Retirement Alert: This Tax Trick Could Be in Danger

By Dan

Source: Office of Management and Budget.

Americans face a potential financial crisis in retirement, and policymakers have generally done their utmost to encourage people to set money aside for their retirement needs. Yet tax provisions that favor retirement accounts are subject to political wrangling, and the administration's new budget proposalincludes a number of recommended changes to how IRAs, 401(k)s, and other tax-favored retirement accounts work. And although one could argue that President Obama has no chance of seeing his proposals get through a Congress in direct opposition to his views, it's entirely possible that sooner or later, one particularly useful tax trick could become part of a compromise package and take away a strategy that many people have turned to in order to boost their retirement savings.

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Closing the back-door RothRoth IRAs came late to the retirement-account party, as traditional IRAs and 401(k) accounts were around for decades before the Roth first became law. Yet for many people, Roth IRAs have numerous advantages, most notably that any income that they generate is tax-free, even when you withdraw money from your account in retirement. That stands in stark contrast to traditional IRAs and most other retirement accounts, which let you save pre-tax money, but then force you to include withdrawals in your taxable income during retirement.

For years, access to Roth IRAs was limited to those under certain income limits. Even now, direct contributions to Roth IRAs still aren't available to single filers making more than $129,000 in 2014, and phaseouts begin for those making $114,000. The corresponding numbers for joint filers are $191,000 and $181,000 in modified adjusted gross income. The impact is to prevent some of the highest-earning taxpayers from contributing to Roth IRAs.

What has changed, though, is that people are allowed to convert existing traditional IRAs to Roth IRAs regardless of income. In the past, those with incomes above $100,000 weren't allowed to do Roth conversions, matching up reasonably well with the contribution income limits. But now, the lack of an income limit on conversions opens up what has become known as a back-door Roth, whereby you contribute to a regular IRA -- which anyone can do if they have earned income -- and then convert it shortly thereafter to a Roth. via Flickr.

The administration's proposal would outlaw Roth conversions that involved so-called after-tax contributions, which come either from non-deductible IRA contributions or from adding more money to your 401(k) above the maximum limit for pre-tax contributions. The net effect would be to close the back-door Roth loophole.

Should you really worry?The obvious retort to any budget proposal is that Washington gridlock will keep it from ever becoming law. Yet among the various proposals the budget includes, eliminating the back-door Roth is actually among the least provocative. Bigger issues like removing the preferential rate on net unrealized appreciation on employer stock or capping total retirement savings will get a lot more resistance. With Roth IRAs still relatively unpopular, limiting the back-door Roth won't create nearly as much controversy.

U.S. Capitol. Source: Wikimedia Commons.

Moreover, even if back-door Roths do disappear, it won't spell the end of the Roth opportunity for high-income individuals. Roth 401(k) contributions aren't limited by income level, so those who have access to a Roth 401(k) at work can still use their employer-sponsored plan to get the favorable tax treatment they want for their retirement savings.

Most analysts argue that the Obama budget is dead on arrival, and it's therefore tempting simply to discount its provisions as irrelevant. Yet by setting the stage for the political debate points for the 2016 elections, the budget's attacks on retirement accounts are notable -- and investors shouldn't entirely rule out the possibility of a relatively minor provision like the back-door IRA becoming the victim of behind-the-scenes deal-making in the nation's capital.

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