2016 Budget: Proposed Restrictions on Roth Conversions

Reviewed: February 06, 2015
By FinanceWeb

The Obama Administration has proposed cutting off a frequently used workaround for people whose incomes are too high to qualify for Roth IRA. The provision passed by Congress in 2010 lifted income restrictions on Roth IRA conversions. IRA holders figured a way to use it to convert regular IRA funds to Roth. The Roth advantages are significant; it provides tax-free income on the accumulated earnings. The Administration seeks to close the option as part of tax reform and increasing federal revenues.

Roth Income Restrictions

Persons who earn more than the rules permit are not eligible to open Roth IRAs. In 2014, the limit was $127,000 for a single person, and $181,000 for married couples adjusted gross income. Persons, who are below this level when starting, lose the benefits in proportions as the near, and then exceed the amount. However, when enacting the conversion law in 2010, there was no income restriction. IRS treated it similar to 401(k) rollovers by taxing the untaxed contributions. Traditional IRA lacks the tax-free accumulations, tax-free distributions, and longer contribution period; these are some of the best Roth IRA features. The trick is in getting the taxes settled on the traditional IRA funds. IRS applies a formula to determine the taxable portion of the traditional funds. The formula separates the taxable and non-taxable portions of the rollover amount by a ratio of the rollover amount to the entire IRA amounts. However, once taxed the funds placed in the Roth account create tax-free accumulations.

Conflict with Rollover Rules

The new policy has a potential conflict with recent IRS rules on Roth IRA rollover of company 401(k) plans. For those able to contribute after-tax money to an employer-sponsored 401(k), there is the option of moving the after-tax funds to a Roth IRA and putting the untaxed earnings into a traditional IRA. This split procedure avoids a tax event and produces a new Roth IRA. The employer plan must allow after-tax contributions to the company 401(k). Some critics feel the new Obama Administration approach to close the conversion appears to be at odds with the IRS provision. When applied to persons with company plans that allow after-tax contributions, it seems to require additional taxation unless they deem the split provision to be a valid non-taxable event.

Legislation Passage Is Uncertain

Some comments note an interesting confirmation. By closing the loophole, the Administration seems to give credit to the idea that it is a valid way to convert to Roth IRA. If it were not, we could just invalidate the attempts and not need to pass a law to close the option. This is an important observation because it is far from certain that Congress will either agree with or pass the proposed changes. It is clear that high-income earners enjoy the best Roth IRA benefits of tax free accumulations and distributions. If Congress does not change the law, there will be additional arguments that the workaround is a valid method for creating Roth IRAs for high-income earners.