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Goodbye, Backdoor Roth?

Goodbye, Backdoor Roth?

The retirement account end run for high earners is on a long list of changes being pushed by government policy makers. Here is what advisors need to know.

The White House has a long list of ideas for both streamlining and improving our retirement savings system, but so far we haven’t heard much about the changes outlined in President Obama’s 2017 budget. Perhaps that’s no surprise, considering that we’re in the midst of a raucous, chaotic presidential election campaign and Congress is deadlocked on just about everything.

But the changes outlined last month by the administration merit a closer look, because they could affect your clients. The ideas contained in the budget give us insight into what mainstream policy experts are thinking—and these ideas sometimes pop up in legislation. Consider the recent clampdown on the restricted application and file-and-suspend loophole for Social Security claimants. That was first proposed in the President’s fiscal 2015 budget, then was enacted on short notice as part of the negotiations that produced the Bipartisan Budget Act last November.

In February, the White House proposed a laundry list of retirement policy changes, some of which have appeared in earlier budget plans. Included are a renewed call for a national auto-IRA, expanded penalty-free retirement account withdrawals for the long-term unemployed, tightened rules for stretch IRAs, and the creation of multiple employer-defined contribution plans for small businesses.

The list also repeals Net Unrealized Appreciation in employer securities (NUA), eliminates stretch IRAs for non-spouse beneficiaries and limits IRA contributions for savers with combined retirement accounts valued over $3.4 million.

But let’s look at just a few proposals that would have significant impact on retirement savers—and their financial advisors: a clampdown on backdoor Roth contributions, harmonization of required minimum distributions (RMDs) and elimination of RMDs for smaller accounts.

Eliminating Backdoor Roth Contributions

Backdoor Roth contributions make little sense in the context of the broader income eligibility rules for IRAs. Joint filers who want to contribute directly to a Roth are subject to an adjusted gross income limit ranging from $183,000 to $193,000 this year.

But the sky’s the limit for conversions—the so-called backdoor Roth. Since 2010, when income limit rules for Roth conversions were removed, high-income individuals could instead contribute to a nondeductible traditional IRA and then convert those dollars to Roths—hence the “backdoor” label.

The White House now proposes preventing any new Roth conversions of after-tax dollars after the effective date of legislation.

Elimination of the loophole would bolster the case for using taxable accounts rather than nondeductible IRAs, argues Christine Benz, director of personal finance at Morningstar. “The main reason to use them now is as a conduit to a backdoor Roth, but if that goes away, planners should look at plain old taxable accounts,” she says. “You get the favorable treatment of capital gains and dividends compared with ordinary income treatment on withdrawals of investment earnings in a nondeductible in an IRA—not to mention more flexibility on withdrawals, since there are no required minimum distributions.”

The one exception, she adds, are accounts holding bonds that generate ordinary income; these will receive better tax treatment in a nondeductible IRA. “For older clients who need to hold bonds but don’t want to draw on them imminently, housing them in a traditional IRA may be the better way to go,” she says. But for people with a long run ahead of them before retirement who anticipate holding mainly stocks, a taxable account may be better.”

Closing the backdoor Roth loophole makes sense, but it does point to an unfortunate trend in retirement policy—the constant fiddling with the rules undermines public trust. “There’s been this black cloud hanging over the Roth,” says Ed Slott, an author and IRA specialist. “In every consumer seminar I do, I get the question, ‘Can I trust the government to keep its word that the Roth will always be tax-free,’ and this would be a crack in the foundation. People would see it as a double-cross.”

Rule changes can also contribute to inertia, adds Benz. “When the rules change, it increases confusion, and sometimes when people are confused, they pull back and don’t do anything.”

RMD Harmonization

The president’s budget proposes “harmonizing” the RMD rules between Roth and traditional retirement accounts. It would introduce RMDs for Roth IRAs and Roth holdings in 401(k) plans after age 70 ½. (The rules for account holders still employed by the plan’s sponsor would continue.) The rule change also would prohibit additional Roth contributions after age 70 ½ (mirroring the rules for traditional IRAs).

RMD harmonization, which has been proposed previously by the White House, would be a Roth killer, because it would eliminate the vehicle’s estate planning advantages, according to Slott. “The RMD is the reason many love to convert, because they never have to touch that money again if they don’t want to,” he says.

That’s a sizeable portion of affluent households. Research shows that a surprisingly large percentage don’t rely on investments as a significant source of retirement income and hence may want to pass it along to heirs tax-free via Roths.

Eliminating RMDs for Smaller Accounts

The best idea in the White House plan is the proposed elimination of RMDs for people holding IRAs and other tax-favored accounts with aggregate value below $100,000 (indexed for inflation going forward). The RMD requirements would phase in for individuals with aggregate retirement benefits between $100,000 and $110,000.

“I hope that will happen,” Slott says. “This is such a pain in the neck for a lot of people, and if you only have $100,000 you’re not looking for an estate planning vehicle, so why saddle people with all these rules and calculations? That one would be great to put into play immediately.”

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