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These Retirement-Planning Loopholes Could Be Closing

Congress is unlikely to do away with the Roth IRA, but it could limit 'backdoor' contributions, end the 'stretch IRA,' or eliminate some popular Social Security filing strategies, says IRA expert Ed Slott.

These Retirement-Planning Loopholes Could Be Closing

Christine Benz: Hi,I'm Christine Benz for Morningstar.com. Could Congress be ready to close some lucrative retirement-planning loopholes? Joining me to discuss that topic is Ed Slott--he is an IRA expert.

Ed, thank you so much for being here.

Ed Slott: Great to be here.

Benz: You recently wrote about these lucrative loopholes that some people have been using for retirement-planning purposes. You think that Congress may be ready to take a look at some of these loopholes and possibly close some of them. Let's take them one by one. One that has been very popular with our Morningstar.com readers is this idea of doing a backdoor Roth IRA. Let's talk about what this strategy entails.

Slott: This is something that I think was an unintended consequence for the tax law. All of these things that we call loopholes are all in the law, although this one might be more of a gray area. To do a Roth conversion, there are no income limits; those were all repealed a few years back. So, if you have $1 billion in an IRA and you want convert it and you make $1 billion a year, there is no limit. But if you want to put $5,500 in a Roth IRA, then they are going to clamp down. So, it's kind of a funny situation: It's unlimited for the big money in Roth conversions, but there are limits on people who can do a Roth contribution. The contributions are limited to only $5,500 a year in 2015--unless you are 50 or over, and then it's another $1,000 (or $6,500 a year). So, there are limitations on who can put in $6,500 as a Roth contribution but no limits on an unlimited amount of Roth conversions. So, what happens is some people can't do Roth contributions--

Benz: Because they earn too much.

Slott: Because they make too much. Right. The income limits, for example, for married joint--it's a phase-out. For 2015, it's $183,000 to $193,000, which means if you make more than $193,000, you can't have a Roth IRA contribution--either the $5,500 or the $6,500. A way around that would be to do an IRA contribution. Now, unlike Roths, there are no income limits on who can do an IRA contribution; of course, in both cases, you need compensation like W-2 earnings or self-employment income to qualify to make a contribution. But assuming you have the wages or earned income, then there's no limit on who can contribute to an IRA. People think there's a limit, but those limits only apply if you are active in a company plan and you want to deduct an IRA contribution. The limits people are familiar with for traditional IRAs are only for deductibility.

What you could do--no matter what your income as long as you have the compensation--is contribute to a nondeductible traditional IRA and then convert that, since anything can be converted to a Roth IRA. Now, you have, in effect, that Roth contribution--except it went in as a conversion. A lot of people call that the backdoor Roth IRA.

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Benz: A lot of people have been doing these since the income limits on conversions were lifted back in 2010, I believe. But there have been some rumblings that Congress could close this loophole. What would happen? Say I've been someone who has been making these backdoor Roth IRA contributions. Would anything happen to the money that I've already gotten in there via this backdoor?

Slott: No,I wouldn't worry about that. That would all be grandfathered. They are not going to go back and start looking back. Remember, these people didn't even take a deduction, so the government is going to actually lose money if they say that you now have to go back because you didn't get a deduction--you never took a deduction for the money that went into the Roth.

Benz: You already paid taxes on that money. But going forward, you believe that potentially just pretax dollars would be eligible for conversion to Roth.

Slott: Yes, they would have some mechanism so that you couldn't do that. But the whole idea is ludicrous because the limits for the conversions are unlimited on big money. So, to go to all this extent to stop putting basically the smaller money, the contributions, into Roth IRAs seems like a lot of activity and effort for not much pay-off.

Benz: One question I sometimes get from our Morningstar.com readers is this idea of Roth in general. I hear from readers who are wondering whether Congress going to take away Roth treatment altogether at some point. Do you think there's a realistic risk of that?

Slott: No. But I understand the concern--that's the number one question I get. I do a lot of consumer programs, and when I talk about the Roth IRA, that's the number one question I get at every consumer seminar. It goes something like this: I talk about the benefits of the Roth--tax-free and all that--and somebody always asks, "But can I trust the government to keep its word that they won't change the Roth rules--that it will always be tax-free, as promised?"

I'm saying yes, for two reasons. One is political, and one is financial. The political: It would be like a political double-cross--reneging on a tax-free promise would be political suicide. I don't think anybody is going to go near it. The financial reason is that the Roth IRA brings in money. This is the magic provision our legislators have been looking for for over 200 years--something that brings in money to the government and people like it. We've never had anything like that.

So, it brings in a ton of money upfront. Remember, the only money that can get into a Roth is already-taxed money. So, it's a windfall for the government, especially the way they do budgeting--only in the short term. So, I don't think they'll ever touch that. It's too good for the government, and they've been already using income from Roth conversions to fill budget holes in actual tax laws as revenue raisers.

Benz: Let's move on to the next one: the so-called stretch IRA. Let's discuss what that is before we get into how potentially those rules might be relooked at by Congress.

Slott: The stretch IRA is just a name; it's not in the tax law. It's funny because I've mentioned it many times in programs and on shows, and people will call and say, "I went to the bank and asked for a stretch IRA; they don't have them." It's not a product. It's a process. It's the ability for an inherited IRA to be stretched or extended over the lifetime of a beneficiary. That's all it is, and the way to get that is by having a designated beneficiary--in other words, a human being--named on the beneficiary form, somebody with a life expectancy.

For example, if you had a 30-year-old who inherited, they could stretch out or extend distributions on their inherited IRA if they were named as a beneficiary on the IRA beneficiary form--not in the will. A 30-year-old could stretch out over 53.3 years. They could go more than 50 years, stretching it out and building a windfall for them that would last the rest of their lives, taking out only minimum distributions.

Benz: This can be really valuable from an estate-planning perspective. But you say the reason that it's at risk is that the IRA is in place to be a retirement-funding vehicle, not so much as a means for the wealthy to pass money on to their heirs.

Slott: That's exactly right. That's one thing that Congress--and both sides of the aisle politically--agrees on. The IRA was never meant as a funding vehicle for beneficiaries. It was [intended as a way for] you to have your own retirement account. That's how IRAs were born back in the early '70s. They were created because people were losing their pensions; companies weren't meeting their pension obligations or living up to their pension promises. People could've worked for 30 years and come out with nothing.

So, somebody came up with the idea of having your own retirement account where you can move the company-plan money in there or put your own money in and you would be in charge of it, and you'd have money to last you for the rest of your life. The idea of the IRA was to be your own retirement account. But over the years, so much as gone into it that many people have a lot more than they'll ever need, and leaving it over to beneficiaries created a great estate-planning move, as you just said, to leave--in some cases--millions of dollars over to beneficiaries. That was never the intent of Congress.

So, I could easily see this one going by the wayside for several reasons. Not a lot of people talk about it; it would be an easy item to stuff into a tax law. It has been proposed in many bills; they just never passed--not because of that provision, because of other provisions. It's always tacked on. And who would fight against it? It's not like Congress is going to see people with protest signs outside of the Capital saying, "Save the stretch IRA." There's no inheritors' lobby that would fight for it. It's a great thing for beneficiaries, but there's not a lot of opposition to it because most people don't even know it exists.

Benz: So, if this stretch IRA is maybe part of my estate plan--I've got assets going in IRAs to, say, children or maybe grandchildren--what is the risk of just leaving that in place? Should I undo what I've done?

Slott: I don't know if you should undo what you've done. But the proposal has been instead of 50 years, like I said, for a 30-year-old or even more years for a younger person, everything would have to come out, generally, in five years after death. Now, if they did that, I would advise lots of people not to do Roth conversions after, say, age 70, because it wouldn't be worth it to pay all that tax upfront to have the beneficiaries have to pay it out in five years after death.

I would look at maybe doing better planning. If anything, as usual, if this ever came to pass--whether the stretch IRA was eliminated and replaced with five years--it would cause people who had financial advice to do the planning they probably should've been doing all along--better planning. For example, you could turn IRAs, take down the money, and put it into a life-insurance product. In other words, take the money down from the IRA. If this is money you had earmarked for beneficiaries that you weren't going to use yourself--as in a stretch IRA--you could take that money out, pay the tax at today's very low rates, and put what's left in a life-insurance policy. The beneficiaries will get a lot more from that amount of money than they ever did with the IRA without any tax. Also, a life-insurance policy is a great way to fund a trust--a lot easier than these large IRAs where people do the stretch through a trust because they want to make sure the kids don't blow it.

That's one angle. Another angle would be using a charitable trust or charitable entities. Now, why would I give my money to charity? You could leave an IRA to a charitable trust that pays the beneficiaries out and simulates a stretch IRA where the beneficiaries can actually end up with more than the charity gets. It's the same thing with the life insurance. You can go through a trust and pay out the beneficiaries and simulate the stretch IRA with better creditor and asset protection and no taxes.

Benz: So, there are a lot of potential wrinkles from an estate-planning perspective. Let's move on to the last set of loopholes. These relate to Social Security strategies; some call them aggressive Social Security claiming strategies. "File and suspend" is one that I know a lot of our Morningstar.com readers have talked about. Some have said they've used claim--

Slott: "Claim and claim again."

Benz: Let's talk about these two sets of strategies--how they potentially may be in jeopardy and what the implications are for people who are attempting to make good decisions about Social Security claiming.

Slott: That's one of the key decisions: When should I begin to collect? For most people, if you wait till age 70--and, obviously, if you need the money, you claim early--but if you wait till 70, you generally get the biggest Social Security check for the rest of your life, and that's really your goal. But if you're a married couple--and these strategies you are talking about only apply to married couples because they involve spousal benefits. Obviously, if you're single, there are no spousal benefits.

So, these are ways to kind of make-believe you claim--but not really claim--just to trigger a benefit for your spouse. So, in either of these strategies, it's about getting a spousal benefit without affecting your own benefit. Even though your spouse is getting it, technically you haven't filed yet, so your benefit keeps building until age 70 when you can get the full benefit. So, Congress might do away with that. There's been some talk of that. But they're here now, and these are things you can do now. If they take it away, then you won't be able to do it anymore. But if you're thinking about doing it, I would get it in now. That's another thing: Once they allow it, they're not going to take it back from people who've already done it. It would create a record-keeping nightmare that nobody wants.

So, I would say if you're close to a certain age where these strategies may pay for you, you may want to take advantage of them now while they're still here.

Benz: One reason you think they could be vulnerable is that they tend to be mainly the province of higher-income folks who can afford to delay Social Security and can afford to take advantage of some of these strategies.

Slott: You could say it that way; but they are more manipulative-type strategies. You're saying you're claiming, but on the other hand, not claiming for the big benefit.

Benz: Ed, it's always great to hear from you. It's great to hear your insights into these potential loophole closings. I think you've given a lot of great advice here today. We appreciate you being here.

Slott: It's great to be here. Thank you, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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