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President Barack Obama calls them loopholes, although investors consider them playing by the rules.
Yet under the president’s newly released budget, some of the tax strategies used by high-income earners to contribute to Roth IRAs or maximize the tax benefits on inherited IRAs would go away.
Right now, to make a full or partial contribution to a tax-friendly Roth IRA, income must be under $131,000 for an individual and $193,000 for a married couple. High earners have gotten around this by making nondeductible contributions — up to $6,500 a year for older investors — to a traditional IRA, which doesn’t have income limits as long as investors aren’t claiming a deduction. After that, they convert the traditional IRA to a Roth.
And thanks to an IRS clarification last fall, workers who are allowed to make after-tax contributions to their 401(k) plans can also roll that money into a Roth. In this scenario, after-tax contribution limits are even higher, so savers could sock away $30,000 or more a year into a Roth IRA.
Under the president’s proposal, these “back doors” into a Roth would be shut starting next year. Money contributed on an after-tax basis to a traditional IRA or retirement plan could not be converted to a Roth.
Of course, these changes would require the backing of Congress, which is unlikely to happen at this point, says Jeffrey Levine, an IRA technical consultant with Ed Slott and Co.
The president’s budget also brings back other proposed IRA restrictions that weren’t enacted.
For instance, the president would require that nonspouses who inherit IRAs — with a few exceptions — take all the money out of the account within five years. Currently, they can take distributions over their own life expectancy, which means the funds can remain in the account for decades and continue to grow while taxes are spread out.
The administration argues that these inherited IRAs were meant to provide retirement security to the original owner, not become a tax shelter for heirs.
The president once again proposes requiring owners of Roth IRAs to take minimum distributions after age 70½, as people do with traditional IRAs, 401(k)s and even Roth 401(k) accounts. On the other hand, he once more suggests that people who have a combined value of up to $100,000 in all IRAs, 401(k)s and retirement accounts be exempt from mandatory minimum distributions.
Another perennial proposal would limit the full tax benefit of retirement accounts and certain deductions to the 28 percent income tax bracket. Basically, those in the 33 percent, 35 percent or 39.6 percent bracket would owe some tax on 401(k) deferrals and other deductions, Levine says.
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Some of the president’s ideas, though, might actually appeal to investors.
Currently, unemployed individuals can tap IRAs before age 59½ on a limited basis without triggering a 10 percent penalty. A new proposal would expand this, allowing the long-term unemployed — those out of work for more than 26 weeks — to withdraw money from IRAs and 401(k)s early without penalty. It would apply to distributions of up to $50,000 annually over two years.
Also new: If your employer offers an annuity through its retirement plan and later drops it as an investment option, you would be able to roll over that annuity into an IRA or other retirement plan, Levine says. Otherwise, a worker would be forced to liquidate the annuity, he says.
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