7 Ways The New Tax Bill Could Impact Retirement Planning

The Ways and Means Committee released the first draft of a major tax bill this week. While it is mostly aimed at increasing taxes to pay for other social policies and government infrastructure initiatives, there are a number of provisions that would change retirement planning.   

You can see a summary by the Ways and Means Committee here. Most of this bill as it relates to retirement planning is more about tax revenue and adding new restrictions. It’s not geared at expanding retirement access or enhancing retirement security of Americans as other bills in front of congress, like the SECURE Act 2.0.    

While congress is looking at adding retirement enhancements, the proposed tax bill released this week is geared towards tax revenue and removing perceived “excess” benefits.   

Let’s look at seven different ways the tax bill would change retirement.   

(1) Limits on High Income Earner Contributions to IRAs: Sec. 138301  

Today, individuals with earned income who are not active participants, and their spouse is also not an active participant in a 401(k) or other qualified account, can contribute to an IRA regardless of their income or other retirement savings.   

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  The new provision would limit any further contributions to an individual’s IRA if the total value of the individual’s IRA and defined contribution accounts exceed $10 million at the end of the prior year, and that person earns more than $400,000 for single and $450,000 for married filing jointly. Roth IRAs already limit contributions based on income so there would be no change with Roth, just with traditional IRAs. For 2021, an individual can contribute up to $6,000 ($7,000 if age 50 or older) to an IRA or Roth IRA.  

(2) Significant Increase in Required Minimum Distributions with Large Account and High Income Earners: Sec. 138302  

Today, Required Minimum Distributions (RMDs) generally kick in on retirement accounts after age 72 and is based on an IRS provided uniform lifetime distribution number (essentially a life expectancy number) and the value of the account at the end of the prior year. This new provision would apply a new (and much larger) RMD for those with larger accounts and significant taxable income.   

  If the individual’s combined traditional IRA, Roth IRA, and defined contribution retirement account balances exceed $10 million at the end of the prior year, the person is subject to RMDs, and has taxable income above $400,000 for single filers and $450,000 for married filing jointly, then there would be a new RMD that is generally 50 percent of the aggregate amount above $10 million. So if you had $16 million, you would have a $3 million RMD since 50 percent of the $6 million over $10 million is $3 million.     

Further expanding on this rule, if the aggregate amount exceeds $20 million, Roth IRAs and Roth accounts, like in a 401(k), would have to be distributed first until the balance fell below $20 million or the Roth accounts are depleted. This new rule would kick in for 2022.    

(3) Roth Conversion Limitations for High Income earners: Section 138111  

Back in 2010, any limits on Roth conversions of assets from traditional IRAs or defined contribution plans based on income were removed. This means that under current law anyone, regardless of income levels, can convert assets between IRAs and Roth IRAs.  

However, there are limits based on income to directly contribute to a Roth IRA. For instance, in 2021 if you earn over $140,000 for a single filer or $208,000 for married filing jointly, you cannot contribute to a Roth IRA directly. This bill would preclude Roth conversions in any year in which a taxpayer had taxable income above $400,000 for single filers and $450,000 for married filing jointly. In essence, high income earners in the future would be prohibited from doing Roth IRA conversions. However, even if this bill as written was passed today this provision wouldn’t kick in until the tax year 2032.  

  (4) End of “Back-Door Roth” Conversions: Section 138111  

As just stated, there are income limits to contribute to a Roth IRA. However, one way around this income limit was to do after-tax contributions to an IRA or a 401(k) and then to convert this over to a Roth IRA. This has often been referred to as a back-door Roth, as it went around the income limits to get money into a Roth.    

Moving forward, this new provision would essentially end the back-door Roth IRA by disallowing any after-tax contributions to be converted or rolled into Roth accounts or Roth IRAs. This provision would kick in for the tax year 2022 so if passed it would give people some opportunity to convert these after-tax contributions by the end of 2021 into a Roth IRA. It is important to recognize that it would not end all conversions as tax-deferred dollars could still be converted to a Roth IRA.   

(5) Limitation on Certain Investments in IRAs: Section 138312   

IRAs have a number of investments and transactions that are not allowed. For instance, certain self-dealing transactions are not allowed and considered prohibited transactions. Additionally, investments into collectibles and life insurance are prohibited transactions inside of IRAs.   

The new provision would prohibit other types of investments that require the IRA owner to obtain a certification, meet a minimum asset level, or obtain some level of education. In essence, this would end investments only for accredited investors in IRAs, private placements, and even certain other funds with asset limits might need to change. This would go into effect for 2022 but would have a two-year grace period to fix any existing investment issues inside of an IRA due to this rule change. This could require a number of current IRA owners to change their IRA investments and allocations very quickly.   

(6) Limiting Self-Dealing Transactions of IRA Owners: Section 138314  

Currently an IRA owner cannot invest his or her IRA assets into a business in which they have a 50 percent or greater interest. As such, you can have a lot of control and still invest in a company within your IRA today. For instance, being an officer in a company, like CEO, with a less than 50 percent interest does not create an issue to invest in the company today inside of one’s IRA.   

However, this new rule would bring the threshold from 50 percent down to 10 percent. Additionally, the bill would prevent investing in an entity that is not traded on an established market in which the IRA owner is an officer of that company, regardless of the ownership interest. This would kick in for 2022 but would allow a two-year transition period for existing IRAs already owning these assets. This rule could impact a lot of self-directed IRAs and cause people to divest businesses and investments that they bought inside of their IRA.  

(7) Marriage Penalty  

Lastly, I wanted to point out the “marriage penalty” found all throughout this bill. A marriage penalty is not really a penalty for married filing jointly taxpayers but when compared to single tax filers, it is possible that some married couples pay tens of thousands of dollars more in taxes than if they were not married.    

The new bill would make a lot of the tax thresholds and higher taxes kick in for single filers at $400,000 and for married filing jointly at $450,000. So if both were not married, they might have $400,000 of income potential each, so $800,000 as two single filers, before they hit the highest tax bracket of 39.6 percent instead of at $450,000 of joint income.   

  This marriage penalty would impact retirement planning in two different ways: first, married couples might just end up with less savings after tax than if they were single filers – allowing less money to be saved for retirement. Second, because many married couples will be more likely to fall into the highest tax rates versus single filers, there is more of an incentive for higher income married filers to save as much as possible in tax-deductible retirement accounts, like a 401(k), to reduce their tax liability and save for retirement.   

Remember, this bill is just one of many floating around congress right now that could impact retirement planning. Furthermore, this is really draft one and won’t likely be the final bill. As we’ve seen in the past, when it comes to major tax reform a lot can change between the first draft and a final bill. It is also not set that there are even enough votes for this current bill in congress. Keep a look out for other changes and how this bill progresses as it could impact your future retirement security.  

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