximately $20,000 in a SEP IRA each year. Over the ten-year withdrawal time frame provided by the SECURE Act, this solopreneur can move their entire inherited IRA into a new plan and defer taxes on most or all of their inheritance.
What are the downsides to this strategy?
One is cost and time. If the person chooses to go the solo 401k route, then the costs of implementing the plan may be quite high, particularly in the early years while the plan is being funded. Not to mention, the additional operational time necessary to maintain the plan. So the 401k option may be best for middle-income earners with high IRA inheritances.
SEP plans don’t cost anything to create or maintain. And you can save similar amounts, in dollars, to a 401k plan. This may make sense for earners who have lower inherited IRA balances in relation to their incomes.
Second is the state of the business. If the solopreneur plans on hiring employees at some point in the future, they should accelerate using this strategy to take assets out of the beneficiary IRA as additional rules will make it less or even untenable. Hiring an employee will force additional contributions in the SEP plan (to the employee) and/or subject the 401k plan to testing.
Third is the state of tax rates. With tax rates currently scheduled to go up after the sunset of the 2017 TCJA (aka the Trump Tax Law) in 2025, an investor might end up paying higher rates in the future than today. But that is without accounting for capital gains taxes on any growth from the after-tax investments.
Fourth, you will no longer be able to contribute to your traditional IRA on a tax-deferred basis in most cases, as you will be covered under a retirement plan. But that money will now be in your new retirement plan, and based on your income, you may still be able to contribute to a Roth IRA as well.
Finally, access to the money can be an issue, but should not be. This plan is completely flexible. Yes, it is true that if money is needed from either the solo 401k or the SEP that it will not only be taxable at ordinary income, it may also be subject to a 10% penalty if taken out before age 59 ½. But does that risk outweigh the tax deferral and growth today? While ideally a person who undertakes this strategy lives within their means and has an adequate emergency fund, if you need additional cash for expenses, you simply take the funds from the beneficiary IRA and pay ordinary income taxes. Any taxes and penalties should not be an issue until after the beneficiary IRA has been exhausted after year 10.
The SECURE Act has thrown many advisors up in arms on how to help their clients inheriting IRAs as the new rules generally mean that their clients will end up with less money than they would have otherwise. But for solopreneurs and freelancers who inherit IRAs, the strategy above may be a great way to help them keep more of their inheritance and minimize taxes over their lifespans.
Russell D. Rivera, CFA, CFP® is the Founder and President of Voice Wealth Management (Voice) in New York, NY. He also likes to think of himself as a Personal CFO and Financial “Therapist” for entrepreneurs, young professionals, and their families. He helps clients make prudent financial decisions regarding spending, saving, investing, and planning while giving a voice to the individual client's financial priorities and experiences.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.