In mid-April, President Barack Obama unveiled his budget for the upcoming year. Although the budget is essentially a “wish-list” for the President and most of its proposals and recommendations are likely to fall by the wayside at some point, the number of retirement related items in this year’s budget is causing many clients to take notice. Below we discuss the six proposals included in this year’s budget that directly relate to retirement accounts so that you can answer the questions that clients are, or soon will be, asking.
1) Mandatory Auto-Enrollment IRAs for Certain Small Businesses
The Proposal – Employers in business for at least two years that have more than 10 employees would be required to offer auto-enrollment IRAs to their employees. Contributions to employees’ IRAs would be made on a payroll-deduction basis. Employees would be able to elect how much of their salary they wish to contribute to their IRA (up to the annual IRA contribution limit), including opting out entirely. In absence of any election, 3% of an employee’s salary would be contributed to their IRA.
The Reason – For nearly 15 years, Congress, along with the Treasury Department and IRS, have been taking steps to increase Americans’ retirement savings contributions by making it easier for employers to establish auto-enrollment in company plans. However, many small businesses choose not to adopt a retirement plan due to the potential costs and/or compliance burden. Many small employers also do not take low-cost steps to make retirement savings easier for employees, such as through the adoption of payroll-deduction IRAs.
The Good – It’s no secret that our country is in the midst of a retirement savings crisis. Too few Americans actively save for retirement, and even fewer save appropriate amounts. Although there is some debate as to how effective this proposal would be in reducing the gap between what people are saving and what people should save for retirement, numerous studies have shown that auto-enrollment tends to increase participation in retirement savings. The proposal also contains a number of credits small businesses could claim for helping to facilitate employees’ retirement savings.
The Bad – Many small businesses are already overburdened with various compliance requirements and any new rules or regulations could be unwelcomed by small business owners.
2) Mandatory 5-Year Rule for Non-spouse Beneficiaries
The Proposal – IRA (and other retirement account) beneficiaries would be required to empty inherited retirement accounts by the end of the fifth year after the year of the IRA owner’s death.
The Reason – The “Green Book”, released by the Treasury Department to explain the proposals in the President’s budget(including the reasons for making such proposals) said the reason for this provision is that “The Internal Revenue Code gives tax preferences for retirement savings accounts primarily to provide retirement security for individuals and their spouses. The preferences were not created with the intent of providing tax preferences to the non-spouse heirs of individuals.”
The Good – Right now, the required minimum distribution rules for non-spouse beneficiaries can be somewhat complex. Requiring all non-spouse beneficiaries to withdraw inherited retirement account funds within five years would simplify the rules, for both clients and advisors. Plus, the proposal exempts certain beneficiaries, such as disabled beneficiaries and minor children.
The Bad – If this proposal should come to pass, it would be the death of the stretch IRA. Non-spouse beneficiaries would face more severe tax consequences upon inheriting retirement accounts and as such, the value of these accounts as potential estate planning vehicles would be diminished.
3) Establish a “Cap” on Retirement Savings Prohibiting Additional Contributions
The Proposal – New contributions to tax favored retirement accounts, such as IRAs and 401(k)s, would be prohibited once clients exceeded an established “cap.” This cap would be determined by calculating the lump-sum payment that would be required to produce a joint and 100% survivor annuity of $205,000 beginning when clients reached age 62. At the present time, this formula produces a cap of $3.4 million. Clients with cumulative retirement accounts in excess of this amount would be prohibited from contributing new dollars to retirement accounts on a tax-favored basis (but accounts could still grow as a result of earnings). The cap would be increased for inflation.
The Reason – Per the Green Book, “The current law limitations on retirement contributions and benefits for each plan in which a taxpayer may participate do not adequately limit the extent to which a taxpayer can accumulate amounts in a tax-favored arrangement through the use of multiple plans. Such accumulations can be considerably in excess of amounts needed to fund reasonable levels of consumption in retirement…”
The Good – It’s hard to find much good in this proposal for clients. Perhaps the only good news is that at $3.4 million, this provision would impact only a very small percentage of retirement savers. But even here, if interest rates increase (which is likely, since they can’t go much lower), then the cap could go much lower since annuities paying $205,000 would cost less. This would impact many more retirees.
The Bad – $205,000 is certainly nothing to scoff at. However, many clients will require significantly more annual income in retirement to maintain their desire standard of living, especially after you factor in taxes. Such clients will need to look for alternative ways to (legally) shelter assets from tax.
4) Create a 28% Maximum Benefit for Retirement Account Contributions
The Proposal – The maximum tax benefit (reduction) for making contributions to defined contribution retirement plans, such as IRAs and 401(k)s, would be limited to 28%. As a result, certain high income taxpayers making contributions to retirement accounts would not receive a full tax deduction for amounts contributed, deferred.
The Reason – Per the Green Book, “In particular, limiting the value of tax expenditures including itemized deductions, certain exclusions in income subject to tax, and certain deductions in the computation of AGI, would reduce the benefit that high-income taxpayers receive from those tax expenditures and help close the gap between the value of these tax expenditures for high-income Americans and the value for middle-class Americans.”
The Good – From a client’s perspective, there is really nothing in this proposal that’s good. Perhaps some can be thankful that, unless they are in a federal income tax bracket higher than 28%, this provision would not increase their tax liabilities.
The Bad – High income clients would no longer be able to receive a true, full deduction for amounts contributed/deferred to a retirement account. For instance, currently if an individual with $500,000 of taxable income defers $10,000 into a 401(k), they will not pay any income tax on that $10,000. Without that salary deferral, that income would be taxed at 39.6% (currently the highest federal income tax rate). However, if this proposal were to become effective, that $10,000 would effectively be taxed at 11.6% (39.6%-28% = 11.6%), since the maximum tax benefit that a client could receive would be limited to 28%.That equates to an additional tax bill of more than $1,000.
5) Eliminate RMDs for Clients with $75,000 or Less in Retirement Accounts
The Proposal – Clients (seniors) with combined savings, across all retirement accounts, of $75,000 or less, would be exempt from required minimum distributions.
The Reason – Per the Green Book, “Under current law, however, millions of senior citizens with only modest tax-favored retirement benefits to fall back on during retirement also must calculate the annual amount of their minimum required distributions, even though they are highly unlikely to try to defer withdrawal and taxation of these benefits for estate planning purposes. In addition to simplifying tax compliance for these individuals, the proposal permits them greater flexibility in determining when and how rapidly to draw down their limited retirement savings.”
The Good – The proposal would decrease the compliance burden and increase simplicity for those individuals with smaller retirement account balances (who tend to have smaller savings on the whole), who generally do not have access to the same level of financial expertise as those with larger account balances.
The Bad – It’s hard to find something to complain about for this one. Perhaps the only gripe some will have is that it further serves to divide “haves” and “have-nots.”
6) Allow Non-spouse Beneficiaries to Make 60-Day Rollovers of Inherited Assets
The Proposal – Non-spouse beneficiaries would be allowed to move inherited retirement savings from one inherited retirement account to another inherited retirement account via a 60-day rollover (in a manner similar to which they can currently move their own retirement savings).
The Reason – Per the Green Book, “These differences in rollover eligibility between surviving non-spouse beneficiaries and surviving spouse beneficiaries (and living participants) serve little purpose and generate confusion among plan and IRA administrators and beneficiaries..”
The Good – Unifying the rollover rules for retirement account owners and beneficiaries would greatly simplify this aspect of retirement accounts and reduce the number of irrevocable and costly mistakes that are often made by beneficiaries under the current rules.
The Bad – Good luck finding the “bad” in this decision. How about that? A budget provision with virtually no downside…