A Close Look at The IRA Proposals in the Build Back Better Act

The Build Back Better Act, which is the $3.5 trillion budget reconciliation bill currently being debated in Congress, contains several tax proposals to pay for the infrastructure items the Democrats want to implement. These proposals include changes to Individual Retirement Accounts (IRAs) which high net worth and high-income earners should be aware of. H.R. 5376, the Build Back Better Act, would create a new required minimum distribution starting in 2022 for high-income earners who have $10 million or more in their retirement plans, prohibit high-income earners from completing Roth IRA conversions starting in 2032, and prohibit “backdoor” Roth IRAs starting in 2022 regardless of income.  A high-income earner under these proposals is someone who has over $400,000 of income if single or married filing separately, $450,000 if married filing joint, or $425,000 for head of household. The income threshold is “adjusted taxable income,” which is taxable income without regard to any deduction for contributions to an IRA or additional income due to a “mega” RMD.

New “mega” RMD

If a high-income taxpayer’s combined traditional IRA, Roth IRA, and defined contribution retirement account balances exceed $10 million at the end of a taxable year, a minimum distribution would be required for the following year. This provision would apply to taxable years beginning after Dec. 31, 2021. The minimum distribution would be 50% of the amount by which the individual’s prior year aggregate traditional IRA, Roth IRA, and defined contribution account balance exceeds $10 million. For example, if John has $600,000 of taxable income and has a $14 million IRA, he must take a distribution of $2,000,000 (50% of the $4 million excess over $10 million). On the other hand, if John’s taxable income is $250,000, he is not a high-income earner and does not have to take a mega RMD even though he has a $14 million IRA.

There is an additional RMD for high-income individuals who have retirement plan balances exceeding $20 million. To the extent that the combined balances in traditional IRAs, Roth IRAs, and defined contribution plans exceeds $20 million, that excess is required to be distributed from Roth IRAs and Roth designated accounts in defined contribution plans up to the lesser of (1) the amount needed to bring the total balance in all accounts down to $20 million or (2) the aggregate balance in the Roth IRAs and designated Roth accounts in defined contribution plans. Once the individual distributes the amount of any excess required under this 100% distribution rule for accounts over $20 million, then the individual is allowed to determine the accounts from which to distribute to satisfy the 50% distribution rule for accounts over $10 million. For example, if Sally has $600,000 of taxable income and has a $15 million traditional IRA and a $10 million Roth IRA, she is $5 million over the $20 million threshold and must take a $5 million distribution from her Roth IRA to get her to a $20 million aggregate IRA balance and then she must take 50% of the excess over $10 million, which in this case is another $5 million distribution (although she can take this last $5 million from either the traditional IRA or Roth IRA, or a combination of both).

The bill exempts these mega EGA RMDs from the 10% premature distribution tax if the account owner is under age 59 ½, however, it is important to note that a distribution from a traditional IRA would be taxable ordinary income. A distribution from a Roth IRA may be partially taxable depending on if the owner is over age 59 ½ and has had the Roth IRA for at least five years, as well as depending on how much of the Roth IRA is growth versus contributions.

The number of Americans with retirement accounts valued over $10 million is limited, but if a mega RMD is passed into law there are some planning techniques for people to consider.

Keep Income Below the $400,000 Threshold

This mega RMD would not apply to people who have retirement balances over $10 million if they do not have income above the threshold. Where feasible, people may want to reduce their taxable income to avoid this mega RMD. It is likely that most people who have such large retirement plan accounts will have taxable income above the thresholds, but it may be possible for some people to reduce their taxable income below the threshold and avoid the RMD (remember that the taxable income threshold is income before any increase in income due to the mega RMD). Owners of large retirement plans may look to charitable deductions to reduce their taxable income. Also, the $10 million threshold applies separately to spouses, so each spouse could have a $9.9 million IRA and avoid the distribution requirement even if their income is over $450,000. In some situations, it may make sense for married couples to file separately because if a non-working spouse has a mega IRA, filing separately may be a way to avoid subjecting the non-working spouse to this mega RMD.

Buy Life Insurance in a Defined Contribution Plan

While IRAs cannot own life insurance, a defined contribution plan such as a 401(k) plan may. Someone who has a large IRA may be able to roll over the IRA into a 401(k) plan, if the plan allows for rolling IRA money into the plan, and purchase life insurance in the 401(k) plan if the plan allows for it (or if the plan is amended to allow for it). Qualified retirement plans may allow for the purchase of life insurance in the plan, but within so-called incidental benefit rules. Generally, defined contribution plans may use up to 49.9% of contributions to purchase whole life insurance or up to 25% of contributions to purchase term, universal, or variable life insurance. There is a “seasoned money” exception to the incidental benefit rule where 100% of seasoned money can be used to pay for life insurance premiums, and those are the funds someone who has a potential mega RMD issue would use to purchase life insurance in the plan.

In the first year, buying life insurance in a plan is not going to avoid the mega RMD because the fair market value of the policy in the first year is generally equal to the first-year premium. However, in subsequent years until the policy crosses over the value of the policy for tax purposes may be less than the cumulative premiums paid. Therefore, someone who is approaching a $10 million retirement plan balance may want to review if purchasing life insurance in the plan with the intention of buying the policy from the plan or distributing it out of the plan before it crosses over may be a way to obtain a “discounted” distribution before the special mega RMD kicks in. The fair market value of the policy would be determined under Revenue Procedure 2005-25 and a distribution of the policy from the plan would be a taxable distribution equal to the policy’s fair market value.

Donate to Charity Using IRA Distributions

Someone may wish to take a taxable distribution from an IRA and donate the cash to charity. While the IRA distribution will be included in income, the charitable donation should partially or fully offset the income. Cash donations are generally deductible up to 60% of AGI, however, for 2020 and 2021 cash donations are deductible up to 100% of AGI. People with mega IRAs may want to review taking a distribution in 2021 while the 100% of AGI rule still applies as a way to reduce the value of their IRA to avoid the MEGA RMD if it is signed into law. However, for those who are under age 59 ½, the 10% premature distribution penalty should be kept in mind.

IRA Distributions to Pay for Life Insurance Premiums

After the SECURE Act imposed a 10-year distribution rule for inherited IRAs (with limited exceptions) many IRA owners reviewed taking IRA distributions during life to pay for life insurance premiums. While the IRA distributions are taxable, the life insurance can provide an income and estate tax-free death benefit, as well as tax-deferred growth of the cash value while the insured is alive. Someone who is approaching the MEGA RMD threshold may want to review if taking IRA distributions strategically over time to pay for life insurance premiums makes sense. For those who are under age 59 ½, the 10% premature distribution penalty would apply unless there is an exception, such as taking substantially equal period payments.

Generally, owners of mega IRAs are going to be high net worth and likely have estate tax concerns, so the life insurance should probably be owned in an irrevocable trust to keep the death benefit out of the insured’s taxable estate.  However, the Build Back Better Act also contains a proposal to have assets held in a grantor trust be included in the grantor’s estate at death, so that proposal needs to be watched and reviewed as well if a trust will own the policy.

Going Forward Defined Benefit Plans May be More Appealing

Small business owners may want to give closer attention to defined benefit plans because defined benefit plans do not fall under this mega RMD. A small business owner who is establishing a new retirement plan may want to strongly consider establishing a defined benefit plan because in some cases these plans can provide significant income tax deductions and would also avoid this mega RMD (only IRAs and defined contribution plans are subject to this mega RMD). As the bill also proposes to increase income taxes on high-income earners, tax deductions from funding a defined benefit plan may be very beneficial with higher tax rates starting in 2022 and defined benefit plans do not have a mega RMD requirement.

Roth IRA Conversion in 2021

While doing a Roth conversion does not avoid the mega RMD as the Roth balance is factored into the $10 million threshold, recognizing taxable income upon a Roth conversion in 2021 instead of taking a taxable distribution in 2022 or later may be advantageous. The proposals contain higher income tax rates starting in 2022 for high-income earners, so paying tax on a Roth conversion in 2021 may be beneficial.

Contributions Would Be Prohibited For High-Income Earners with $10 million IRAs

The proposal would prohibit contributions to IRAs for high-income individuals who have aggregate retirement accounts of $10 million or more. Certain contributions would not be considered an annual addition, such as contributions to SEPs and SIMPLEs, rollover contributions, and accounts acquired by death, divorce, or separation. An excise tax would apply if there were a prohibited annual addition. This proposal would apply to tax years beginning after Dec. 31, 2021. Prohibiting people who have $10 million in their IRAs from making a $6,000 annual contribution is not likely to have much impact on them.

High-Income Earners Would Not Be Able to Do Roth Conversions Starting in 2032

The proposal would prohibit a conversion of a traditional IRA to a Roth IRA if the IRA owner were a high-income earner. However, this would not apply until after December 31, 2031, so high-income earners would have 10 years to do Roth conversions and so the IRS can collect the taxes owed on those conversions. People who may lose the ability to convert to a Roth starting in 2032 should review if doing so before then would be advantageous.

No More “Backdoor” Roths Regardless of Income Level

The proposal would prohibit after-tax amounts in a non-Roth retirement plan or traditional IRA from being converted to a Roth IRA or designated Roth retirement account. This would apply starting in 2022 and would apply to everyone, not just high-income individuals. Many people who cannot make a direct Roth IRA contribution because they are over the contribution threshold use the backdoor Roth strategy, so this proposal would affect many individuals. Anyone looking to complete a backdoor Roth IRA for 2021 should keep an eye on this proposal and be ready to complete it before year end. People who cannot make direct Roth IRA contributions and can no longer do a backdoor Roth may consider using cash value life insurance which provides tax-deferred growth and an income-tax-free death benefit.

The final tax bill may look very different than what is currently proposed. That said, individuals who may be impacted by these proposals should watch the developments in Washington D.C. and may want to meet with their financial professionals to determine what planning and steps should be taken before New Year’s Eve.