Roth IRA

Tax Increases & Retirement Funding Limits Incoming

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The House Ways and Means Committee released a tax plan designed to pay for (part of?) the bi-partisan Infrastructure Bill and the larger spending bill that Democrats are trying to pass through a process known as “reconciliation”.  The House tax plan contains fewer tax hikes and fewer changes to the tax code overall than President Biden’s initial plan released earlier this year.  While the President’s plan always seemed unlikely to garner enough support, the House plan has the makings of a real starting point for negotiation.  The Senate is moving forward with its own legislation and eventually, both Chambers will need to pass a bill, then reconcile into one bill which is re-passed.  With the Democrats having slim margins in both the House and Senate (courtesy of the VP tie-breaker there), it will be difficult to get enough support from the progressive and more moderate side of the party at the same time.  They’ll either need to do that or bring some Republicans on board in order to get enough votes to pass the broad package.  In summary, there are bound to be a lot of changes to the details here, but we’re close enough to actual proposed legislation, that I thought it would be a good idea to lay out the key portions of the current proposal.  As a side note, there is a fair shot that some/all of the changes will wind up being last minute, end-of-year, potentially retroactive to this year changes.  The timing of enactment and the effective date of each change are going to determine whether or not any action can/should be taken to minimize the impact of tax hikes, or take advantage of temporary opportunities for deductions, credits, etc.  December is going to be a fun month tax-wise, as it has been for the past several years.  Stay tuned.

Currently Included in the House Plan:

  • An increase in the top marginal income tax rate from 37%, back to where it was pre-TCJA at 39.6%.  In addition, the 32% and 35% brackets would be compressed so that the top bracket begins at $400K Single / $450K Joint.
  • A 3% “surtax” on those earning more than $5M in a given year.  A surtax is just a fancy way of adding to the income tax rate, effectively creating a new top bracket of 42.6% for those earning > $5M.
  • An increase in the tax rate on long-term capital gains (LTCG) tax for upper-income taxpayers (in the top tax bracket for LTCG which starts at ~$450K single / 500K joint) from the current 20% to 25%.  Note: this provision would become effective as of 9/13 if I’m reading it correctly (i.e. sales prior to that date would be taxed at the existing rate, sales on or after would be taxed at the new rate).  If true, there’s no ability to sell in advance, though since the rate is only going up 5%, and that might change in a future administration, I can’t see why anyone would sell anything other than for a short-term need anyway.
  • A decrease in the corporate tax rate from the current 21% to 18% for low-income (up to $400K) corporations and an increase to 26.5% for high-income (over $5M) corporations.
  • Limits on the 199A “20% small business deduction” to a max of $400K Single / $500K Joint.  Those aren’t income limits to take the deduction…  they’re limits on the max amount of the deduction.  There had been an alternate proposal (Wyden plan) to eliminate the Specified Services Trade or Business provisions as well as the W-2 income and unadjusted basis of assets provisions, and instead just institute income limits.  That’s not included in the House plan.  (Of course it’s not…  it would have simplified something!)
  • Contributions to IRAs / Roth IRAs would be prohibited if their value (in aggregate in case there are multiple accounts) exceeds $10M in value and income for the year exceeds $400k single / $450k joint.
  • Add a new Required Minimum Distribution (RMD) to IRA, Roth IRA, and defined contribution (e.g. 401k) accounts (in aggregate) that exceed $10M in value if income for the year exceeds $400k single / $450k joint.  The RMD would be 50% of the amount that exceeds $10M.  Additionally, if the balance of those accounts exceeds $20M, a 100% distribution is required from the Roth portions until the total balance is less than $20M or the Roth accounts are exhausted.
  • Roth IRA conversions and 401k Roth Conversions would be prohibited for those with income over $400k single / $450k joint.  Additionally, after-tax contributions to 401k and the conversion of after-tax contributions to Traditional IRAs would be prohibited regardless of income (i.e. the end of the “backdoor Roth” and the “mega backdoor Roth”).
  • IRAs would not be able to hold 1) private investments that can only be offered to “accredited investors”, 2) securities in which the owner has a >= 50% interest (10% if not tradable on an established securities market), and 3) the securities of an entity in which the IRA owner is an officer.
  • Lifetime gift / estate tax exclusion is reset to its 2010 level of $5M per individual (adjusted for inflation) instead of that happening after 2025 as scheduled by TCJA.
  • Changes to bring most Grantor Trusts back into the estate of the grantor and to eliminate the valuation discount frequently used when gifting portions of family limited partnerships (FLPs) to the next generation.
  • More money for the IRS to boost its audit programs.  Everyone hates and audit, but this is sorely needed.  The IRS lacks the resources to keep up with tax cheats.

Notably Not Currently Included:

  • Increase in the State And Local Tax (SALT) maximum deduction.  This is the cap put in place as part of the TCJA that limits both single and joint filers to a maximum Federal deduction of $10k for taxes paid to states and localities.  Several high-tax state representatives in the House have said they will not vote for any tax and spend package that doesn’t relax the current SALT limit, and House leadership has implied that a change to the SALT deduction is still on the table and may be added to the bill at a later date.
  • Loss of Basis “Step-Up” at death.  This feature of the current tax code allows those who inherit property (real estate, securities, farms, businesses, etc.) to have the cost basis of the property reset to its value on the date of death of the owner.  This allows substantial gains to go untaxed if the property is held until death.  The President’s tax plan would curb basis step up, but such curbs were not included in the recent draft from the House.  The head of the Senate Finance Committee has indicated that this may wind up in the Senate bill, so it’s not dead yet either.
  • Elimination of tax-free loans from securities portfolios.  The current tax code allows owners of brokerage accounts to use the account as collateral to take out loans.  The proceeds from the loans can then be used to support expenses, rather than selling assets and potentially paying capital gains tax on those sales.  This practice helps to avoid selling assets such that basis can be stepped up at death (see bullet above) and capital gains tax is never collected.

After-Tax 401ks & Rollovers To Roth IRAs

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The IRS recently clarified rules surrounding rollovers of qualified plans (401ks, 403bs, etc., all of which I’ll refer to as “401k”s for the rest of this post for simplicity) to IRAs which can have a dramatic impact on a plan participant’s ability to save for retirement in some situations. For those of you who want to read the official IRS notice, it is Notice 2014-54, released on September 18, 2014. For everyone else (which is probably everyone), I’ll summarize what changed and what it means for you. First some background…

Virtually everyone understands the pre-tax portion of a 401k. You defer a portion of your salary as a deposit to your 401k and that amount is not taxed in the period it’s earned. Instead, it grows tax-deferred until retirement, at which time you can withdraw it (usually after age 59 ½ without penalties) and pay tax at withdrawal. Another, newer type of 401k is a Roth 401k. In a Roth 401k, you are taxed on the income that you defer to your 401k, but it grows tax free and is not taxed at all (under current laws) at withdrawal in retirement. If your tax rate is the same at the time of deferral as it is in retirement, then both types of 401ks produce the same amount of after-tax money in retirement. For most people who are into their mid-earning years, the premise that they’ll earn less in retirement and have more ability to control what portion of their retirement savings is subject to tax each year means they’ll probably be in a lower tax rate in retirement. This means they’d favor the pre-tax “Traditional” 401k. While the generalization is true, in general, like much of financial planning, the details of choosing between a Traditional 401k and a Roth 401k are complicated and really need to be evaluated on a case-by-case basis. Regardless of whether you contribute to a Traditional 401k, a Roth 401k, or a combination of the two, the IRS limits contributions at $17,500 per year (indexed to inflation and likely to increase to $18,000 for 2015) + $5,500 more if you’re over age 50. If your employer makes contributions to your 401k via matching, profit sharing, or direct contributions, a second limit applies. That is that your contributions plus your employer’s contributions cannot exceed $52,000 for 2014 (again indexed to inflation).

In addition to the Traditional and Roth 401ks, there is less well-known and less-popular type of 401k called the After-Tax 401k. Many plans do not allow an After-Tax 401k due to the difficulty in accounting for so many types of contributions. For those that do allow it, in this type of 401k, contributions are taxed in the year you earn them (they don’t go into the account pre-tax like a Traditional 401k), but at withdrawal in retirement, you only pay tax on the growth since you’ve already paid tax on the amounts you contributed. This is much less powerful from a tax perspective than pre-tax in (Traditional 401k) or tax-free out (Roth 401k), but is still advantageous in some cases because it means the growth (interest, dividends, and gains) is not taxed each year as it is earned and so that growth can continue to compound tax-deferred until withdrawal. The After-Tax 401k is not subject to the $17,500 employee contribution limit, but is subject to the $52,000 total contribution limit. This means that if you’re maxing out your Traditional/Roth 401k, and your employer isn’t contributing $34,500, and your plan allows an After-Tax 401k, there is room for you to contribute to your After-Tax 401k. Unfortunately, the tax on the growth of an After-Tax 401k is assessed at ordinary income tax rates rather than at lower, capital gain rates as an ordinary taxable brokerage account would be taxed. So, in general, an efficiently managed taxable brokerage can be a better option than an After-Tax 401k, especially when considering the liquidity advantage that comes with being able to access your money at any point for any purpose. This has been the root cause of the limited popularity and use of an After-Tax 401k.

Once you leave your employer, you can withdraw from your 401k and rollover the money to an IRA. Traditional 401ks go to Traditional IRAs and Roth 401ks go to Roth IRAs, all preserving their tax status. With After-Tax 401ks, it’s more complicated. If After-Tax 401k money is rolled over to a Traditional IRA, a portion of the Traditional IRA becomes “basis”, which is not taxed again at withdrawal and every withdrawal will be part growth (taxed) and part return of basis (not-taxed). If it’s rolled over to a Roth IRA though, the tax treatment used to be unclear. Many tax practitioners and plan administrators thought that the IRS would consider Traditional 401k money and After-Tax 401k money together in one rollover, assessing a prorated amount of tax if one were to try to roll pre-tax money to a Traditional IRA and after-tax to a Roth. This treatment would be consistent with the way the IRS taxes conversions from Traditional IRAs to Roth IRAs. If there are both pre-tax and after-tax (basis) dollars in a Traditional IRA, and you attempt to convert a portion of that Traditional IRA to a Roth IRA, you’d be taxed pro-rata on the amount. Others came up with complicated multi-step schemes to try to isolate the After-Tax portion of a 401k in its own account, such that it could be converted to a Roth tax-free. IRS guidance on Sep 18 clarified that effective immediately, After-Tax 401k dollars can be rolled over directly to a Roth IRA without any tax being due as long as it’s done at the same time as Traditional 401k money is rolled over to a Traditional IRA.

I find it hard to believe that this treatment will be around forever, but at least for now, this has opened the door for massive amounts of money to be tucked away in an After-Tax 401k and then rolled directly to a Roth IRA at the time service with that employer is terminated. Here’s an example of how it could work for someone earning $200k per year, maxing out her Traditional 401k with an 8.75% ($17,500) contribution, receiving a 3% ($6,000) employer contribution, and working for three years before moving on to another opportunity at a different employer:

 

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The person above would be able to stash away $85,500 in a Roth IRA after only 3 years while otherwise earning too much per year to be able to directly contribute to a Roth IRA. It’s clearly not for everyone since you need to have a lot of free cash flow in order to take advantage of the large contributions and your plan needs to include After-Tax 401k contributions as an option. If it can work for you, and you’re looking to tuck away large amounts of tax-advantaged money, this is a really big deal.

So here’s what to do: If you’re maxing out your $17,500 401k contribution each year and looking to put more than that away for retirement, send your 401k plan administrator a note (or call) and ask, “Does my 401k plan allow after-tax (non-Roth) contributions after I’ve hit my $17,500 maximum pre-tax contribution each year?” If the answer is “yes”, you can start to take advantage of this immediately.

One final note to keep in mind… tax rules are always changing. There’s nothing to say the IRS won’t change its mind or that Congress won’t pass a law to stop this treatment of After-Tax 401ks. That’s true of any tax law or IRS interpretation of that law. It’s prudent to monitor the tax landscape and adjust decisions accordingly. Contact your financial advisor before and while attempting something like this or if you have questions about it.