4 retirement account tax loopholes that could soon close
President Obama's 2017 budget proposal includes a number of changes to retirement accounts that the administration is calling "loophole closures". These retirement tax policies will result in a higher tax bill for the relatively small segment of the population that uses them. Here are several changes to retirement accounts in Obama's budget that will result in tax increases for some people.
Five year rule for inherited retirement plans. When you inherit a 401(k) or IRA from someone other than your spouse, you have several distribution options under current tax law. One option is required minimum distributions that can be spread out over your lifetime. Under Obama's budget proposal, this distribution option would be reduced. The budget proposes decreasing the maximum distribution term for non-spouse retirement account beneficiaries to five years. Instead of paying the income tax due on retirement account distributions over 20 or 30 years, you could be required to pay it within five years. This change was calculated to reduce the federal deficit by 6.3 billion between 2017 and 2026.
No more backdoor Roth IRA contributions. Roth IRA contributions are permitted for individuals whose adjusted gross income is below $132,000, or married couples filing jointly who bring in $194,000 or less. However, there are no income limits on Roth IRA conversions. This has given rise to the backdoor Roth IRA contribution.
You can make a non-deductible contribution to a traditional IRA, and then roll it over into a Roth IRA. The 10 percent early withdrawal penalty is waived on these conversions, and since the traditional IRA wasn't tax deductible, there is no tax liability as a result of the rollover to the Roth IRA. This enables high earners to take advantage of the many benefits Roth IRAs provide. The President's budget, if adopted, would eliminate the 2010 legislation that made backdoor Roth IRAs possible. Only people who earn below the income limits would be eligible to make Roth IRA contributions. The White House estimates that this tax change will reduce the deficit by $251 million between 2017 and 2026.
Limit the total accrual of tax-favored retirement benefits. Retirement accounts have annual contribution limits that restrict the amount that can be deposited in these tax-favored accounts. However, some wealthy individuals have managed to accumulate millions of dollars in retirement accounts that they are deferring paying tax on. Obama's budget proposes preventing wealthy individuals from using loopholes to accumulate huge amounts in tax-favored retirement accounts. This proposal is projected to save the federal government almost $30 billion between 2017 and 2026.
A higher tax rate on capital gains. All withdrawals from traditional retirement accounts are taxed at your regular income tax rate, regardless of what the money was invested in inside the account. However, outside of retirement accounts, long-term capital gains are currently taxed at a much lower rate than your ordinary income. The tax rate on most net capital gains is typically no higher than 15 percent for most taxpayers. Obama's budget proposes increasing the top tax rate on capital gains and dividends to 28 percent.
Presidential budgets are seldom passed in their initial form. However, it's worth paying attention to the budget process if you are affected by any of these tax hikes. A letter to your elected representative could make a difference.
Related: 10 things we've all said while filing our taxes
Jeff Rose is a certified financial planner, U.S. combat veteran and the founder of GoodFinancialCents.com.
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