Every once in a while, financial news is momentous enough that Congress decides they must Change How Things Are Done. A recent example: a ProPublica report published earlier this year revealing that the wealthiest Americans held hundreds of millions or, in the case of Peter Thiel, billions of dollars in Roth IRAs — retirement accounts meant to help lower- and middle-class families save for retirement.
Now the House Ways & Means committee is considering legislation that includes a raft of changes to tax-advantaged retirement accounts meant to curb their perceived use as tax shelters for the rich. These include overhauls to the rules on how and how much savers can invest in Roth IRAs, which are funded with money investors have already paid taxes on, and which grow tax-free until funds are withdrawn in retirement.
Investing in a Roth or converting a traditional IRA to a Roth IRA is a long-term choice, one that requires a certain amount of faith that Congress won't change the rules to make Roths less attractive after you've opted to use one. "Tax laws are always written in pencil," says Ed Slott, a certified public accountant and publisher of IRAHelp.com. "But Congress secretly loves Roths. They're addicted to the revenue they produce."
Most investors will be unaffected by any upcoming tweaks and can be relatively confident that Roths will remain an attractive retirement savings option for years to come, Slott says. But whether the changes could affect your finances or not, if you've been thinking about this kind of retirement account and it makes sense for your situation, "it behooves you to convert to a Roth now," he says. "You get to move money into tax-free territory. And the larger your account, the better a deal it is."
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House Democrats are looking to kill two birds with one stone: boosting tax revenue in order to fund their $3.5 trillion budget plan and ensuring that the megarich don't "abuse" the Roth IRA.
Currently, there are income limits to contribute to a Roth. In tax year 2021, individuals earning more than $140,000 can't fund such accounts. Many taxpayers skirt this rule, however, by employing a strategy known as a "backdoor" Roth, in which they contribute to a traditional IRA or a 401(k), which carries no income limits, and then convert the balance to a Roth. Investors owe income tax on the conversion, but from there, money in the account can be withdrawn tax-free, provided that the account holder is 59½ and has held the account for at least five years.
Legislators are aiming to close this loophole by instituting changes to the rules. Among them: Under the new bill, Roth conversions would be banned for individuals earning more than $400,000 to $450,000 (depending on filing status) beginning in 2032.
Starting in 2022, individuals with retirement savings of more than $10 million would be barred from contributing more money to traditional or Roth IRAs, and would receive new required minimum distributions, including immediate distributions from Roth accounts if savings in those tax-free accounts exceed $20 million.
The legislation would also bar investors in IRAs from holding investments that require buyers to be accredited investors, generally defined as those with a net worth of over $1 million.
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If any of the above changes apply to your financial situation, you're in the vast minority, Slott points out. "Most people will look at these rules and say, 'Good, that doesn't affect me," he says. "Indeed, 99% of people will probably be unaffected."
But that doesn't mean changes to tax law don't raise hackles among investors who worry that Congress could someday decide to erode the savings power of Roth accounts. "I do a lot of consumer programs, and I get this question at every program," Slott says. "'How can I trust the government to keep its word that Roths will always be tax-free?'"
You can't, says Slott, but it's a pretty good bet. That's because every dollar that you put into a Roth or convert to Roth status is money that the government is earning up-front taxes on. "Congress has tipped their hand" he says, that Roths are likely to remain tax-free. "Even this rule meant to crack down on people earning more than $400,000 gives them 10 years to make a conversion. That's because Congress still counts on that revenue to fill their budget gaps. It's like telling a 2-year-old you'll punish them when they're 12."
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Whether you're at Peter Thiel's level or an Average Joe, converting some of your retirement savings into a Roth account can be a powerful retirement planning move, says Slott. Because you're taxed on the money you convert upfront, you're essentially making a bet that you'll owe a higher tax rate when you're ready to withdraw the money than you're paying now. If you're early in your career and earning a modest salary, it's a reasonable bet that you may be in a higher tax bracket when you retire, Slott points out.
Even if you don't expect big salary increases, "by taking down your taxable IRA balance and adding to a Roth, you're hedging against the possibility that tax rates could go up in the future," he says.
If you have a large sum of money in your traditional IRA, converting it to a Roth all at once can saddle you with a big tax bill and could even push you into a higher tax bracket, depending on your income and the amount you're converting. "For larger accounts, you might want to make a series of annual conversions over time," he says. If you can, talk to a tax professional before making any major moves in your retirement portfolio that affect the taxable status of your retirement savings.
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