Will Congress End Backdoor Roth Conversions?

ORetirement investors could find it harder to use tax loopholes to protect Uncle Sam’s money if the Senate upholds the House version of President Joe Biden’s social security bill.

The Build Back Better (BBB) ​​bill that was approved by the House on November 19 focuses on limiting the tax avoidance strategies favored by the wealthy. Some of these were exposed in a recent Propublica investigative report, including the $5 billion Roth IRA held by Paypal founder Peter Thiel.

“These policies are designed to level the playing field a bit,” said Brent Lipschultz, partner in EisnerAmper’s Personal Wealth Group.

These provisions had been removed from a previous version of the bill, then reinserted as negotiations continued between Democratic Party factions in Congress. It is not yet certain that they will become law because BBB must now undergo negotiations in the Senate before he ends up on Biden’s desk.

BBB to end abuse of Roth retirement accounts

A high-profile piece of Build Back Better legislation would prevent the wealthiest from taking advantage of Roth IRAs, which were authorized in the late 1990s to help middle-class Americans save for retirement.

Contributions to Roth IRAs are made after you pay taxes on the money. In other words, the money you save is taxed “upfront,” allowing for the Roth IRA’s biggest advantage: Subsequent withdrawals are free of federal income tax, regardless of how much you earn. investments.

“I think the American people are overtaxed. I therefore strongly support and have for many years advocated lowering taxes on American workers,” said Senator William Roth in 1998, whose work in passing legislation allowing Roth IRAs and later Roth 401(k) got the accounts that bear his name.

Apologies to Senator Roth, but the Roth IRA’s backdoor workarounds have turned its benefit for workers into a tax-free piggy bank for ultra-wealth. Various workarounds and loopholes have been abused by the wealthy to shelter income tax money in Roth IRA accounts.

Proposed rules for high net worth investors with defined contribution accounts

BBB would impose a new requirement on high-income individuals and couples who have balances of $10 million or more in all defined contribution retirement accounts, such as IRAs and 401(k)s, to make withdrawals .

Single filers who earn more than $400,000 a year and married couples earning more than $450,000 a year would not be able to contribute to their funds and would be required to withdraw 50% of any amount over the $10 million threshold. Let’s say you had $16 million in an IRA and 401(k) at the end of 2029. Under these new rules, you would need to withdraw $3 million. (The plan does not take effect until December 31, 2028.)

There is another arrangement that is more difficult for Roth accounts, such as Roth IRAs and Roth 401(k)s. It applies to any couple or individual whose income is above the above thresholds, with more than $20 million held in defined contribution retirement accounts, and any portion of that amount in a Roth account. They must withdraw either the entire Roth portion or an amount from all accounts to reduce their combined balance to $20 million, whichever is less.

So if you had $15 million in a traditional IRA and $10 million in a Roth IRA, you would first withdraw $5 million into your Roth IRA to bring the total down to $20 million, then withdraw the half of what is left over $10 million, which would equal $5 million.

BBB would crush Roth conversions

The BBB legislation contains another double whammy specifically for Roth accounts. Beginning in 2022, the bill proposes to end so-called mega backdoor Roth conversions. Regardless of income level, you will no longer be able to convert after-tax contributions made to a 401(k) or traditional IRA to a Roth IRA.

An additional rule would seek to prevent Roth conversions of any kind made by anyone earning more than $400,000, or any couple earning more than $450,000, by 2032.

Who benefits from Roth Backdoor Conversions?

The result of these various rule changes is that Roth conversions, which only became a wealth management strategy for the very wealthy in 2010, will soon be a thing of the past for the wealthy.

“You’re not going to see conversions in the higher tax brackets [if these rules go into effect]”, Steffen said. “Low-income people don’t have the assets to convert, nor the cash to pay the tax.

A quick look at the latest IRS data tells the story: of more than 200 million U.S. filers, less than 724,000 made a Roth conversion in 2018. About 60% of those conversions were made by households earning between $100,000 and $500,000.

The annual income thresholds described above — $400,000 for single filers and $450,000 for married couples — would be adjusted for inflation over time. The new rules would essentially ban the 18% Roth conversions made by taxpayers who received more than half a million in income.

The Roth mega backdoor seems like a particularly glaring loophole. Under the strategy, people with lots of cash to spare make so-called after-tax contributions to their 401(k) — these can be as high as $58,000 for those under 50 in 2021. , if your plan allows it – and then roll the funds into a tax-free Roth account.

The point seems to be one of fairness: the pension system just wasn’t meant to do that.

Would the BBB Backdoor Roth reforms impact you?

Most Americans are then spared these changes which, fair as they are, do little to help average people save for retirement.

In fact, the concept of Roth conversions has little effect on middle-income earners: only 86,000 filers who earned between $50,000 and $100,000 (out of nearly 52 million) even used a Roth conversion in 2018.

Instead, more Americans would be affected by the changes that have been debated under the bill known as Secure Act 2.0, including updating the Saver’s Credit and implementing automatic enrollment in pension plans.

The first would turn the saver’s credit into a refundable credit, meaning that low-income households who may not owe taxes could benefit, while the second would require most employers to register their employees with a 401(k) plan.

The Secure Act 2.0 legislation will likely go through many twists and turns as it evolves, so it’s unclear which of these reforms might ultimately succeed.

While it does a lot to appeal to the upper class, the BBB would fall short of the needs of middle-class workers who are already using an employer-sponsored pension but don’t have enough savings. According to the Federal Reserve, only 55% of households headed by someone between the ages of 55 and 64 have a retirement account, and those households have a median wealth of just $134,000, barely enough to live on once you stop spending. to work.

In fact, the most important asset for pre-retirees is their future Social Security benefits, which also significantly reduce wealth inequality.

Given that the trustees’ recent report showed that a key Social Security trust fund will run out a year earlier than expected, you’d think lawmakers would seize the opportunity to shore up the pension program.

Unfortunately, any reform will have to wait for a later date.

“It’s not the flavor du jour,” said Steffen.

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