Wealthy retirement investors may have a harder time using tax loopholes to shelter money from Uncle Sam should the Senate confirm the House’s version of President Joe Biden’s proposed social legislation.
The draft of the Build Back Better (BBB) bill that was approved by the House on Nov. 19 focuses on limiting tax-avoidance strategies favored by the rich. Some of these were exposed in a recent Propublica investigative report, most notably the $5 billion Roth IRA owned by Paypal founder Peter Thiel.
“These policies are designed to level the playing field a little bit,” said Brent Lipschultz, a partner in EisnerAmper’s Personal Wealth Group.
These provisions had been yanked out of a previous version of the bill, then were reinserted as negotiations continued among Democratic Party factions in Congress. It’s not yet certain they will become law as BBB now must undergo negotiations in the Senate before it winds up on Biden’s desk.
BBB to End the Abuse of Roth Retirement Accounts
A high-profile part of the Build Back Better legislation would stop the uber-wealthy from taking advantage of Roth IRAs, which were authorized in the late 1990s to help middle class Americans save for retirement.
Contributions made to Roth IRAs are made after you’ve paid income taxes on the money. In other words, the money you save is taxed “up front,” enabling the biggest Roth IRA benefit: Withdrawals down the road are free of federal income tax, no matter how much your investments have gained.
“I think the American people are taxed too much. So I strongly support and have advocated for many years reducing the taxes on the working people of America,” said Senator William Roth in 1998, whose work passing legislation enabling Roth IRAs and later Roth 401(k)s got the accounts named after him.
Apologies to Senator Roth, but backdoor Roth IRA workarounds have turned his boon for working people into a tax-free piggy bank for the uber-wealth. Various workarounds and loopholes have been abused by the rich to shelter money from income taxes in Roth IRA accounts.
Proposed Rules for Wealthy Investors with Defined Contribution Accounts
BBB would impose a new requirement on high-income individuals and couples who own balances of $10 million or more across any defined contribution retirement accounts—such as IRAs and 401(k)s—to make withdrawals.
Any single tax filers who earn more than $400,000 a year, and married couples earning above $450,000 a year, couldn’t contribute to their funds and would be required to withdraw 50% of any amount above 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’d have to take out $3 million. (The plan doesn’t kick in until Dec. 31, 2028.)
There’s a further provision that’s harder on Roth accounts—like Roth IRAs and Roth 401(k)s. It applies to any couple or individual with income greater than the thresholds above, 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’d first have to take out $5 million in your Roth IRA to bring the total down to $20 million and then withdraw half of what’s remaining over $10 million, which would equal $5 million.
BBB Would Tamp Down Roth Conversions
The BBB legislation packs another double whammy specifically for Roth accounts. Starting in 2022, the bill proposes to end so-called mega backdoor Roth conversions. Regardless of income level, you’d no longer be able to convert after-tax contributions made to a 401(k) or a traditional IRA to a Roth IRA.
An additional rule would aim to prevent Roth conversions of any kind made by anyone making more than $400,000, or any couple making more than $450,000, by 2032.
Who Benefits from Backdoor Roth Conversions?
The upshot of these various rule changes is that Roth conversions, which became a wealth management strategy for the very wealthy only as recently as 2010, will soon be a thing of the past for the well-off.
“You’re not going to see conversions in the top tax brackets [if these rules go into effect],” said Steffen. “Low income people don’t have the assets to convert, or the liquidity to pay the tax.”
A quick glance at the latest IRS data tells the story: Among more than 200 million U.S. tax filers, fewer than 724,000 did a Roth conversion in 2018. Roughly 60% of those conversions were carried out by households that made between $100,000 and $500,000.
The annual income thresholds outlined above—$400,000 for single tax filers, and $450,000 for married couples—would be adjusted for inflation over time. The new rules would essentially bar the 18% of Roth conversions that were done by taxpayers who took in more than half-a-million in income.
The mega backdoor Roth seems like a particularly egregious loophole. Under this strategy, people with plenty of money to spare make so-called after-tax contributions to their 401(k)s—these can amount to as much 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 retirement system just wasn’t meant to do this.
Would the BBB Backdoor Roth Reforms Impact You?
Most Americans then are spared from these changes that, no matter how just they happen to be, don’t do much to help average folks save for retirement.
In fact, the concept of Roth conversions has little effect on middle income earners: Only 86,000 tax filers who made between $50,000 and $100,000 (out of almost 52 million) even used a Roth conversion in 2018.
Instead, more Americans would be affected by changes that have been debated as part of proposed legislation known as Secure Act 2.0, including updating the Saver’s Credit and implementing auto-enrollment in retirement plans.
The former would turn the Saver’s credit into a refundable credit, which means low-income households who might not owe taxes could benefit, while the latter would require most employers to enroll their employees in a 401(k)-type plan.
The Secure Act 2.0 legislation will likely go through many more twists and turns as it evolves, so it’s not certain which of those reforms may ultimately make it.
Though it does much to address the upper class, the BBB wouldn’t address the needs of middle-class workers who already use an employer-sponsored retirement but don’t have enough saved. Just 55% of households helmed by someone between 55 and 64 have a retirement account, according to the Federal Reserve, and those households have a median holding of just $134,000, hardly enough to live on once you stop working.
In fact the most important asset for pre-retirees is their future Social Security benefits, which also happens to significantly reduce wealth inequality.
Given that the recent Trustees Report showed a key Social Security trust fund will be depleted one year earlier than expected, you’d think lawmakers would take this opportunity to shore up the pension program.
Unfortunately, any reforms will have to wait for a later date.
“It’s not the flavor of the day,” said Steffen.
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