A proposed Bill in the House of Representatives seeks to put new rules and limitations on IRA's as well as traditional qualified retirement accounts. This Bill seeks to raise revenues for various government programs in the name of ending a decade's old practice of “subsidizing retirement savings once account balances reach very high levels.”
The reach of this new rule change will impact people differently. Some will only apply to a minority of fortunate Americans who managed to grow significant balances inside their retirement accounts. Other rules changes seek to end a nearly decade's long “loophole” that allowed otherwise non-qualified savers to establish a Roth IRA.
New $10 Million Cap
The proposed rule change establishes an effective cap on IRAs before a new Required Minimum Distribution (RMD) comes into play. This RMD has no age attainment requirement–i.e. you could be 25 and be subject to it. Once your IRA reaches a balance north of $10 million, you must distribute funds from the IRA totaling 50% of the difference between your balance and $10 million.
For example, if you end the year with an IRA balance of $11 million. You'll need to withdraw $500,000 from the IRA per the new rule. No word in the language of the Bill about the precise taxability of this RMD. So if you are under 59.5 you'd presumably not pay a 10% excise tax for making the distribution, but the bill's language is not clear on this.
No Roth IRA if Other Retirement Account Balances Equal $20 million
The Bill also proposes a second RMD specifically for Roth IRA's when balances for all retirement accounts exceed $20 million. It specifically requires the distributions to come from Roth accounts first. This effectively forces savers to distribute 100% of their Roth IRA's to meet the RMD if the amount needed to satisfy the RMD exceeds the balance of the Roth IRA.
For example, if you have $20 million in a 401(k) and $5 million in a Roth IRA the first RMD requires you to withdraw $5 million. The second prong of this rule change requires that you first take this amount from the Roth IRA. In this case, you will completely drain the Roth because the RMD is the balance of your Roth IRA.
No More Sneaking in the Backdoor
In 2010 tax legislation became effective that removed the income limit that prevented Roth IRA conversions. Americans who earned too much income to open a Roth account were also blocked from converting their traditional IRA into a Roth account prior to this tax law change.
Beginning in 2010, however, the income restriction on conversions went away, and Americans of any income level were free to convert non-Roth IRA's to Roth's. The idea was to raise tax revenue through the conversion of traditional IRA balanced to Roth's.
But another strategy took shape for high-income earners wishing they could start a Roth. They simply opened a non-deductible IRA–so no tax deduction was taken for the contribution to the account–and then converted the non-deductible IRA to a Roth IRA a year later. Since the income restriction on conversions was gone, the “backdoor” Roth strategy–as it became known–as a wildly touted trick financial advisors offered up to their higher-earning clients. And it works still today as a way to get into a Roth if you can't directly open one up due to income restrictions.
The new bill in the House seeks to close and lock the backdoor.
The new bill specifically restricts conversions to Roth IRAs for certain income levels, but it doesn't just stop there. The new Bill also proposes ending “all employee after-tax contributions to in qualified plans and prohibits after-tax IRA contributions from being converted to Roth regardless of income level.”
There is a subtle, but significant implication to this rule change that might impact a strategy some American's adopted back in 2015. Back then, the IRS ruled that rolling a non-deducted IRA contribution into an IRA and converting it to a Roth IRA was permissible. This opened the door for employees covered under 401(k) et. al. plans to make non-deducted contributions to their 401(k)'s up to the maximum contributions amounts with the plan to later convert those balances into a Roth IRA. The IRS further clarified at the time that none of the gains in these accounts would be taxable since the employee never took a tax deduction for making the contribution. This set the stage for making large contributions in the hopes of amassing large sums in what would eventually become a non-taxable Roth IRA. We covered this on the old podcast.
Income Thresholds for New Tax Rules
The Bill does establish income thresholds before being subject to these rule changes–with the exception of converting non-deducted retirement savings to Roth accounts, it clearly states that it would no longer be allowed regardless of income level.
These income thresholds are:
- $400,000 for single filers
- $450,000 for married filers
- $425,000 for head-of-household filers
This means that if your taxable income falls below these amounts, these rules mostly will not apply to you.
Not Yet Law
I want to be clear that this Bill is pending legislation. It's not yet law. So there is ample time for things to change. It's unlikely that this Bill will die in Congress, but it's also likely that it will change to some degree before ending up on the President's desk.