The much-cherished Roth IRA is in a strange transition year this taxpaying season. Last fall, the Internal Revenue Service released a notice clarifying that people who can make after-tax contributions to their 401(k) plans would also be able to roll that money over into a Roth.
That little move pretty much blew past existing limits for Roth IRA savers. The regular limits established by the IRS for the 2014 tax year are $5,500 for married couples with income of $181,000 or less. Those couples with income greater than $191,000 were excluded from contributing to a Roth altogether.
But by rolling over money from a 401(k), savers can set aside much more than that. For this year, the IRS has established an individual contribution of $59,000 for taxpayers aged 50 and older.
The IRS had already removed the limits on rollovers from traditional IRAs back in 2010, and taxpayers took advantage in a big way: Traditional-to-Roth IRA conversions increased to $64.8 billion in 2010 from $6.8 billion in assets in 2009. This was the first time conversions exceeded contributions, with 57 percent of the conversions coming from people with six-figure incomes. The newly clarified rules regarding 401(k) rollovers could bring a similar impact.
This obviously has tremendous estate planning implications. Taxpayers who had limited access to the Roth’s tax-planning advantages — remember, the assets can grow tax-free, and provide a tax-free stream of income in retirement — now have much greater ability to make use of them. And even though 2014 has ended, filers have until the tax deadline of April 15, 2015, to make contributions to a Roth that would count against the 2014 taxpaying year.
The bad news: There may be a limit to how long these advantages are available. President Obama’s proposed 2016 budget plan would, as a revenue-enhancing measure, eliminate the ability to roll after-tax money from a 401(k) into a Roth IRA. The plan would also restore limits to rollover from traditional IRAs into Roths.
The chances of Obama’s proposal becoming law are not great, given his relations with the GOP-controlled Senate and House. But the chances are not zero, so anyone who wants to take advantage of the 401(k) rollover provision may want to do so over the next month.
Who should be taking advantage of these possibly temporary rules? If your clients are in one or more of these states, they should consider a Roth:
Those who have maxed out on a 401(k) but want to put more away. The contributions for Roth IRAs and 401(k) plans are not cumulative. Clients can contribute the maximum amount to both plans as long as they qualify to contribute to each.
Those who are keeping an IRA in their estates. Retirees whose incomes are less than those of their children are well-poised to take advantage of this tactic. The Roth conversion will be taxed at a lower rate than what heirs would pay if they decided to convert the account from a traditional IRA to a Roth later on.
Those who expect their income and their tax rates to go up. Since taxes are historically at fairly low rates now, it makes sense to convert now, pay the current tax rates, and avoid possibly higher marginal rates in the future. If clients’ current income has them in a lower bracket, and it might be going up in the future, it also makes sense to take the tax hit now and enjoy the tax-free income in the future. That’s especially relevant for younger savers who are just setting up an estate plan.
Caveat: When clients convert from a tax-deferred account, like a traditional IRA, to a Roth, they must pay taxes on that money. It could be a sizable hit, so before the conversion takes place, clients will need to ensure that they have enough liquid assets cover it.
Even if particular clients may not be suitable for a Roth conversion, it might be helpful to alert them of the existence of this possibly temporary tactic. It’s always better to have your clients aware that, as their estate planner, you are looking out for any available advantage for them.