Executive Summary
Earlier this month, President’s Obama released his budget request for the Federal government for the coming 2016 fiscal year. Included in the budget are a long series of tax proposals, summarized in the so-called “Treasury Greenbook” that provides an explanation of each proposal and what it would entail.
While the tax proposals in this year’s budget span a wide range of categories and topics, the proposed retirement changes are significant, and include some good, some bad, and some that are downright ugly. This week, we review some of the good (eliminating RMDs for those with less than $100,000 of retirement assets and allowing inherited IRA rollovers for non-spouse beneficiaries) and the bad (Roth crackdowns including no more backdoor Roth contributions and new Roth RMDs after age 70 ½). Next week, we’ll look at the ugly, including the infamous proposed $3.4M “cap” on retirement accounts (which is actually far less restrictive than it has been made out to be in the media), and the potential elimination of stretch IRAs and Net Unrealized Appreciation (NUA) rules.
Of course, the caveat is that these tax proposals are just that – proposed – and most would require legislative action from Congress to implement... which may not happen anytime soon! Nonetheless, the proposals provide important insight into what the White House considers to be “bargaining chips” for tax reform going forward, which means there is at least some “risk” that they could be introduced into legislation (or attached to existing legislation) in the coming years!
Retirement-Related Proposals In The President’s Budget Request
Every year, the budgeting process for the Federal government kicks off with the President’s annual budget request, which details not only an allocation of budget dollars to various Federal agencies and programs, but also typically includes various legislative proposals for Congress to consider. Included amongst these proposals are typically a series of tax-related reforms, which the Treasury Department explains in a document called the “Greenbook”.
While this year’s budget-based tax proposal span a wide range, from reforming the international taxation of businesses, to providing tax relief to small businesses, encouraging certain manufacturing, energy, and other initiatives, and streamlining tax administration, this year’s budget proposal also includes a number of important proposals pertaining directly to retirement accounts and their associated rules. Below, we explore the good and the bad of the proposed changes!
Expand Required Automatic Enrollment To IRAs For Small Businesses (With A Tax Credit)
While automatic enrollment for 401(k) plans was dramatically expanded under the Pension Protection Act of 2006, the fact that not all businesses offer employer retirement plans has created a significant disparity. While automatic enrollment in 401(k)s has been estimated to increase retirement plan participation rates amongst eligible employees to more than 90%, the (voluntary) IRA participation rate for those who must create their own accounts sits at less than 10%. The trend is especially problematic amongst small businesses, who tend not to offer plans either due to the cost of making employer contributions, or simply the time and hassle (and some cost) to establish the plan in the first place.
Accordingly, under the proposal, employers in business for at least two years that have more than 10 employees would be requires to include automatic enrollment into an IRA on a payroll-deduction basis (unless the employer offers a qualified plan or a SEP or SIMPLE IRA to employees already). Contributing to a Roth IRA would be the default, and contributions could go to a single IRA custodian designated by the employer, or the employer could allow each employee to choose their own provider. (Although not specifically noted, the Federal MyRA program would presumably be at least one option for the single-IRA-custodian option.) The employer would not be required to make any employer contributions, would have no retirement plan compliance obligations, and would have no liability or responsibility for determining employee eligibility to make tax-favored IRA contributions in the first place.
Small employers (fewer than 100 employees) would be eligible for a (non-refundable) tax credit of up to $1,000/year for 3 years to defray setup costs, plus a further credit of $25 per enrolled employee (up to $250/year) for 6 years. Notably, the proposal would also increase the tax credit for small employers that do offer an employer retirement plan (including a qualified plan, SEP, or SIMPLE) from the current $500/year for 3 years up to $1,500/year instead, plus another $500/year for new planers that include auto-enrollment.
Notably, a related provision would also require “long-term part-time” workers to participate in employer retirement plans as well (beyond just automatic IRA enrollment), once the employee has worked for at least 500 hours/year for three consecutive years (if the employer offers a qualified plan solution in the first place).
The proposal has a target effective date beginning in 2017, to allow time for the proper automatic enrollment IRA and payroll deduction systems to be established. The requirement to cover part-time workers in (existing) employer retirement plans would begin in 2016.
Penalty-Free Withdrawals From Retirement Accounts For The Long-Term Unemployed
Under current law, the 10% early withdrawal penalty is waived for funds withdrawn from an IRA by someone who is unemployed and using the money to cover his/her health insurance premiums.
With the proposed changes, this rule would be expanded to apply to employer retirement plans in addition to IRAs, and would apply to not only funds used for health insurance premiums, but any withdrawal once someone has been unemployed for more than 26 weeks (and has received unemployment benefits for that time period). The total amount of distributions eligible for penalty-free withdrawal would be limited to the greater of $10,000, or half of the individual’s account balance in the IRA or qualified plan, up to a maximum of $50,000/year for two years (or $100,000 total).
These amounts would still apply in addition to the existing rule for penalty-free withdrawals for health insurance premiums, and the new rules are proposed to apply beginning in 2016.
Qualified Annuity Portability Through In-Kind Distributions from Employer Retirement Plans
As a part of the ongoing retirement policy changed aimed to encourage and facilitate the use of lifetime income annuities in retirement, the Treasury recently issued regulations allowing Qualified Longevity Annuity Contracts (QLACs) inside of employer retirement plans, along with guidance on how plan sponsors can include income annuities as a default target date fund investment option. However, a significant caveat to these rules is that plan sponsors have been wary to consider introducing annuities into employer plans, given the uncertainty of how to unwind the arrangement (without adverse surrender charge or tax consequences to the plan participants) if the employer decides to stop offering income annuities in the future.
Accordingly, the Greenbook proposal would allow greater “annuity portability” by allowing a plan to complete an in-kind distribution of a lifetime annuity product (even if otherwise illiquid) as though it were a direct rollover to an IRA or another retirement plan, if the current plan will no longer be authorized to hold such annuities. Such distributions could occur as a trustee-to-trustee transfer to avoid income tax consequences, and would therefore avoid any early withdrawal penalties, and would be allowed even if there was not otherwise an event that would permit the plan participants to take a distribution from the account.
The proposal would apply for in-kind annuity distributions occurring in 2016 and beyond.
Eliminate Required Minimum Distribution (RMD) Obligations For “Small” Retirement Accounts
For those who are spending from their retirement accounts, the existence of the Required Minimum Distribution (RMD) rules is a moot point, because such withdrawals would have occurred anyway, just to cover retirement spending needs. However, for those who have the wherewithal to preserve their retirement accounts and defer withdrawals, the RMD rules are intended to ensure that eventually those assets are withdrawn and taxed.
A caveat to the RMD challenge, though, is that for many people with “modest” account balances, the decision to keep assets inside of their retirement accounts is not merely to generate more tax-deferred compounding growth to bequeath to the next generation (as the assets aren’t “needed”), but simply because they live entirely on other fixed-income sources (e.g., Social Security and/or pensions) and the retirement accounts are all the excess assets/savings they own and is intended as a reserve to cover anything/everything they might need to pay for in the future.
Accordingly, the Greenbook proposal would exempt someone from the RMD rules if the aggregate value of all their IRA and other retirement accounts is no more than $100,000 on the “measurement date” (generally, when he/she reaches age 70 ½). Thus, as long as the individual’s account balance was below the threshold when RMDs were scheduled to begin, they will never apply for the rest of his/her lifetime, even if the account balance grows over $100,000 in the future (though if new contributions/rollovers/transfers that weren’t previously counted are added, a new measurement date is applied). For those with an account balance over $100,000, the rules would phase in ratably as the aggregate retirement accounts go from $100,000 to 110,000, and full RMDs would be due if the account balance was $110,000 on the measurement date (even if the account balance fell below that threshold later).
The value of assets in defined benefit plans, as well as lifetime income annuities, would not be included in assessing the $100,000 threshold, which may make it appealing for some (especially those close to the line) to partially annuitize enough retirement assets to get themselves below the $100,000 threshold by age 70 ½.
Notably, the rules also indicate that the date of death would be a measurement date, implying that the rules may apply to inherited retirement account balances below the $100,000 threshold as well (though this is not entirely clear from the Greenbook).
The proposal would only apply for those who first reach age 70 ½, or who pass away, in 2016.
Allow Non-Spouse Beneficiary 60-Day Rollovers For Inherited IRA And Employer Retirement Plan Accounts
While the standard rules for IRAs and employer retirement plans is that account owners can move their retirement accounts using either a trustee-to-trustee transfer, or by taking a distribution of the funds and “rolling them over” within 60 days, a notable exception applies in the case of inherited retirement accounts.
Under IRC Section 408(d)(3)(C), a 60-day rollover is not permitted for the non-spouse beneficiary, although it is allowed for a surviving spouse (who can roll over the funds into his/her own account). This somewhat arbitrary restriction on 60-day rollovers for non-spouse beneficiaries means, unfortunately, that once a beneficiary receives a distribution check from an inherited account, it is irrevocably distributed, even if the beneficiary meant to just transfer it (but failed to actually do a trustee-to-trustee transfer).
To ease the situation, the budget proposal would change the existing rules under IRC Section 408(d)(3)(C), and allow surviving non-spouse beneficiaries of an inherited employer retirement plan or inherited IRA to roll over any distribution from such accounts into an inherited IRA within 60 days (as long as the inherited IRA is established properly with the new IRA provider).
The rules do not specifically indicate whether inherited IRA 60-day rollovers would have to be coordinated with the new once-per-year rule on 60-day rollovers from the beneficiary’s own IRAs.
The proposal would allow for a 60-day rollover of any distributions from inherited retirement accounts that occurs in 2016 or beyond.
Kill “Backdoor Roth” Contributions By Limiting Roth Conversions to Pre-Tax Dollars
The standard rules for Roth conversions allow taxpayers to move funds from a traditional IRA to a Roth, where the transfer itself is a taxable event but all future growth enjoys the tax-free growth of a Roth. The fact that a Roth conversion triggers income taxes now in exchange for avoiding them later (when the traditional IRA would have otherwise been spent/liquidated) means that the Roth conversion outcome is driven by marginal tax rates; if rates are higher now and lower in the future, the traditional IRA wins, but if rates are lower now and anticipated to be higher in the future, the Roth wins.
An important caveat to this general rule is that while a Roth conversion triggers recognition of taxable income for the value of the IRA, the taxable amount is reduced (on a pro-rata basis) by any non-deductible (i.e., “after-tax”) contributions inside of the IRA. In the extreme, if the value of the IRA (or really, all IRAs in the aggregate under IRC Section 408(d)(2)) is exclusively non-deductible contributions, the tax consequence of a Roth conversion is $0, and the funds are simply converted “for free” from being merely tax-deferred to being totally tax-free.
Given this potential, an increasingly popular strategy in recent years has been the so-called “backdoor Roth contribution”, where those whose income is too high to make a normal Roth contribution can instead contribute to a non-deductible IRA and then convert it to a Roth shortly thereafter; since Roth conversions have had no income limits (since 2010), the end result is an indirect Roth contribution. And while there is some risk to doing the contribution-then-conversion “too fast” and triggering the step transaction doctrine, with a “reasonable” amount of time between the contribution and subsequent conversion it really is possible to get more money into a Roth than the standard contribution limits allow. Similarly, with the recent acquiescence of the IRS under Notice 2014-54 to allow splitting after-tax 401(k) contributions for Roth conversion (and rolling over the pre-tax remainder), individuals have yet another potential means to make an indirect Roth contribution by converting non-deductible contributions.
To shut down this perceived “abuse”, the Treasury Greenbook proposal would simply limit any/all Roth conversions to be only permissible for pre-tax dollars; in other words, to the extent that any of the IRA or employer retirement funds are after-tax, they would simply not be eligible for conversion at all. This would effectively stop all “backdoor” Roth contributions, whether through IRAs or 401(k) plans; in fact, it would even limit Roth conversions of after-tax retirement funds under the normal pro-rata conversion rules as well.
As with most other Treasury Greenbook proposals, this new rule is targeted for Roth conversions that occur in 2016 and beyond. As with the other proposals, it remains to be seen whether the rule will be implemented, but if it is, there may be a flurry of Roth conversions throughout the end of 2015 as anyone who has after-tax funds in a retirement account makes one last attempt to convert them! Either way, though, backdoor Roth contributions would be curtailed in 2016 and beyond (though high-income individuals may still want to make after-tax nondeductible contributions to traditional retirement accounts for other reasons, such as avoiding the 3.8% Medicare surtax!).
Introduce RMDs For Roth IRAs And Limit Contributions After Age 70 ½
In the spirit of “simplifying” the RMD rules, the Treasury Greenbook also proposes to harmonize the rules between traditional and Roth IRAs (and also between Roth IRAs and Roth 401(k) plans). Accordingly, the proposed changes would introduce RMDs for Roth IRAs that would begin after age 70 ½ (just as with traditional IRAs and Roth 401(k) plans, and also to limit new contributions to Roth IRAs beyond age 70 ½ (as with traditional IRAs).
Notably, these proposals are done not only to harmonize the rules, but also to eliminate the “incentive” for individuals to pull money out of Roth 401(k) plans and put them into Roth IRAs. Since in some circumstances it may be preferable to keep funds inside an employer retirement plan (e.g., better asset protection, possibly more favorable fees and expenses in some situations), the budget proposal points out that there shouldn’t be an RMD-avoidance incentive to roll the assets out.
As with the prior proposal eliminating RMDs for small retirement accounts, this proposal would apply to anyone turning age 70 ½ in 2016 or beyond (which means even today’s 69-year-olds could find themselves subject to RMDs from Roth accounts next year if this proposal is adopted!).
As noted throughout, ultimately the tax changes suggested in the budget proposal are just proposals, and not even potential legislation (yet?) and certainly not passed into law. And many of these retirement changes have actually been proposed for several years now. Nonetheless, as the White House tips its hand about what’s “on the table” as bargaining chips for tax negotiations, there is certainly an elevated opportunity – or risk – that some or all of these provisions may someday come to pass!
So what do you think? Do you anticipate that any of these proposals will ultimately be passed into law? Will you be adjusting any of your current retirement planning advice to clients in advance, or are you waiting to see what happens?
Seems like they could just as easily “harmonize” the rules by eliminating required distributins from Roth 401k accounts. One set of rules for “traditional iras and 401k accounts; one set of rules for Roth accounts.
Ben,
That would require a drastic re-write to the 401(k) rules. As is, Roth accounts were an “add-on” to the 401(k) framework (which is why they have RMDs in the first place); creating non-RMD-based 401(k) plans would be a much more significant legislative change, and also have a lot of ramifications for plan adminstrators and record-keeping systems.
That aside, obviously there’s a desire to reduce the size of the tax expenditure as well, which is certainly a secondary motivating factor right now. But adding RMDs to Roths really is “easier” legislatively and administratively than removing RMDs from (Roth) 401(k) plans.
– Michael
I had scanned the Greenbook previously and again after this blog. I did not previously see the proposal about the Backdoor Roth proposed revision – actually still don’t see the level Michael is professing but I believe it is likely written correctly above. I’m sure this has been and will continue to be a focus item for Congress. I am a huge fan of tax bracket arbitrage and use this conversion / recharacterization opportunity since it came into existence. Thanks for summarizing and sharing MK.
Bruce,
Link to the current Greebook is in the article.
The proposal is printed on page 173 (which is actually PDF page 185 given the cover pages, table of contents, etc.).
– Michael
Michael, thank you for taking the time to provide me with a direct pointer! In general, although this is not tax law until it is approved as you indicate above changes may be warranted. I may keep more of a 2015 focus on conversion (convert even more) #and# drive deeper into a tax bracket to get my personal and some other investors and clients (if they so choose) more income tax ‘paid in full’ assets / accounts to look back at our changing history and smile that a portion of my larger portion of my income taxes are completely paid. Again – I believe this will continue to be a focus for congress.
Although the perceived abuse of the non-deductible back door rollover for IRA’s will now be done away with (pending this passes, which is unlikely), for the client who has multiple IRA’s that consist of both pre-tax and post-tax contributions, this doesn’t have much of an impact, isnt that right? With or without this proposal the taxable amount of the conversion is still weighted in the aggregate, resulting in the same amount taxed under either scenario (pre tax or post tax contributions being rolled over). For the majority of clients who in fact have quite a bit in IRA’s (most of which are deductible), this will not directly impact.
One more thing – I will hope that these Roth proposed changes will be grandfathered so as not to impose RMD’s on Roth IRA’s that were already in place as of 12/31/2015. And Thanks again for these high quality intellectual capital blogs and forums for comments!
Ditto on that. Almost all my retirement savings were through 401Ks since they were invented. But after I got laid off work with thousands of others during the 2008 recession, I had effectively been forced into early retirement at 58 and have been slowly doing Roth conversions during these low income years, paying for income taxes with nonretirement savings. My partner was laid off for 20 months as well but found another job. We both turn 66 this year and have thus far each converted about half to Roths. If we have to take RMDs on existing Roth IRAs at 70-1/2, there won’t be enough time to recoup those taxes through nontaxable growth. We hope to be able to convert and/or withdraw most before turning 70, at which time we plan to marry even though we will be hit with a marriage penalty. The extra Social Security ex-spousal benefits for 4 years between 66-70 for both of us is worth the wait. I also plan to start a second small pension at 70. I want those Roths to grow in case partner ever needs long-term care or to leave to our grown kids (who have no pensions).
I was forced into early retirement from the Great Recession at age 43!
I don’t have a problem with the IRA cap. Any *normal* individual would have to be doing very well to get up to that cap. It’s only dodgy folks like Romney who somehow have managed to accumulate $125M in one’s Roth!