High-Income Backdoor IRA Strategies May Backfire If New Tax Bill Passes
Updated: Oct 29, 2021
While the old saying is that the "rich get richer," a proposed tax code will prove a remarkable exception if the House has its way. The legislation would mandate an annual required minimum distribution for retirement accounts exceeding $10 million. It's aimed at accounts potentially being used as tax shelters by some of the high-income earners rather than at the low-and middle-income savers whom the tax-advantaged nest eggs were initially created to help.
IRAs allow individuals with incomes that fall under specific limits to contribute after-tax dollars into investment accounts and withdraw investment earnings tax-free after they reach the age of 59 ½. But some high-income individuals are using a backdoor strategy involving the conversion of traditional IRA and Roth 401(k) accounts to take advantage of the tax shelter. The proposed bill would put an end to this practice. Its purpose is "to avoid subsidizing retirement savings once account balances reach very high levels." The House Ways and Means Committee passed the change in distribution rules to help fund the ambitious social programming within the $3.5 trillion Build Back Better program. According to its authors, it would help pay for education, paid leave, childcare, and climate measures while also leveling the tax code's playing field.
The bill was reportedly inspired by news of an IRA owned by billionaire Peter Thiel. Valued at $2,000 in 1999, it grew to $5 billion over twenty years. Complex calculations surrounding distributions could require the 53-year-old PayPal co-founder to withdraw all but $20 million of the fund's holdings. And would owe income tax on its growth due to him being under the age at which IRA investment earnings are tax-free.
According to a recent analysis by the Joint Committee on Taxation, only 28,600 individual taxpayers with IRAs valued at over $5 million. Though the number of taxpayers impacted by the change would be small, their use of IRAs to shield their wealth has drawn the ire of many, including Ron Wyden, D-Oregon, who is chair of the Senate Finance Committee. "IRAs were designed to provide retirement security to middle-class families, not allow the high-income earners to avoid paying taxes."
As things currently stand, taxpayers can continue making contributions to their IRA accounts regardless of their holdings. Still, if the bill is passed, those whose combined IRA and defined contribution plans (including 401(k) plans) are worth more than $10 million would be prohibited from depositing any additional funds. However, there are exceptions for those whose taxable income falls under threshold levels of $400,000 for single filers, $425,000 for heads of household, and $450,000 for married taxpayers filing jointly.
It is unclear whether the bill will pass, though it has strong support from House Democrats. If it does, the new rules will begin applying in 2022, with a two-year transition period. The formula is based on specific account size, type of account, and other factors and represents a complex calculation. Evading the potential impact is possible by making strategic adjustments to your taxable income, so if you fall into this category, be sure to contact us to determine your best steps to avoid having to take a significant tax hit.