New proposals to the federal spending bill could impact the tax advantages of Roth IRAs. The main elements of the proposed bill are that they would eliminate the so-called “back-door” conversions of traditional retirement accounts to a Roth. So let’s see how this might affect your retirement account.
Roth Conversions Explained
The main difference between a Roth IRA and a traditional IRA is when you pay taxes on the money. With a Roth IRA, your contributions are taxed before they are applied to the account. This means that when you are ready to withdraw the money during your retirement, you will not have to pay any taxes at that time. With a traditional IRA, your contribution is made with before-tax dollars, and you will have to pay taxes when you begin receiving distributions. This means you will see a larger paycheck during your contributing years, but you will pay when you withdraw the money.
Roth IRAs have several other advantages, such as they do not require minimum distributions. You can also pass on Roth IRA assets to your heirs tax-free. In addition, some accounts allow you to convert your traditional retirement account to a Roth IRA. Some people do this to avoid the required distributions of traditional IRAs and allow their money to continue growing tax-free.
The catch is that because you have not already paid taxes on the money in the Traditional IRA, you might have to pay the taxes owed at the time when you do the conversion. To make the decision, you have to calculate how much you would the gain in interest if you left the money in the account.
Input the relevant principal, interest rates, and how much longer you will be contributing until your retirement. The calculator will provide your expected retirement savings at the end of the time period. Compare that amount versus any taxes or fees you would pay to make the conversion. At least, this is how it works if you are the average person with an average income level. This might not be the case if you happen to be a billionaire.
What Are the Proposed Changes?
Currently, many accounts are available for conversion to a Roth IRA, but they have to follow specific rules. The proposed changes would eliminate back-door conversions for those with giant tax-sheltered IRAs. The Roth IRA was developed to help middle-class Americans save more for their retirement. In addition, it was meant to ease the tax burden on those with average incomes so that they would not have additional taxes at a time when their earning potential is reduced.
This new proposal came about because it was found that billionaires, such as Peter Thiel, were using their Roth IRAs as a tax shelter for millions of dollars of capital gains from investments. A third-party investigation found that Thiel had approximately $5 billion in his Roth IRA.
Thiel, and others, were able to enjoy the tax-free accumulation of wealth using a loophole in the Roth IRA law. How it worked is that Thiel started his Roth IRA account with shares of his new startup company, Paypal. At the time when he opened the account, the shares were valued at under $2,000 total. After that, the company grew, and as it did, the value of the shares in his Roth IRA account grew to the $5 billion mark.
The catch is that all of this money grew and was treated as if taxes had already been paid on it, as it would be if it were a regular contribution from a paycheck. For the average American, most had already paid taxes that were deducted from their paycheck before the contribution was taken out and put into their Roth IRA account.
The money in Thiel’s account grew without passing through the system that applies to most Americans. Because it was not from the sale of a stock, he never had to report it on his taxes as a capital gain and pay taxes on it. It was never taxed as income. He can then withdraw the money tax-free at age 59 ½, never having paid any taxes on the money at all. The proposed law would eliminate this loophole for the ultra-wealthy.
Who Would It Affect?
Changes would only affect those with retirement accounts that exceed $10 million and those with an annual income of over $400,000. Those with balances in their retirement account of over $20 million could be forced to make withdrawals. Roth conversions would not be allowed for these retirement accounts.
For most, these new changes will not have an effect because it only affects those whose retirement accounts exceed these thresholds. The major impact that it will have is that it cuts out a tax loophole for wealthier Americans, but most will not see a difference in their accounts.