Roth Conversions Under Fire

Debate continues in Washington over the proposed tax changes contained in the Build Back Better Act and the Bipartisan Infrastructure Bill.  These tax proposals would raise the top marginal income tax rate from 37% to 39.6%.  The increased top marginal rate, combined with the expanded 3.8% net investment income tax, would apply to active business income.  In addition, a new 3% surcharge for high-income taxpayers with adjusted gross income above $2.5 million ($5 million for married couples) creates a maximum federal tax rate of 46.4%.  The maximum capital gains tax rate would increase from 20% to 25%, but earlier the proposed rate was as high as 39.6%.  While both proposals contain numerous provisions affecting both individuals and businesses, one key area under scrutiny in both proposals are Roth IRAs.

You may have seen news articles pointing out Peter Thiel’s $5 billion Roth IRA was originally funded with $2,000 worth of his initial PayPal shares.  Coincidence or not, restrictions on Roth IRAs are very likely to be implemented under the current tax proposals.  Wealthy savers won’t be allowed to contribute to Roth or traditional IRAs if the combined value of their defined contribution plans exceed $10 million in the prior year.  This would apply to single individuals earning more than $400,000 or married joint filers earning more than $450,000.  Furthermore, “back-door” Roth conversions of after-tax traditional IRA or 401(k) will be off limits for those earning more than $400,000 per year.  Historically through “Mega-backdoor” Roth conversions, wage earners could contribute up to $58,000 in after-tax money to a 401(k), roll it into an IRA, and then make a Roth conversion.  This process would be banned for everyone.  “Backdoor” and “mega-backdoor” limitations would be banned starting in January 2022.  All Roth conversions would be banned for high-income earners starting in 2032.

If the combined balance of an investor’s IRA, Roth IRA, 401(k) and other defined benefit plans exceeds $10 million, they would be required to distribute the excess balances.  The new required minimum distribution (RMD) would be 50% of any amount over $10 million.  An RMD of 100% would apply to any balance beyond $20 million.  Mr. Thiel could be facing a rather large RMD with a 40% tax rate.

It is important to note the estate tax exemption is proposed to return to the pre-Tax Cuts and Jobs Act limit of $5 million in 2022.  This exemption creates a significant estate tax issue for some who were not previously exposed to estate taxes under the higher estate tax exemption.  With more estates being affected by estate tax, it is possible to avoid an estate tax trap using Roth accounts.  Traditional IRAs are subject to estate tax and essentially taxed on an embedded income tax liability.  To help illustrate this scenario, assume a $1 million traditional IRA is within an estate subject to estate tax.  The $1 million traditional IRA would be subject to a 40% estate tax.  However, when the $1 million is distributed to the beneficiaries, the distribution would be subject to ordinary income tax, potentially at 39.6%.  The net cash after estate tax and ordinary income tax on $1,000,000 would only leave $204,000 remaining.  If this $1 million traditional IRA was converted to a Roth IRA in 2021 and we assume the highest tax rate of 37%, the resulting Roth would be subject to estate tax, but not the ordinary income tax on distribution.  While it’s never fun to pay a 37% tax rate, this strategy could generate $174,000 in tax savings as shown here:

Example Savings

Traditional IRA$1,000,000Roth IRA$1,000,000
Cash outside of IRA$370,000Cash outside of IRA (After Tax on conversion)$0
Estate Tax($548,000) ($400,000)
Ordinary Income tax on distribution($396,000) $0
Net Cash$426,000 $600,000

There may be an extra incentive for 2021 Roth conversions even at higher ordinary income tax rates, especially for those with estate tax considerations.  Keep in mind the tax proposals are still being negotiated.  However, Roth conversions and the estate tax exemption are both known points of scrutiny.

This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. The opinions expressed in this commentary should not be considered as fact. All opinions expressed are as of the published date and are subject to change. The information has been obtained from sources we believe to be reliable; however no guarantee is made or implied with respect to its accuracy, timeliness, or completeness.   It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation.

Acumen Wealth Advisors, LLC® is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Acumen Wealth Advisors, LLC® and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Acumen Wealth Advisors, LLC® unless a client service agreement is in place.