As congressional Democrats continue their interparty negotiations over the size and scope of President Joe Biden’s signature $3.5 trillion Build Back Better legislative package, there are a lot of questions regarding if the bill will pass as currently written and how the legislation may impact retirement savings.
Sensing a flashpoint issue for voters, opposing political groups are targeting retirement savers and reporting that they could see their accounts raided by Democrats. For his part, the president promises that no American making under $400,000 a year will see their taxes increase to pay for the package. So, what’s the true story? Ultimately, it’s more nuanced than either the president or his opposition suggest.
To help separate the facts from the hyperbole, let’s review five key retirement-focused revenue offsets included in the current proposal (which may yet change), look at who exactly will be affected and outline how those individuals’ taxes may be impacted.
Three provisions impacting certain high-income taxpayers
- Limitations on contributions to an IRA
This provision would put restrictions on annual additions (regular contributions) to a traditional or Roth IRA for individuals whose combined IRA and defined contribution (DC) plan account balances exceed $10 million. It would be applied to the year in which the cap is exceeded and only to single taxpayers (or married taxpayers filing separately) with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000 or heads of households with taxable income over $425,000 whose total retirement savings exceeds $10 million.
An important note: This provision doesn’t prohibit rollovers or accounts obtained due to a death, divorce or separation. Nor does it prohibit additional contributions to SIMPLE IRAs, SEPs, employer-sponsored defined contribution, or nonqualified deferred compensation plans.
This change would go into effect at year end—after Dec. 31, 2021. But, we see the impact as relatively minimal. Most individuals with $10 million or more in savings won’t be significantly impacted by the inability to make $6,000 ($7,000 if age 50 or more in 2021) in additional annual contributions to an IRA.
- Certain high-income individuals must take distributions when combined retirement account assets exceed new cap
For individuals with combined IRA and DC plan accounts (including employee stock ownership plans) that are in excess of $10 million, this policy change would trigger required distributions equal to 50% of the amount in excess of $10 million.
This distribution would need to be taken in the year following that in which the cap is exceeded. In contrast to required minimum distributions (RMDs), these distributions are not triggered based on the age of the account holder. The provision would impact single and married filing separately taxpayers with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000 and heads of households with taxable income over $425,000.
Depending on the level of savings in excess of $10 million, the impact of this policy could be significant due to the increased tax liability and the forced liquidation of positions. This provision could also be particularly problematic for companies with ESOPs, who may be forced to buy back shares of participants impacted by the savings cap.
The proposed policy would go into effect after Dec. 31, 2021.
- "Backdoor Roth” conversions banned for certain high-income taxpayers
This provision would prevent high-income taxpayers, same income levels as previously noted, from employing the common practice of converting tax-deferred, employer-sponsored plan accounts and traditional IRAs to Roth accounts (by paying income taxes on the current balance to receive tax-free growth in the future). This practice is referred to as the “backdoor Roth” as individuals above certain income levels are prevented from making contributions to a Roth IRA.
In this instance, tax-deferred monies could still be rolled over to a traditional IRA, but conversions to a Roth account wouldn’t be allowed for the impacted taxpayers. The overall impact, however, will depend on two factors:
- How an individual’s current tax bracket compares to their anticipated tax bracket in retirement; and
- Expectations of future market performance. If an individual expects to be in a higher income tax bracket in retirement, a Roth conversion allows them to pay a presumably lower income tax on those savings now. If being in a lower tax bracket in retirement is anticipated, but a strong market growth is also anticipated in the ensuing time period, the tax-free growth of a Roth account may be beneficial.
In either case, the elimination of Roth conversions could be detrimental to a tax planning strategy. Unlike the other two near-term policies, the effective date here would be after Dec. 31, 2032.
Two provisions impacting many IRA owners
- Restrictions on the types of investments in an IRA
This provision prohibits IRAs from holding any investments that:
- require the IRA owner to have certain minimum levels of assets or income, or have completed a minimum level of education, licensing, or accreditation
- are not tradable on an established securities market and the IRA owner has a 10% or greater ownership interest (either direct or indirect); or
- are associated with an entity in which the accountholder has a substantial interest (10% or more) or is an officer or director of the entity.
In practice, these investment holdings wouldn't be allowed in an IRA, and IRAs already holding them would have a two-year transition period to comply.
In addition to the increased tax liability of a forced liquidation, this policy could be very challenging for IRA owners with not-liquid and hard-to-value assets. It could also have a significant impact on the funding of small businesses, partnerships, and LLCs. If the bill passes, impacted IRA owners will have two years to make the change or face full taxation of all assets in the IRA. The clock would start after Dec. 31, 2021.
- “Super Roth” conversions banned
Some employer-sponsored plans allow after-tax contributions. This provides an opportunity for individuals to maximize annual savings by contributing to a tax-deferred and/or Roth account up to the annual limit ($19,500 for individuals in 2021) plus an additional $38,500 in after-tax contributions, less any employer contributions. (Individuals who are eligible for catch-up contributions have even higher limits.) Once eligible for distribution, the after-tax accounts can then be converted to a Roth account (either within the employer-sponsored plan or rolled to a Roth IRA) and enjoy potential tax-free growth. The bill would eliminate Roth conversions for after-tax accounts in both IRAs and employer-sponsored plans.
If this policy is implemented, after-tax monies could not be converted to Roth, causing the taxpayer to ultimately pay income taxes on potential investment earnings. This would impact anyone with after-tax IRA or after-tax employer-sponsored accounts, regardless of income. That would be a significant change for anyone with an employer-sponsored plan allowing after-tax contributions and for people who have the financial means to save beyond the statutory cap. And, it would start at the end of the 2021 year.
I hope this provides some clarity regarding how the current version of the proposed Build Back Better legislation could impact retirement savers. Stay tuned as the Democratic leadership seeks to shrink the size of the bill to meet the demands of key members of their caucus. As that process progresses, it’s quite possible that the retirement provisions covered here may be altered or even eliminated. The smart money, however, is on at least some changes to tax law that will have widespread impact on many Americans’ retirement savings.
Lance Schoening is Principal Financial’s director of policy, government relations