Secure Act Quirk Opens a Tax Savings Window in IRAs

The new year brings advisors lots of changes to retirement planning, thanks to the passage of the Setting Every Community Up for Retirement Enhancement (Secure) Act in late 2019 (as part of the year-end spending bill).

In addition to increasing the age for required minimum distributions and dropping restrictions on IRA contributions for some workers, the sweeping retirement bill also generally puts an end to the use of "stretch IRAs." Buried in this mountain of legislation, certified financial planner and CPA Jeffrey Levine found a quirk that he says could save retired taxpayers thousands of dollars over several years.

Levine, head of advisor education for Kitces.com and CEO of BluePrint Wealth Alliance, and other members of Kitces' team have been meticulously reviewing the new law.

After firing off a series of 34 tweets on the Secure Act last month, Levine's diving into it further in early January and just discussed (via social media) the convoluted issue of the Secure Act's impact on qualified charitable distributions via a new anti-abuse rule.

"To get any of this, you need a basic understanding of new QCD anti-abuse rule," Levine said on Twitter last week. "Basically, any QCDs are 'rejected' until total amount rejected = DEDUCTIBLE Trad'l IRA contributions made ≥ 70.5 Behold the glitch in the Matrix!"

For those without the time to digest the anti-abuse rule and Levine's full analysis of it (see below), the CPA and popular planner gave the following summary.

"By forgoing the Traditional IRA deduction to which one might otherwise be entitled, it's possible to "trade" pre-tax Traditional IRA money for after-tax Traditional IRA money. Our Tax Code is absolutely ridiculous!" he tweeted.

Which clients will be affected by the QCD anti-abuse rule? Individuals who want to contribute to an IRA and also to make charitable donations from the IRA.

A QCD, done properly, allows an IRA holder to donate up to $100,000 a year from the IRA directly to a charity without paying taxes on the donation.

Levine explained in another Tweet: "The contribution is nondeductible and, over time, the contribution can be distributed tax-free (pro-rata). The gains on the nondeductible contribution would be tax-deferred, but subject to income tax when distributed. IRS looks at all IRAs as 1 giant IRA. Separate acct = useless."

How does this benefit retirees? "Gains grow tax-deferred vs. being taxable each year if put into a brokerage account. Relative benefit would depend on things like tax rate, yield, type of yield, turnover, etc.," he said.

An Example

In a lengthy explanation of this IRA/QCD quirk on Twitter, Levine analyzed the strategy by comparing the situation of twins Mason and Sylvia. Both are 73 and single with adjusted gross income of $150,000, prior to contributing to a traditional IRA or to taking an RMD of $10,000 for 2020 from this IRA in pretax dollars.

If Mason makes a $7,000 deductible IRA contribution and uses his $10,000 RMD to support a charity, he has the $10,000 RMD transferred directly to the charity — following all of the QCD rules, according to Levine.

His AGI will be reduced by $7,000, but the QCD anti-abuse rule will negate this amount of his RMD from QCD treatment. This process means that amount will be included in his AGI, which is then $150,000.

If Mason takes the standard deduction of $13,700, his taxable income for 2020 would be $136,300. The remaining balance in his traditional IRA is all pretax.

His sister Sylvia, however, makes a $7,000 traditional IRA contribution in 2020 and voluntarily does not take the deduction. She contributes her $10,000 RMD to charity and adheres to all QCD rules. Her AGI is not reduced.

"But because Sylvia did not take a deduction for that contribution, she is not subject to the SECURE Act's QCD anti-abuse rule. Thus, her entire $10,000 RMD is treated as a QCD and does not increase her income. Sylvia's AGI is, therefore, $150,000 (the same as Mason's)," Levine explained on Twitter.

She takes the standard deduction and thus has taxable income of $136,300.

Since Sylvia did not take a deduction from her traditional IRA contribution, she has $7,000 of after-tax (nondeductible) money in her traditional IRA. This money will be distributed back to her tax-free over time, according to the CPA.

"It seems utterly ridiculous that one might benefit in such a manner by rejecting an otherwise allowable deduction. But as the split examples above show, it is precisely what can happen," Levine explained.

The potential impact? "If such contributions are made continuously, over a number of years, and perhaps even by both spouses of a married couple, the cumulative tax savings by forgoing the otherwise allowable deductions could reach well into the tens of thousands!"

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