Roth IRAs have become tremendously popular over the past decade, particularly among the ultra-wealthy, which has made them into a target for regulators. President Obama wants to require investors to begin withdrawing money from Roth IRAs at age 70½ — just like traditional IRAs — rather than being able to pass along the assets to heirs without them worrying at all about any income taxes owed.
As a result, many financial advisors have become a bit more hesitant when it comes to recommending conversions to their wealthier clients.
Becoming a Convert
Roth IRAs provide a number of benefits relative to traditional IRAs and other retirement programs, including tax-free withdrawals during retirement and no required minimum distributions. In general, converting traditional IRAs and other retirement assets into Roth IRAs is seen as a tax-savvy move that will save significant money over the long run and during retirement. (For more, see: Converting Traditional IRA Savings to a Roth IRA.)
In order to qualify for a Roth IRA, investors must have “earned” income from working and contribute within the government’s annual maximum. The amount that individuals are allowed to contribute depends on their modified adjusted gross income (“MAGI”), where individuals earning more than $129,000 or families earning more than $191,000 are ineligible to contribute to an IRA.
The maximum contribution limit each year is currently set at $5,500, although individuals age 50 or older can contribute up to $1,000 extra per year to catch up to a total of $6,500 annually. If earned income is less than the eligible contribution amount, then the maximum contribution amount is automatically set to the earned income amount, which limits contributions for many people. (For more, see: Roth vs. Traditional IRA: Which is Right for You?)
The White House is considering a number of changes designed to limit the use of Roth IRAs to enhance the wealth of the ultra-rich. In some ways, these proposals are simply designed to close loopholes that have been exploited to use Roth IRAs as an estate planning tool or for other unintended purposes. Other changes implemented by the IRS have made it easier for both the well-off and the average person to invest. (For more insight, see 6 Important Retirement Plan RMD Rules.)
The two major proposals under consideration include:
- Roth IRA’s could have mandatory withdrawals starting at age 70½, similar to traditional IRAs, in order to prevent the use of Roth IRAs as an estate planning tool and restore its true purpose for retirement savings.
- Roth IRA conversions could be limited to pre-tax dollars in order to eliminate the so-called “backdoor Roth IRA” where by wealthy individual ineligible for an IRA would setup and convert a traditional IRA to circumvent the law.
On the flip side, a 2015 IRS ruling has made it easier for anyone to rollover an after-tax 401(k) into a Roth IRA. The rule enables individuals to easily rollover their entire after-tax 401(k) balance into a Roth IRA in order to take advantage of the tax and estate planning benefits. In essence, the ruling also ups the contribution limit to $53,000 per year (the 401(k) limit) and helps the wealthy. (For more, see: Know the Rules for Roth 401(k) Rollovers.)
Navigating the Maze
Roth IRAs are likely to remain a regulatory target for some time, since they can be used in unintended ways by the wealthy. Despite these potential changes, most investors are probably better off taking advantage of the tax benefits of a Roth IRA, as long as they aren’t using it for unintended purposes like estate planning. Those using Roth IRAs for the latter may want to consider their decisions more closely.
Wealthier individuals willing to take the risk of regulatory changes may want to consider the 401(k) to Roth IRA strategy in order to increase their contribution limits each year, since 401(k) contribution options are generally more flexible. Again, it’s important to keep in mind that the estate planning benefits of the Roth IRA could change, which could alter the dynamics of contributions for many. (For more, see A Closer Look at The Roth 401(k).)
Finally, it’s important for advisors to note the differences between after-tax 401(k) contributions and Roth 401(k) contributions when making these decisions on behalf of their clients. In some cases, clients may be better off sticking with a Roth 401(k) rather than attempting a rollover into a Roth IRA, especially with the uncertainty surrounding Roth IRA regulations moving forward.
The Bottom Line
Many advisors have been hesitant when rolling over traditional IRAs into Roth IRAs to take advantage of the historically favorable treatment due to potential upcoming changes from the Obama Administration. As a general rule, advisors shouldn’t shy away from conversions as long as they aren’t motivated exclusively by the potential benefits that could disappear with regulatory changes. (For more, see: Asset Distributions: a Key Consideration for Retirees.)