Maxing out contributions to retirement plans to avoid taxes has become a common strategy, but three popular techniques could be cut under proposals afloat in Washington. Here’s a look at the proposed changes, and who would be affected by them.
Capping retirement plan tax benefits
Current law encourages taxpayers to save for retirement by deferring income taxes on money they contribute to retirement plans — and on the earnings on those contributions — until they withdraw the money later in life. However, since higher earners are taxed at higher rates, the biggest rewards from retirement incentives also go to high earners. Someone in the highest personal tax bracket, the 39.6% bracket, saves 39.6 cents on the dollar by participating in a 401(k) plan. For a low earner in the 15% bracket, it’s 15 cents on the dollar.
If you contribute the annual maximum of $18,000 (for those under 50), you would save $7,128 in the 39.6% tax bracket, compared with $2,700 in the 15% tax bracket. For people 50 and over, the maximum contribution is $24,000; in the 39.6% bracket, you’d save $9,504; in the 15% tax bracket, just $3,600.
President Obama’s 2016 budget calls for a 28% maximum tax benefit for contributions to retirement accounts. This means taxpayers in the 28%, 25%, 15% and 10% brackets wouldn’t be affected. Those in the 31%, 35% or 39.6% tax brackets, however, would not receive the full tax break. Their benefit would top out at 28 cents on the dollar.
The idea may have bipartisan traction. Republican Dave Camp, who at the time was the chairman of the House tax-writing committee, proposed in his Tax Reform Act of 2014 that the deduction for retirement account contributions should be even lower: 25%.
Putting a lock on back-door Roth IRAs
Contributions to a Roth IRA aren’t tax-deductible like those to a traditional IRA — but qualified distributions from a Roth IRA in retirement aren’t treated as taxable income. A taxpayer can contribute to a Roth IRA only if the taxpayer’s modified adjusted gross income, or MAGI, is less than a certain amount. As of 2015, a married taxpayer filing a joint return is permitted to make a full contribution at a MAGI of less than $183,000, and the allowable contribution 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 nondeductiblecontributions to a regular IRA or to convert money in a regular IRA into a Roth IRA. A taxpayer who converts money in a traditional IRA must include the converted amount in income to the same extent that it would be includible if it had been distributed to the taxpayer. In other words, the amount is includible in income to the extent that it is not a return of the IRA owner’s basis in the account.
This ability to convert money from an IRA to a Roth provides a “back door” to a Roth IRA for people who would otherwise be ineligible for a Roth account because of the income restrictions. Such people can put money into a nondeductible IRA and then convert thatnondeductible IRA into a Roth IRA.
Obama’s 2016 budget would require 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. A similar rule would apply to amounts held in eligible retirement plans such as 401(k) plans. This proposal would effectively kill most back-door Roths.
Setting a deadline on inherited IRAs
In most cases, people who inherit an IRA have the option of stretching out distributions over their lifetimes. As a result, a taxpayer with a Roth IRA can potentially provide tax-free income to heirs for decades, since Roth withdrawals are typically not taxed and the funds in the IRA can continue to grow tax-free.
The president’s 2016 budget and many recent tax-related bills propose eliminating this “stretch IRA” option and replacing it with a law requiring beneficiaries other than spouses to withdraw the money within five years. Under Obama’s proposal, exceptions would apply to any beneficiary who, as of the date of the IRA owner’s death, is disabled, chronically ill, not more than 10 years younger than the IRA owner, or a minor child.
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.
Learn more about Craig on NerdWallet’s Ask an Advisor.