If you want to know what areas you should be aiming to take advantage of with your finances look no further than the “loopholes” that are included to be closed or slashed in proposed budget deals or by presidential candidates on the campaign trail.
Two of the “loopholes” we are going to look at in this newsletter are the Backdoor Roth IRA and the Stretch IRA. These two strategies were on the chopping block of President Obama’s recent budget proposal.
Backdoor Roth IRA
Very few things in personal finance can have as positive benefit as the Roth IRA. With a Roth IRA you contribute money to your IRA and never have to pay tax on that money again. As the money grows each year you do not pay tax on the gains or income the account generates, nor do you pay tax when you withdraw money from the account. A triple benefit is since the IRS is not collecting tax on the withdrawals there is no such thing as Required Minimum Distributions (RMDs) on a Roth as there are on a traditional IRA. Also, unlike the Traditional IRA, you can also take out your contributions from the Roth at anytime without penalty. It can be a retirement, education saving, and emergency fund tool all wrapped in to one. Unfortunately the Roth IRA does have income limits on contributions into it. If you earn over $176,000 in 2015 as a married couple you are not allowed to contribute to a Roth. Don’t fear though, even if your income is over the limit you can still get money into a Roth IRA by using the “backdoor” strategy.
How to take advantage of the Backdoor Roth IRA.
Utilizing a backdoor Roth IRA is simple and straightforward. First you create and add a contribution to a non-deductible IRA. Soon after the funds hit the non-deductible IRA you would convert it into a Roth IRA. No tax is owed and your money is in the Roth where it can grow and you can take distributions tax free.
The Stretch IRA is a wealth transfer method that allows you the potential to “stretch” your IRA over several future generations. Under current rules, as a beneficiary when you inherit an IRA you can space out the distributions over the course of your life. The tax benefit is that the IRA can stay in tact for a longer amount of time growing tax-deferred.
If the provision in the new budget deal is passed, almost any non-spouse beneficiary would be forced to withdraw all of their inherited retirement accounts by the end of the fifth year after the account owner has died, effectively killing the tax benefits that come with the stretch IRA.
How to take advantage of the Stretch IRA
IRA accounts at death of the owner pass by beneficiary designation. It is typical practice for most IRA owners to name their spouse as the primary IRA beneficiary and their children as the contingent beneficiaries. While there is nothing wrong with this strategy, it might require the spouse to take more taxable income from the IRA than what he/she really needs when he/she inherits the IRA. If income needs are not an issue for the spouse and children-, then naming younger beneficiaries (such as grandchildren or great-grandchildren) allows you to stretch the value of the IRA out over generations. This is possible because grandchildren are younger and their required minimum distribution (RMD) figure will be much less at a younger age.
The backdoor Roth and the Stretch IRA are not the only items included in the budget proposal. The table below is from Financial Blogger, Michael Kitces and describes all of the potentially impacting changes.
The good news is that we are in an election year and there is little likelihood that any of the President’s substantive tax changes will actually come to pass. Although it does give an indication of what is on the radar screen of potential crackdowns and loophole closers that could appear in future legislation. The crackdown on Social Security file and suspend and restricted application claiming strategies last year was an example of this.