The Roth IRA was designed over two decades ago as a way for working middle class workers to put money aside for retirement. People earning less than $ 95,000 at the time could spend the money and then let it grow tax-free until retirement, when they could make withdrawals without having to pay any taxes. tax.
“I wanted to make these IRAs available to a lot, a lot of people,” said Senator William Roth, who worked on the design of the pension plan, noted when Roth IRA debuted in 1998.
Since then, Roth IRAs have indeed been used by millions of people, including some of America’s wealthiest citizens, far from the middle-income worker for whom the retirement plan was designed. But that could end soon if Democratic lawmakers succeed in pushing through their. This effort includes a provision that would close a loophole that now allows wealthy people to bypass Roth IRA income limits.
This strategy, while legal for now, is seen by critics “as a way to beat the system to avoid paying taxes,” said Charisse Mackenzie, president of Saturn Wealth, a Gilbert-based financial advisory firm. , Arizona.
Democratic lawmakers are targeting the wealthy and corporations with proposals to raise taxes for both groups, as part of a strategy to fund theirto strengthen social safety net programs. This approach includes cracking down on tax evasion and tax evasion by the rich.
Two tax codes
The Roth IRA loophole allows investors to avoid paying taxes on investment gains accumulated over years, if not decades. This can offer a huge benefit since participants in traditional IRAs have to pay ordinary income tax on their earnings once they have withdrawn the money.
The flaw is now under increased scrutiny after ProPublica recently reported that PayPal co-founder Peter Thiel operated a Roth IRA to amass $ 5 billion in fortune. Due to the Roth IRA’s tax structure, Thiel will not have to pay tax on that $ 5 billion as long as he keeps it in the plan until he is 59 and a half in 2027, according to the investigative journalism group.
Thiel is not the only wealthy person to have used the Roth IRA to grow their wealth virtually tax-free. Nearly 500 taxpayers held at least $ 25 million each in their Roth IRA in 2019, compared to around 300 taxpayers in 2011, according to data compiled by the Joint Committee on Taxation in July and the Government Accountability Office.
In comparison, the typical Roth IRA saver has a lot less than that stashed away in their account. The average balance is less than $ 49,000, while the typical annual contribution to Roth or traditional IRAs is around $ 3,900 per year, according to the Employee Benefit Research Institute.
The data tells a “story of two tax codes,” said Senate Finance Committee Chairman Ron Wyden, an Oregon Democrat, in a July statement on the findings of the Joint Tax Committee. “IRAs were designed to provide retirement security for middle class families, not to allow the super rich to avoid paying taxes.”
By design, the Roth IRA focuses on the modest annual contributions of working-to-middle-income earners. To this end, the pension plan has income and contribution limits – for example, young single workers who earn less than $ 125,000 are eligible to save up to a maximum of $ 6,000 in after-tax dollars in a Roth IRA, according to IRS regulations.
Because of their function of paying taxes now, avoiding taxes later, Roth IRAs are often recommended for younger workers who expect to be in higher tax brackets as they age and their incomes are increasing.
So how can wealthy taxpayers skim millions in these modest plans? This is in part due to a loophole called the Roth IRA “backdoor”.
People who earn above the Roth IRA income threshold – around $ 200,000 for married couples – can use this strategy to gain access to the accounts. It works by allowing investors with a traditional IRA to convert some of those funds to a Roth IRA, even if they earn more than the income threshold to contribute to a Roth account.
Investors who use a backdoor Roth IRA must pay taxes on the money they convert to Roth, because only after-tax money can go into these accounts. But assets can grow tax-free until investors withdraw funds without penalty after age 59 and a half.
While regular Roth backdoor conversions are capped at $ 6,000 per year, there is also another type of conversation called Roth ‘mega backdoor’ that allows people to convert up to $ 38,500 of their 401 (k ) into a Roth IRA. However, people have to work at companies with 401 (k) programs that enable mega-backdoor conversions, with The Wall Street Journal report that between 20% and 30% of 401 (k) plans allow the practice.
High net worth investors can use backdoor Roth IRAs to store stocks of value, like Tesla or Apple, or even to pocket pre-IPO stocks that owners believe could eventually rise in value. For high-income workers who expect these assets to appreciate – or to be in a higher tax bracket once they hit 59 and a half – it’s a lucrative tax strategy.
“How does the law work”
“For tax professionals like me, this is great,” said Rob Cordasco, founder of Cordasco & Company and CPA. “There is nothing illegal, illegal – this is how the law works.”
While these strategies may be legal, they are criticized because of the perception that they allow wealthier taxpayers to build their assets virtually tax-free. Interestingly, Thiel didn’t actually use the Roth IRA backdoor conversion. Instead, because he earned less than $ 74,000 the year he started his Roth IRA, below the income threshold at the time, he could open a Roth IRA, ProPublica reported.
But he used the Roth IRA to buy shares in his startup, which would later become PayPal and was not yet publicly traded. Thiel paid $ 0.001 a share to buy 1.7 million shares – a matter of the heart, according to ProPublica. In one year, the value of his Roth IRA has grown from $ 1,700 to nearly $ 4 million, according to the publication. This is a strategy that most investors cannot tap into, as they do not have access to shares of private companies or at special prices.
Some lawmakers say such strategies play with the system in favor of the rich while depriving the federal government of tax revenue.
The Democratic lawmakers’ proposal would prevent the use of Roth IRAs by the wealthy in two ways. First, all Roth IRA conversions would be prohibited from 2032 for single taxpayers earning over $ 400,000 and married taxpayers with incomes over $ 450,000. On top of that, the Roth IRA backdoor ‘mega’ conversion would be prohibited from January 2022.
Of course, this means that wealthy investors could use the regular Roth conversion strategy until 2032. After that, as an example, married taxpayers who earn between the Roth IRA income limit of $ 200,000 and the new one. restriction of $ 450,000 could still use a backdoor conversion. But taxpayers above that $ 450,000 limit would be cut off from Roth conversions.
Second, the proposal targets retirement accounts with assets over $ 10 million. Investors with more than this amount in a Traditional or Roth IRA would be required to withdraw 50% of the assets above that $ 10 million. Investors with more than $ 20 million would be required to withdraw as much as needed to bring the balance down to $ 20 million.
Of course, these latest rules would only impact a select group of investors, as around 3,600 people have invested more than $ 10 million in a Roth or traditional IRA, according to The data of the Joint Tax Commission. If passed, the plan would prevent some high net worth investors from using the strategy. But it could also make it harder for some high-income workers who relied on Roth conversions to pocket money, experts said.
“The main impact of the backdoor is on those earning between $ 200,000 and maybe $ 1 million, somewhere in that range, who are still looking to save for their retirement,” Cordasco said. Eliminating the backdoor strategy could make it “harder for someone like that to put more money aside.”