The Ways and Means legislative proposal would include a number of provisions aimed at tightening the rules on retirement accounts for high-income taxpayers. Additionally, there are added restrictions on Roth conversions and eligible investments that can be held in an IRA even if a taxpayer does not meet the ‘high-income’ threshold. The House changes affect several IRA planning strategies taxpayers use for income, capital gains and estate tax planning. These proposals would also require qualified retirement plan administrators to amend plan documents for new distribution rules. The key changes that have been proposed are highlighted below with potential planning strategies to consider.
Required Minimum Distributions increase for high-income taxpayers with large balances
A high-income taxpayer with applicable retirement account balances that exceed $10 million would face a new Required Minimum Distribution (RMD) for years after Dec. 31, 2021. For aggregate accounts above $10 million but below $20 million, it appears that the RMD would be 50% of the aggregate account balance above $10 million. The additional distribution amount would be regardless of age and apply to qualified plan accounts, IRA accounts and Roth accounts (Roth IRAs are excluded from the age 72 RMD requirements). There is a separate calculation for increased RMDs if the aggregate retirement account balances are in excess of $20 million. This separate calculation appears to focus on reducing excess amounts from Roth IRAs.
- High-income taxpayers are those with $450,000 (MFJ) or $400,000 (S) of ‘adjusted taxable income’ as defined by the newly added section 409(B) under the proposal. Adjusted taxable income is determined without regard to (1) any deduction for annual additions to individual retirement plans to which section 409B(a) applies, and (2) any increase in minimum required distributions by reason of section 4974(e) as added by the proposal.
- Applicable retirement plan accounts would include IRAs and Roth IRAs as well as the vested balances in section 401(a) qualified defined contribution plans, section 403(b) tax-deferred annuities and section 457(b) governmental plans.
- Allocation of the RMD among a taxpayer’s various plans would be at the discretion of the participant.
- Rollover distributions would not be considered eligible distributions.
- The 10% early withdrawal penalty would not apply for early distributions required under this provision.
- Defined contribution plans would need to allow participants to receive a distribution if required under this new provision to maintain their ‘qualified’ status. The participant would certify to the plan that he or she is subject to the increased RMD requirement and provide the amount elected to be distributed.
- A 35% withholding would apply to taxable distributions from qualified retirement plans, 403(b) plans and 457(b) governmental plans. Plan participants would not be able to elect out of the withholding, but no withholding requirement would be imposed on Roth designated accounts.
The additional RMD requirement would only apply to taxpayers who meet both the high-income threshold and have applicable aggregate retirement account balances over $10 million. Taxpayers close to the income or retirement account balance threshold may want to be mindful of planning strategies that can lower income or applicable account balances. This provision does not include defined benefit retirement plan balances, which could make these types of plans more attractive in the future. The taxpayer does not need to be of RMD age for the distribution requirement to apply. Taxpayers that may be affected should consult their tax adviser to discuss strategies. The implications for qualified plan administrators are also significant and amendments to plan documents would likely be needed for qualified plans if this proposal is passed in its current form.
Prohibited investments held by IRA accounts
An IRA would no longer be eligible to hold certain investments discussed below after Dec. 31, 2021 or the IRA would cease to be treated as an IRA. If the IRA loses its status, the assets (all assets in the IRA, not just those that are prohibited) would be deemed distributed to the owner on the first day of the year and subject to an early withdrawal penalty. If an IRA already holds these investments on the date of enactment the proposal states that the taxpayer has until Dec. 31, 2023 to comply with the new requirements. The prohibited investments under the proposal would include:
1. Securities in which the issuer requires a specified minimum amount of income or assets, a specified education level, or specific licenses or credentials in order to purchase the investment.
2. Interests in a non-publicly traded entity if the IRA owner holds a 10% or greater interest in the entity.
• Constructive ownership rules apply and include entity interests held by the IRA.
3. Interests in a non-publicly traded entity for which the IRA owner is an officer or director of the entity (or has similar powers and responsibilities).
The proposal clearly goes after unregistered investments for which the SEC requires investors to meet the ‘accredited investor’ standard or other restrictions by issuers. This would prevent all IRAs from owning such securities. As a result of this change, there may be an increased interest in other tax-sheltered products such as private placement life insurance (PPLI). Taxpayers should consult their advisers to discuss the complexities of these before considering investments.
The impact of the limitation of investing in entities for which the IRA owner holds a 10% or greater interest or is an officer of director are much more restrictive and could have a significant impact on private equity and hedge funds, among others. It is not unusual for private equity investors to buy into investment funds through an IRA to benefit from the tax-deferral on income and growth. It should be noted however that the long-term capital gains rate often associated with these investments is available if such investments are owned outside of an IRA, which requires all income paid out to receive ordinary treatment. Taxpayers who hold these investments within their IRA should consult a tax adviser to discuss strategies in removing these assets within the allotted time frame.
Roth conversions and back door Roth contributions
A high-income taxpayer would no longer be able to convert amounts held in an IRA or other non-Roth account to a Roth IRA or Roth designated account. This would be effective for taxable years beginning after Dec. 31, 2031.
In addition, all taxpayers, regardless of income level, would not be able to convert any portion of an account to a Roth IRA or Roth designated account if any portion of the IRA or qualified plan account has any after-tax contributions. Thus, for example, a pure pre-tax IRA rollover account might still be eligible for conversion to a Roth IRA, but an IRA that has both rollover amounts and some after-tax IRA contributions would apparently not be eligible. This would be effective for taxable years beginning after Dec. 31, 2021.
- High-income taxpayer would use the same ‘adjusted taxable income’ thresholds as outlined above.
It is important to note the delayed effective date in disallowing Roth conversions for high-income taxpayers. The provision would leave Roth conversions as an option until Dec. 31, 2031, providing a generous window of opportunity for many taxpayers to still convert to a Roth and take a current income tax hit. The provision would also disallow the ‘back door’ Roth contribution for a taxpayer unable to make such contributions directly if the taxpayer is trying to convert an after-tax IRA contribution. This prohibition has a 2022 effective date. Under the provision, taxpayers that want to convert from an IRA with both pre-tax and after-tax amounts would need to convert to a Roth account by Dec. 31, 2021.
IRA contribution limit for high-income taxpayers
Under the provisions, IRA contributions would be limited for high-income taxpayers if aggregate balances in applicable retirement plan accounts exceed $10 million after Dec. 31, 2021. If this limit is met, no ‘annual additions’ would be allowable for the year by or on behalf of the individual to any IRA that will cause the vested balances to exceed $10 million. If such a contribution is made, an excise tax applies.
- High-income taxpayer would use the same ‘adjusted taxable income’ thresholds as outlined for additional RMDs discussed above.
- Aggregate accumulations would be determined by the fair market value of assets on the last day of the prior taxable year.
- All IRAs and Roth IRAs, qualified 401(a) retirement plans, 403(b) plans and 457(b) governmental deferred compensation plans would be treated as applicable retirement plans.
- ‘Annual additions’ would be defined as any contribution to an individual retirement plan.
- Acquisition of an IRA by reason of death, divorce or separation, or by rollover contribution would not be treated as an annual addition but such funds appear to be counted as part of the aggregate balances at the end of the year.
- SEP and SIMPLE plan contributions by the employer or employee would not be treated as annual additions but these contributions would reduce the available annual additions for other applicable retirement accounts.
- The section 4973 (6%) excise tax would apply to ‘excess contributions’ that result in the aggregate accumulations exceeding $10 million. It is not clear how this would interact with the required minimum distributions discussed above.
- New reporting requirements for plan administrators if a participant in any applicable retirement account has a vested balance of at least $2.5 million at year-end. The plan administrator will apparently have to report the participant’s name, identifying number and the amount to which the participant is entitled.
This proposed limitation would only apply to taxpayers who meet both the high-income threshold and have over $10 million in applicable retirement accounts, similar to the additional RMD provision above. This could make income planning particularly important for taxpayers close to the high-income threshold but would affect a small number of individuals overall. Defined benefit plan contributions and balances would not be affected by this provision. These types of plans may become more attractive if the proposal passes in its current form. The new reporting requirement for some plans with participants that have over $2.5 million in their account will likely have a larger impact on employer plans than IRAs since IRAs already have Form 5498 reporting in place, which requires the reporting of year-end account balances.
The IRS, the Department of Labor and the courts have long held that an IRA owner is a ‘disqualified person’ with regard to his or her IRA as a ‘fiduciary’ of the IRA. Thus, a long list of transactions between an IRA owner and an IRA (or Roth IRA) are already seen as prohibited and can subject the IRA to complete loss of exemption (i.e., a distribution of the full account). As an example, a sale of an asset from an IRA owner to his or her IRA, or a sale from the IRA to the individual owner or a family member is a prohibited transaction. The Ways and Means provision specifically adds an IRA owner to the list of section 4975 disqualified persons, possibly because some people have argued that an IRA owner can give up being a fiduciary of his or her own account and thus avoid prohibited transactions. In addition to adding this language to the definition, the proposal extends the statute of limitations for prohibited transaction failures.
The statute of limitations for assessment or increase in tax would be extended to six years in certain situations relating to IRAs and prohibited transactions. If the reporting on a return of any information relating to the valuation of IRA assets has a substantial error, regardless of whether it was intentional, the statute will not expire before the date that is six years after the return containing such errors is filed. Prohibited transactions would also have the same extension of time whether it involves an IRA or not. This would apply to taxes for which the three-year statute of limitations period ends after Dec. 31, 2021.
- IRAs involved in prohibited transaction will cease to be considered an IRA and the value of the assets will be treated as a distribution subject to the early withdrawal penalty.
This provision would extend the statute from three years to six years for IRAs and other retirement plans that participate in prohibited transactions. Before entering into any transaction with an IRA, an IRA owner should discuss any such transaction with a tax advisor who is familiar with prohibited transaction requirements.
The House proposals would implement a variety of new restrictions on IRAs and potentially some other types of retirement accounts that target high-income or wealthy individuals. While some of the new proposed restrictions have income thresholds, others apply to all taxpayers. The new restrictions proposed on investments held within an IRA, the inability to convert after-tax contributions to a Roth and the extended statute for prohibited transactions are far-reaching provisions. As a result, if these changes are passed in the current form, they could have major effects on private equity entities and hedge funds that welcome IRA investment. The laws surrounding IRAs and other types of retirement plans can often be complex and convoluted, so discussions with a tax adviser may be important. It is not yet clear whether these items will make their way into the final bill but given the need for revenue to support the reconciliation bill, some of the items could survive. RSM will be watching these proposals closely as the legislation moves through the House committees and goes through a similar process within the Senate. It will likely take a few months before a vote on the final version of the reconciliation bill is passed by both the House and Senate.