Biden Budget Declares War on Supersized IRAs

 
 
 

What You Need to Know

  • President Joe Biden’s budget proposal takes aim at loopholes used by wealthy taxpayers to accumulate large Roth IRAs.

  • Such accounts have been the subject of Democratic lawmakers’ scrutiny for several years, but changing the rules has proven to be difficult.

  • Policy experts say Biden’s budget is likely dead on arrival in the House but will represent a jumping-off point for upcoming negotiations.

This week, President Joe Biden released a proposed federal budget that would raise taxes on the wealthiest Americans to help address the solvency of key federal government entitlement programs such as Medicare and Social Security.

Much of the public interest thus far has been drawn to the president’s proposal to hike payroll taxes on Americans making over $400,000 per year and allowing the government new power to negotiate drug prices — all part of an effort the White House says will extend the solvency of a key Medicare program for another quarter century.

For financial advisors working with clients focused on retirement, however, others parts of the proposal are generating significant interest, particularly a provision that appears intended to eliminate so-called “mega backdoor Roths.”

As detailed in a White House fact sheet released on Thursday, the budget would stitch up certain loopholes that let billionaires exploit middle-class retirement savings incentives.

“Tax breaks for retirement savings are supposed to help middle-class workers put a little aside for the future,” the fact sheet states. “But some billionaires have used a loophole in the law to accumulate tens of millions of dollars in tax-favored retirement accounts — far in excess of what’s needed for retirement security — and never taking distributions from those accounts.”

To address this situation, the budget proposal would limit the amount taxpayers with incomes over $400,000 can hold in tax-favored retirement accounts, and it includes what the White House calls “other safeguards to prevent abuse of these accounts by some of the nation’s wealthiest individuals.”

The proposal does not provide further details on which regulations it would change and how. But according to the White House, these reforms will save $23 billion.

Beating Down the Mega Backdoor

Washington watchers in the advisory industry will find this part of the budget proposal to be familiar, as Democratic lawmakers in Congress have been striving for several years to eliminate the ability of the wealthiest Americans to amass supersized accounts through strategies like mega backdoor Roth conversions.

In basic terms, a backdoor Roth IRA conversion involves making an after-tax contribution to a traditional IRA and then converting that amount to a Roth IRA, creating a “back door” for investors whose income is too high to make a direct Roth contribution.

Individuals with a 401(k) plan can take this a step further using the “mega backdoor Roth” strategy. Once an employee maxes out their pretax 401(k) contributions for the year — the limit is $22,500 in 2023 — their employer may allow them to contribute after-tax money to the account. Individuals may be able to make up to $66,000 per year in total pre-tax and after-tax 401(k) contributions.

In the ideal scenario, an individual would contribute up to the maximum allowed in after-tax contributions, then do an in-service withdrawal as a rollover to a Roth IRA. The best scenario is if their plan allows these in-service withdrawals at any time or any age, giving the tax-sheltered money many years to appreciate within the Roth account.

“Clients can roll over tens of thousands of dollars a year from a 401(k) to a Roth IRA if the plan is properly set up,” Jamie Hopkins of Carson Group explained in an article. “They can even set up a plan in such a way so the entire [annual contribution] is after-tax money that’s distributed to a Roth IRA each year with minimal tax implications.”

High-Profile Mega-Roths Have Raised Ire

Congressional scrutiny of wealthy investors’ use of Roth accounts first emerged in earnest in the wake of reporting published by ProPublica in June 2021, which showed that venture capitalist Peter Thiel was able to accumulate as much as $5 billion tax free.

As ProPublica reported, Theil utilized a self-directed Roth IRA to invest in alternative holdings such as startups, real estate and partnerships. Specifically, Thiel was able to put 1.7 million shares of then-private PayPal into a self-directed Roth IRA in 1999.

The total value of the PayPal shares was below the $2,000 contribution limit at the time. Those shares have since exploded in value, along with other investments Thiel has made. However, since the assets are sheltered in a Roth account, they aren’t subject to tax.

By the end of September 2021, Democrats in the House of Representatives had introduced various measures intended to curtail such outcomes. One proposal put forward by Rep. Richard Neal, D-Mass, would have prohibited taxpayers from contributing to their IRAs once their account balance exceeded $10 million.

Neal’s proposal would have also dramatically increased the required minimum distributions for high-income taxpayers with large balances and eliminated pathways used by the wealthiest Americans to create backdoor Roth IRAs.

Ultimately, while those proposals were successfully advanced out of their respective committees, they failed to make it through the full legislative process, and now that Republicans are in control of the House, passage of such measures is seen as unlikely.

A Budget Dead on Arrival?

Even at this early juncture, policy experts say Biden’s plan has little chance of becoming law as proposed. Still, they see the proposal as an important signpost for negotiations over government spending in the weeks and months to come.

“It’s really just a wish-list of items that will never get to his desk,” Ed Slott, IRA expert and president of Ed Slott & Co., tells us. “The wealth tax once again is dead on arrival. … It’s really just an opening gambit to begin negotiations.”

House Speaker Kevin McCarthy has told reporters the House budget plan will be delayed because Biden’s budget was a month late and Republicans need to analyze it. But on Wednesday, he flatly ruled out Biden’s proposed tax increases.

“I do not believe raising taxes is the answer,” he said.

McCarthy has said he would not back cuts to Medicare and Social Security, and that his caucus would focus on the domestic discretionary budget that covers everything from cancer research to Head Start. It will also look for savings by cutting Medicaid, food stamps and other anti-poverty programs.