Retirement Planning Loopholes May Be Closed Soon

Retirement planning is supposed to be a good thing. Through the years, the Congress and government at large have promoted sound retirement by providing and expanding incentives for (mostly middle class) Americans to plan and fund their own retirement. However, continued deficit spending and ballooning public debt in recent years have resulted in a number of proposals that aim to close down certain retirement planning techniques that some have deemed inequitable.

Wealthy Americans Reap “Disproportionate” Benefits

Under the current system, taxpayers are encouraged to save for retirement by the rules allowing individuals to defer the tax on income that they contribute to retirement plans, and on the earnings on those contributions, until the individual retires or until after his or her death. However, since higher earners are taxed at a higher marginal rate and have higher effective rates, the biggest rewards from retirement incentives also go to high earners. An American worker earning enough to break into the highest marginal tax bracket (income higher than $413,199 for an individual filer as of 2015) saves 39.6 cents on the dollar by participating in a Code Sec. 401(k) plan. The comparable benefit for a low earner (read: average American worker) is 15 cents on the dollar. High earners would likely plan and save for retirement without disproportionate incentives, which suggests that reallocating available incentives might be a deficit reducing (or at least deficit neutral) way to promote retirement saving among other groups of the population.

Reallocating Incentives

In recent years, there have been numerous proposals to shift the benefits of retirement incentives. For example, in both his 2015 and 2016 budgets, President Obama has proposed a cap on the total amount of savings in a tax-deferred retirement vehicle. This proposal would put a limit of approximately $3.4 million on the total amount of contributions and accruals of benefits inside of an individual’s 401(k)s, defined benefit plans, and IRAs. That amount would increase with the cost of living.

The President’s 2016 budget creates a 28% maximum tax benefit for contributions to retirement accounts. Thus, a taxpayer in the 28% ordinary income tax bracket or lower would be unaffected by this provision. However, a taxpayer in a higher tax bracket, i.e., the 33%, 35%, or 39.6% ordinary income tax bracket, would not receive a full tax deduction (exclusion) for amounts contributed or deferred into a retirement plan. For example, suppose a taxpayer had $500,000 of taxable income and deferred $10,000 into a Code Sec. 401(k) plan. He would pay tax equal to the rate applicable to $500,000, less 28% of the $10,000. This particular proposal isn’t limited to “tax and spend Democrats”- former House Ways and Means Committee chairman Dave Camp, a Republican, in his Tax Reform Act of 2014, proposed limiting the deduction for retirement account contributions to 25%.

Shutting the Back Door

A taxpayer is permitted to make a contribution to a Roth IRA only if the taxpayer’s modified adjusted gross income (MAGI) is less than a specified limit that is indexed for inflation. For example, for 2015, a married taxpayer filing a joint return is permitted to make a full contribution if the taxpayer’s MAGI is less than $183,000, and the contribution limit is phased out over the range of $183,000 to $193,000.

However, there are currently no income limits on a person’s ability to make nondeductible contributions to a regular IRA or to convert money from a regular IRA to a Roth IRA. A taxpayer who converts an amount held in a traditional IRA must include the converted amount in income to the same extent it would be includible in income if distributed and not rolled over. That is, the amount is includible in income to the extent it is not a return of basis. This ability to convert money from an IRA to a Roth provides a “back-door” to a Roth IRA. A taxpayer who is not able to make a contribution to a Roth IRA because of the rule of Code Sec. 408A(c)(3) can nonetheless put just as much into a nondeductible IRA and then convert that
nondeductible IRA into a Roth IRA.

President Obama’s 2016 budget proposal provides that future Roth conversions be limited to pre-tax money only. Thus, after-tax amounts (those  attributable to basis) held in a traditional IRA could not be converted to Roth amounts. A similar rule would apply to amounts held in eligible retirement plans. This proposal would effectively kill most back-door Roths.

Stretching Too Far

In most cases, people who inherit an IRA have the option of taking distributions over their lifetimes. As a result, a taxpayer with a Roth IRA can potentially provide tax-free income to his heirs for decades since Roth withdrawals are typically not taxed and the funds in the IRA will continue to grow tax-free.

The President’s 2016 budget and many recent tax-related bills have included a provision to kill the stretch IRA and replace it with a law requiring beneficiaries other than spouses to withdraw the money within five years. Under the President’s plan, exceptions would apply to any beneficiary who, as of the date of the IRA participant’s death, is disabled, a chronically ill individual, an individual who is not more than 10 years younger than the participant or IRA owner, or a child who has not reached the age of majority.

For traditional IRA beneficiaries who may be forced to withdraw larger amounts of money over a shorter period than they otherwise would, this proposal could potentially result in a significant tax increase. Roth IRA beneficiaries wouldn’t face the same tax increase but would lose the ability to have a tax-free source of income (and enjoy tax-free growth for funds in the IRA) for an extended period.

Time Is Running Out

For the moment, these proposals are just that- proposals. Between the perennial fiscal crisis and Congressional gridlock, no significant changes to the existing tax regime are likely in the next couple of years. However, limiting access to provisions derided as “loopholes for the rich” is a tried and true means of cashing in on populist ire. The techniques discussed here are neither widely known nor commonly used among tax payers at large. That means that most citizens wouldn’t notice if they were “retired” from the tax code. Please contact us, our accounting and tax services can help.