Budget Plan Would Limit Roth Conversions, ‘Stretch’ IRAs

By Andrew Remo • February 04, 2015 • 0 Comments
In addition to proposals for a retirement savings cap, double-taxing contributions of those above the 28% tax bracket, and encouraging automatic enrollment, President Obama’s budget blueprint for fiscal year 2016 contains proposals that would change the tax treatment of IRAs and qualified retirement plans.

The Treasury Department has determined that two of the proposals will raise money, and the other will cost money over the ten year budget window.

Stretch’ IRA

Under current law, the beneficiary of an inherited retirement account (from either qualified plans or IRAs), if significantly younger than the deceased plan participant or IRA owner, can stretch distributions from that account over many years. Obama’s new budget proposal would force non-spouse beneficiaries of retirement plans and IRAs (with certain exceptions) to take distributions from these inherited accounts over no more than five years. The Treasury estimates that this “stretch IRA” proposal would raise $5.5 billion over a 10-year period.

Limiting Roth Conversions to Pre-Tax Dollars

Under current law, individuals with a modified adjusted gross income over $131,000 ($193,000 for joint filers) are not permitted to make a contribution to a Roth IRA. However, no income limits apply for non-deductible (after-tax) contributions into traditional IRAs. This allows individuals who cannot contribute to a Roth IRA to nonetheless make a non-deductible (after-tax) contribution into a traditional IRA, and then immediately convert that contribution to a Roth IRA to get around the income limits.

Obama’s budget proposal would end that practice by disallowing any after-tax amounts held in traditional IRAs or qualified retirement plans to be converted to Roth. The Treasury estimates that this proposal would raise $385 million over a ten year period.

Expand Penalty-Free Distributions for Long-Term Unemployed Individuals

Under current law, early distributions (taken prior to attaining age 59½) from an IRA or qualified plan are subject to a 10% tax penalty (with exceptions for certain hardships, including unemployment). An unemployed individual is eligible to receive a penalty-free distribution from an IRA if that individual has received unemployment benefits for 12 weeks, and the distribution is made during the year (or succeeding year) in which those benefits were received. The total amount of the distribution cannot exceed the premiums paid for health insurance. Penalty-free distributions from qualified plans are not allowed for these individuals.

Obama’s budget proposal would expand this exception considerably for longer-term unemployed individuals. Under the proposal, individuals who have received unemployment benefits for 26 weeks (or the maximum period for which unemployment benefits are available under state law) would be able to make penalty-free distributions from either an IRA or a qualified retirement plan (or both). For individuals who own only IRAs, the total amount of these penalty-free distributions cannot exceed half of the fair market value of the IRA or $10,000. For individuals with qualified plans, the total amount of these penalty-free distributions cannot exceed half of the fair market value of the qualified plan or $50,000 per year (totaling no more than $100,000).

The proposal would require additional reporting from a plan administrator on Form 1099-R to track these new qualified plan distributions. The Treasury estimates that this proposal would cost $2.5 billion over a 10-year period.