Executive Summary
Every year, the proposed changes to the tax laws encapsulated in the President’s budget request for the Federal government are recorded in the Treasury Greenbook, which is then taken under advisement by Congress to create its own budget resolution. And while the President’s budget request does not necessarily dictate what Congress will decide to do, it does provide valuable insight into potential legislation that may be considered in the coming months and years.
While some tax proposals in the Greenbook are relatively minor, or pertain to issues not directly relevant to our work as financial planners, this year’s FY2016 budget request had several proposals that would represent major changes in the world of planning for retirement accounts, both during clients’ lives and after they pass away.
Accordingly, following on last week’s review of the “good” and the “bad” of the proposed tax law changes for retirement accounts, we look at some of the “ugly” provisions that could have a more dramatic impact in the coming years, from the possible elimination of stretch IRAs (requiring the 5-year rule for most non-spouse beneficiaries), to a $3.4M “cap” on retirement accounts (though it is actually just a cap on new contributions to retirement accounts), and the proposed repeal of the Net Unrealized Appreciations (NUA) rules for those who were born after 1965!
Eliminate Stretch IRAs And Require 5-Year rule For All Non-Spouse Beneficiaries
From a tax policy perspective, the tax code provisions allowing tax-deferred growth for traditional retirement accounts (and tax-free growth for Roths) were created to help individuals and couples save for retirement, not their heirs. While this challenge is at least partially ameliorated by the fact that beneficiaries themselves are subject to Required Minimum Distributions after the death of the original retirement account owner, the fact that many/most retirement accounts are left to younger individuals of the next generation means that often the tax preferences for retirement accounts apply even longer for beneficiaries than for the original contributor!
Accordingly, the Treasury Greenbook proposal would alter the rules for beneficiaries of employer retirement plans and IRAs. While spousal beneficiaries would remain eligible to roll over the account into the surviving spouse’s own retirement account, all other non-spouse beneficiaries would become subject to the 5-year rule, where the entire account balance must be liquidated by the end of the 5th year after death.
Some exceptions to this 5-year rule for non-spouse beneficiaries would apply; if the beneficiary is disabled or chronically ill, or is not more than 10 years younger than the original retirement account owner, the beneficiary would still be permitted to stretch over his/her life expectancy. In the case of a minor child, the funds would be eligible to stretch based on life expectancy as long as the child remains a minor, but the child beneficiary would become subject to the 5-year rule upon reaching the age of majority (i.e., if the child inherited at age 5, and is no longer a minor at the age of 18, then the account would have to be distributed by December 31st of the year the child turns 23). In addition, to the extent that an account is left to one of the above beneficiary types that are able to stretch, then upon the death of that beneficiary, any subsequent beneficiary would be required to follow the 5-year rule thereafter (i.e., if the IRA is left to a disabled beneficiary who stretches RMDs, and the disabled beneficiary dies, the next beneficiary in line will be subject to the 5-year rule).
For “modest” retirement accounts, the application of the 5-year rule to non-spouse beneficiaries may be some loss of tax deferral, but would not necessarily be very damaging, as the beneficiary could still effectively stretch the funds out over 6 tax years (including the partial tax year the original owner dies, and the 5 subsequent years). However, for very large account balances, compressing distributions into just 6 tax years could drive a beneficiary’s tax bracket significantly higher, potentially making it more appealing for the account to be converted to a Roth while the original owner is still alive (assuming the original IRA owner could convert at a lower tax rate) so the 5-year rule would at least apply to a non-taxable inherited Roth. The potential for accelerated distributions would also make the current rules for qualifying a “see-through” trusts as the designated beneficiary of a retirement account a moot point (though trusts may still be used for non-tax purposes).
The rules are proposed to take effect for any retirement account owner who dies beginning in 2016 or later (and if the account is already an inherited retirement account, the death of any beneficiary-owner would trigger the 5-year rule for subsequent beneficiaries). Notably, the rules do contain an exception that would allow stretch treatment to still apply for any IRA annuity that has a restricted beneficiary designation already in effect if/when the proposal is enacted, which creates some incentive for those who fear the rule being passed to purchase one soon rather than later! On the other hand, this potential change to the 5-year-rule for all has been proposed repeatedly since 2012, and it remains unclear whether it will ultimately be passed at all!
Limit To Retirement Contributions For Those Who Exceed ($3.4M) Cap On Aggregate Account Balances
Although retirement accounts already have annual contribution limits of various types, the potential to contribute to multiple different types of accounts at the same time, systematically over a long period of time, creates the potential for extremely large retirement accounts (and a significant “cost” of foregone revenue for the Federal government). As a result, the Treasury Greenbook includes a proposal that would limit ongoing contributions to retirement accounts once all the account balances in the aggregated exceed certain thresholds.
Specifically, the rules would limit the aggregate of all tax-favored retirement account balances to an amount that is sufficient to purchase the maximum lifetime income permitted under a defined benefit plan (currently $210,000/year as a joint and survivor benefit starting at age 62). Given today’s interest rates, this would equate to an account balance of $3.4M for a 62-year old. As this limit is adjusted annually for inflation, the target defined benefit amount and therefore the associated cap would be expected to rise over time (all else being equal).
To the extent that an individual’s aggregate account balances across all retirement accounts exceeds this threshold, the otherwise applicable IRA, 401(k), and other contribution limits would be reduced to $0. In other words, no new dollars could be added to any retirement accounts, once the threshold is exceeded. If the account balance falls below the threshold (e.g., due to a market decline), contributions could resume.
Notably, because the cap is calculated based on the account balance that would be necessary to purchase a $210,000/year annuity at age 62, the dollar amount of the account cap would actually be much lower at younger ages (given an assumed growth rate as a part of the actuarial calculation), and the cap would rise over time as the individual ages. For most, the cap would likely simply keep pace with ongoing contributions anyway, but to the extent that individuals saved more in the early years (up to the cap) and the account balance then outperforms the actuarial growth assumption, the cap would be exceeded (and may remain exceeded ‘indefinitely’ unless subsequent bear market losses bring the value back down again). Presumably, the Treasury and IRS would issue a table ever year specifically the maximum aggregate retirement account cap by age (and based on ‘current’ actuarial assumptions), which taxpayers would have to reference to determine if they will be allowed to contribute in the upcoming year.
Given that the cap would be calculated annually based on then-current actuarial assumptions, the cap may also fluctuate from year to year as interest rates (and therefore actuarial growth rate assumptions) change; as a result, while the cap would be $3.4M based on current rates, it could be significantly lower if/when/as interest rates rise in the future. Nonetheless, to the extent that an individual finds their aggregate account balances in excess of the cap, subsequent contributions would be limited, regardless of whether the threshold was crossed because account balance outgrew the cap threshold, or because the cap threshold fell below the aggregate account balances. Conversely, an individual might be able to save again in the future either because the account balance falls below the cap, or because the cap rises if/when/as interest/growth rate assumptions decrease. Rising longevity over time – and updated mortality tables – would also potentially increase the cap, though the Treasury has not yet indicated what mortality assumptions would be used, nor how often they would be updated.
From a planning perspective, while the retirement “cap” has been discussed as a means to prevent a “Romney-sized IRA” (after the controversial disclosure during the 2012 presidential campaigns that Mitt Romney had an IRA worth more than $20M), the reality is that because the proposal would merely prevent new contributions but not ongoing growth, it doesn’t actually limit the strategies that produce mega-IRAs (like entrepreneurs putting startup stock inside of an IRA). Arguably, for someone who already has $3M+ in retirement accounts, contributing $18,000 to a 401(k) or $5,500 to an IRA wasn’t really going to move the needle much anyway. In fact, the reality is that under the proposed rules, the best thing that savers could do – at least those who are optimistic about long-term investment returns – is maximize the value of their IRA up to the cap as soon as possible, to allow more years for favorable growth to compound.
Strategies that distribute IRA contributions around the family would also become more appealing, from doing spousal IRA contributions (e.g., if a working spouse is over the cap but the non-working spouse is not), to putting children on the payroll so that they have some earned income and then gifting them (and/or paying them) the dollars necessary to make their own retirement account contributions.
Notably, the retirement account cap could also distort some asset location decisions for affluent clients who are approaching the cap. While in general, it’s beneficial to put high-return (and tax-inefficient) assets inside of retirement accounts, doing so and actually getting good returns can just push the account over the cap more quickly (to the extent the returns exceed the actuarial growth assumptions). Ironically, this means that high-return tax-inefficient assets may be great in a retirement account for those far beyond the account cap (where contributions won’t be possible anyway), or those far below the account cap (who don’t have to worry about ‘too much’ growth anyway), but problematic for those who are close to the cap.
As with all other budget proposals, these rules are not effective yet, and it remains to be seen whether they will be implemented (as this is the third year in a row it’s been proposed without any progress). In this year’s Greenbook, the proposal was targeted to be effective for 2016.
Repeal The Exclusion For Net Unrealized Appreciation (NUA)
The Net Unrealized Appreciation (NUA) rules allow employees who have accumulated employer stock inside of their employer retirement plan to later distribute it out of the plan and into a brokerage account. By doing so, the employee only reports the cost basis of the securities (from inside the plan) in income for tax purposes, with the remaining “unrealized appreciation” deferred until the stock is sold… and when the stock is sold, all of that unrealized appreciation that built up inside the plan is eligible for long-term capital gains treatment. By contrast, if the funds had remained inside the account, the growth would have (someday, upon withdrawal) been subject to ordinary income treatment.
Of course, if the stock had been purchased outside of the retirement plan, it would have been eligible for long-term capital gains treatment in the first place, but in many cases the only assets available to invest were inside of the account, or alternatively the employer stock may have been accumulated because the employer actually provided it to the employee in the first place (e.g., a profit-sharing contribution, as part of an ESOP, etc.). In those cases, the employee gets the preferential long-term capital gains treatment for appreciated stock, even though it was purchased inside the plan.
Notwithstanding some of the tax benefits, both regulators and legislators have been increasingly concerned in recent years about the risks to employees of having their retirement account assets concentrated in a single stock holding (especially when it’s the same company which they are already counting on for employment!). Thus, in 2006 the Treasury begun to promulgate Regulations that would require qualified plans to offer diversification choices for employees with significant employer stock positions.
Continuing that theme, and the concern that giving tax incentives for employer stock inside a qualified plan may be incentivizing people to over-concentrate their investment risk, the current Treasury Greenbook proposal would repeat the NUA rules altogether, for those who have not yet reached age 50 as of December 31, 2015 (regardless of whether they already have appreciated securities inside of their qualified plan). Those who are already age 50 or older this year (i.e., those who were born in 1965 or earlier) would still be eligible for NUA treatment (ostensibly for employer securities already long-held inside the employer retirement plan).
Employees who are under age 50 but do have highly appreciated employer stock inside of their qualified plan may look to complete an NUA distribution this year (either if/after they separate from service, or as an in-service distribution if the plan allows); while such a distribution would be subject to early withdrawal penalties, the penalty would only apply to the cost basis of the securities, and if the appreciation is significant enough (and the cost basis is small enough), it may still be worthwhile to pay the small penalty to take advantage of the rules before they’re changed (recognizing that this still must be passed into law in the first place!).
As noted last week, in the end the proposals from the President’s budget request are just proposals, and don’t have to even be included in Congress’ own budget resolution, much less actual budget (or related) legislation. And in fact, the proposal to eliminate stretch IRAs is not new, nor is the potential cap on retirement accounts; both have been included in prior budget requests from the White House, and both have been passed over for several years. Nonetheless, given the ongoing efforts to reform the tax code, these proposals do provide a glimpse of what may be coming in the future, and at the least deserve to be recognized when considering retirement account planning issues for clients!
So what do you think? Are you upset by these proposed changes to retirement accounts, or do you think they're "fair" for the reasons given by the Treasury and President Obama? Are you going to wait to see if these actually come into law, or will they impact your advice to clients now?
