United States: SECURE 2.0 – Defined Contribution Plan And IRA Distributions Reconsidered

SECURE 2.0 made significant changes to the required minimum distribution ("RMD") rules. Several of those changes relax the basic RMD rules and reduce the penalties applicable when RMDs are not made. Other, more technical changes to the RMD and early distribution rules are intended to encourage the use of defined contribution plan and individual retirement account ("IRA") funds to purchase life annuities. The reforms build on changes made by 2019's Setting Every Community Up for Retirement Enhancement Act ("SECURE 1.0") and follow years of interest on Capitol Hill and at the Internal Revenue Service and Department of Labor in policy changes to facilitate defined contribution and IRA distributions that provide lifetime income.

Changes Relaxing the Required Minimum Distribution Rules

SECURE 2.0 made several changes to the rules dictating when distributions from defined contribution plans and IRAs are required and the penalties that apply if those rules are not followed:

· Increase in minimum distribution age – Under SECURE 1.0, the age at which distributions from defined contribution plans and traditional IRAs must start was raised to 72 beginning in 2020. SECURE 2.0 further raises the required minimum distribution age to 73 beginning this year and then 75 beginning in 2033. The increasing age threshold suggests that Congress is more concerned with the risk that a significant number of people will outlive their retirement savings than it is with vindicating the original idea behind requiring minimum distributions, which was that retirement accounts should be spent (and taxed) during the participant's lifetime rather than used as for estate planning purposes.

· Roth plan distributions – Under current law, distributions from Roth accounts in employer plans are subject to the same RMD rules as traditional plan accounts, but distributions from Roth IRAs are not required until after the account holder's death. SECURE 2.0 extends the RMD exemption for Roth IRAs to Roth accounts in employer plans beginning with distributions required in 2024. Given that the RMD rules were designed to limit tax deferral, this change is not surprising – applying them to Roth accounts (which are post-tax), and applying different rules to Roth IRAs and Roth accounts in employer plans, was an odd policy.

· Surviving spouse RMD election – Beginning in 2024, SECURE 2.0 allows the surviving spouses of defined contribution plan participants to elect to be treated as the deceased participant for purposes of the RMD rules. Depending on the ages of the deceased participant and surviving spouse, this option may allow the surviving spouse to delay RMDs.

· Reduced penalties for RMDs – Previously, individuals who failed to take required minimum distributions were generally subject to a 50% excise tax on the amount not distributed as required. SECURE 2.0 reduced that penalty to 10% if the shortfall is corrected within a two-year correction window or 25% if not. In addition, under SECURE 2.0's expansion of the IRS correction program known as EPCRS, certain RMD failures that were previously subject to excise taxes may now be exempt from excise tax if corrected in accordance with EPCRS procedure.

· More forgiving statute of limitations for RMD failures under IRAs – Before SECURE 2.0, a statute of limitations with respect to excise taxes applicable to a RMD failure began to run only when the IRA account holder filed an excise tax return reporting the failure. As a result, taxpayers who were not aware of the RMD failure or the excise tax return requirement could be subject to very high tax bills due to accumulation of interest and penalties. As discussed in this previous post, SECURE 2.0 provides that a three-year statute of limitations begins to run as soon as the taxpayer files an individual tax return for the year in which the RMD failure occurs.

Changes Intended to Encourage the Use of Annuities

SECURE 2.0 also made several changes to some longstanding rules that have discouraged the election or purchase of life annuities with defined contribution plan or IRA funds. (The changes also apply to annuities provided under defined benefit plans.) As with the changes to the general RMD rules, the changes to the annuity rules are intended to increase the likelihood that individual retirement accounts will provide lifetime income (and thereby reduce the number of people who outlive their retirement savings). The reforms are comprehensive enough that they should make a difference in the availability and uptake of annuities as a distribution option, which has been quite low historically. It is far from certain that the changes will have a significant impact, however.

· Permitting commercial annuities with common guarantees – Before SECURE 2.0, the RMD rules contained an actuarial test that certain guarantees commonly included in commercial annuities did not meet. Under SECURE 2.0, that test has been relaxed so that more types of commercial annuities can be offered under plans and IRAs. Annual increases in annuity payments of less than 5% per year are now permitted, as are certain death benefit and period certain guarantees. The hope is that annuities with these features will appeal to people who are reluctant to elect traditional life annuities. In particular, the availability of death benefit features may increase uptake of annuities among people who do not like the idea of losing the entire amount if the annuitant dies soon after the annuity is purchased.

· Removing the disincentive to partial annuitization – Before SECURE 2.0, partially annuitized accounts had to be bifurcated (i.e., split into annuity and non-annuity parts) for purposes of calculating required minimum distributions, which generally resulted in higher RMDs. Now, the amount distributed from annuity contracts may simply be subtracted from the total distribution required for the year. As a result, RMDs from partially annuitized accounts will generally be lower.

· Removing impediments to QLACs – Longevity annuities are deferred annuities that begin payment at an advanced age, thereby providing insurance against the risk of outliving retirement savings. Qualified longevity annuity contracts, or "QLACS", are longevity annuities the value of which may, prior to annuitization, be excluded from the account balance used to determined RMDs. (A QLAC's annuity starting date may not be later than age 85.) The IRS issued final regulations on the use of QLACs in 2014, but utilization has remained low. To encourage the purchase of deferred annuities under plans and IRAs, SECURE 2.0 raised the dollar limitation on QLAC premiums to $200,000 (as indexed for inflation) and eliminated the account balance percentage limitation. (Under the 2014 regulations, QLAC premiums could not exceed 25% of an individual's account balance or $125,000.) The new limit applies to contracts purchased on or after the date of SECURE 2.0's enactment. With respect to "free look" periods and QLACs with joint and survivor benefits, SECURE 2.0 made clarifications that are effective for contracts purchased on or after July 2, 2014. SECURE 2.0 specified that QLACs may include free look periods of as long as 90 days from the date of purchase. SECURE 2.0 also specified the conditions under which a divorce occurring between purchase of the annuity and the annuity starting date will not affect the permissibility of benefits under a QLAC with joint and survivor benefits.

· Clarification of early distribution penalty exemption – SECURE 2.0 provides that annuity payments are eligible for an exception from the 10% early distribution penalty that applies to distributions from qualified retirement plans. It provides that, for purposes of the exception from the 10% penalty that applies to substantially equal periodic payments, annuity payments are now deemed to be substantially equal if they satisfy the RMD rules. (Under Code Section 72(t), the exception applies to substantially equal periodic payments that begin after the participant separates from services and are made over the life expectancy of the participant or the life expectancies of the participant and beneficiary.)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.