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President Proposes IRA Changes

The president's proposals to cap retirement account contributions and scrap stretch IRAs don't hold water.

Natalie Choate, 05/10/2013

President Obama's budget for 2014 contains five proposed tax code changes that would directly impact our clients' retirement benefits. He would:

> Prohibit additional contributions to any IRA, 401(k) plan, or other defined contribution plan for an individual whose combined plan balances already exceed $3.4 million.

> Eliminate the "stretch" IRA concept by requiring a five-year maximum payout period for inherited retirement benefits.

> Limit the value of the tax deduction for contributions to retirement plans (among other deductions) to 28%, regardless of the individual's actual tax bracket.

> Eliminate the requirement of taking annual minimum distributions for an individual whose total account balances are under $75,000.

> Allow beneficiaries to do a "60-day rollover" for inherited retirement benefits.

The president's budget is sometimes considered a mere "wish list," and some of these proposals have appeared in President Obama's prior budgets without achieving enactment. Nevertheless it is useful to examine these ideas, since some of them may become law someday. I'll start here with the proposal to cap contributions and eliminate the stretch IRA concept.

Capping Contributions
The concept of this proposal (a new one that did not appear in the president's previous budgets) is simple and fair: Our law gives tax breaks to individuals to encourage them to save for retirement. Once a person has saved up plenty of money for his or her retirement through such tax-advantaged plans, we should stop offering tax incentives for that person to save even more. The person can save more if he or she wants to, but why should the taxpayers subsidize such further savings?

Under a tax-qualified defined benefit pension plan, the largest pension an employer can fund for any employee is $205,000 per year for life starting at age 62. Therefore, says the president, once an individual has accumulated enough in his or her defined contribution plans to provide a pension of $205,000 a year, he or she should not get to make further tax deductible or tax-favored contributions, any more than an employer can get tax deductions for funding more than that size pension.

This sounds perfectly reasonable and fair. Unfortunately, in my opinion, it is not a good idea. The proposal amounts to killing a mosquito with a sledgehammer, based on the following three considerations:

1. This proposal would require an entirely new information-gathering and enforcement mechanism. Right now the only person who knows how much you have in all your various defined contribution plans (your IRAs, your 401(k) accounts at all past and present employers, your 403(b) accounts, etc.) is you (and possibly the IRS). Under this proposal, that information would need to be gathered for every employee in every 401(k) plan before the employer could contribute! Because your employer could not contribute more to your 401(k) plan if you already have $3.4 million in some IRA someplace else, this would require information-gathering and reporting on tens of millions of IRA owners and 401(k) plan participants, to catch....who?

2. There are relatively very few people who have more than $3.4 million in their defined contribution accounts. There are probably thousands of such people who have accumulated "too much," but that's a drop in the bucket compared to the millions and millions who have "too little." So this newly created giant dragnet will snare just a few people.

3. The rumor is that this proposal was inspired by the report that presidential candidate Mitt Romney's IRA was worth tens of millions of dollars. OK, let's say that's true. If a new client walked into your office today and said, "I have $50 million in my IRA; what should I do?" how likely is it that you would urge her to put more money into that IRA? In other words, we're trying to prevent the super-rich from putting $6,500 into an IRA or $50,000 into a profit-sharing plan....but if their IRAs are already that large, they don't want to put more in anyway! So it's the plan administrators (and the guy or gal with $3.5 million) that gets punished, not the "whales" with the $10 million and up IRAs.

My advice? Mr. President, forget this one!

Kill the Stretch!
Killing the stretch IRA and mandating a five-year post-death payout for (most) retirement plans is supposed to accomplish several goals: Bring the law back into line with the purpose of the tax code's retirement provisions, which is to provide for retirement, not wealth transfer; raise revenue; and simplify the rules.

Unfortunately, all three of those justifications are wrong.

It's true that the purpose of the code's retirement plan provisions is to encourage people to save for their retirement years, but it's not true that a "wealth transfer" component is inconsistent with that. A significant death benefit has always been a component of the retirement-savings rules, perhaps in recognition of the fact that building a legacy is a major motivation for people to save. Society can benefit from that urge if the result is that people save adequately for their later years.

The ancestor of today's minimum distribution rules was the "incidental benefit rule," which has decreed (since the inception of the tax-favored retirement provisions of the code) that retirement benefits had to be distributed to the owner, upon retirement, in a form that would cause at least half of the benefits' value to be distributed to the owner during his or her lifetime. Not 100%, just half! Thus a 50% death benefit "wealth transfer" component has always been part of the "deal."

Also, ending the stretch payout will not raise revenue. Despite the allure of the stretch IRA, very few stretch-outs (in my experience) actually get implemented. Most beneficiaries want immediate cash, not a stretch payout. Even when the participant plans for a long-term stretch payout to his beneficiaries, what happens in most cases is that the participant lives a long time and spends the money down during life. A participant who dies "young" typically leaves the benefits to a surviving spouse who rolls them over and then spends them down during his or her long overlife. So how many substantial stretch payouts to young beneficiaries actually get implemented? Not that many!

Finally, even though a fixed-term payout period for everybody would theoretically be simpler than the life expectancy payout, the five-year term is too short. It means the law then has to contain lots of exceptions. The president's proposal contains six! There are exceptions (five-year payout does not apply) for minor, disabled, and chronically ill beneficiaries, the surviving spouse, a beneficiary who is close in age to the decedent, and beneficiaries of those who are already dead. That's not simplification.

If you really want to simplify, mandate a 21-year fixed-term payout period for all post-death benefits (and keep the spousal rollover). That would be fair to everyone, it would be long enough so people wouldn't be discouraged from saving in retirement plans, and it would eliminate the "designated beneficiary" lottery system we now have. That's what I would do if I were president!

Natalie Choate will be speaking at a location near you if you live in Waltham, Mass. (5/31/13); Philadelphia (11/14/13); Charlotte, N.C. (5/16/13); Chicago (5/13/13); Columbus, Ohio (5/17/13); Brooklyn Center, Minn. (6/18/13); Indianapolis (6/21/13 and 9/18/13) or South Bend (10/17/13), Ind.; Denver (8/9/13); Green Bay, Wis. (9/27/13); or Atlanta (10/30/13 and 11/1/13). See all of Natalie's upcoming speaking events at http://www.ataxplan.com/seminars/schedule.cfm.

Natalie Choate practices law in Boston with Nutter McClennen & Fish LLP, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is a leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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