There are plenty of tricks to maximizing your retirement benefits, and more than a few are considered “loopholes” that taxpayers have been able to utilize in order to pay less to the government. However, as often happens when too many people (in the eyes of the government) make use of such shortcuts, the government seeks to block taxpayers effort to tax advantage of those shortcuts.
Back-door Roth IRA conversions
The U.S. Congress created this particular loophole by lifting income restrictions from conversions from a traditional Individual Retirement Account (IRA) to a Roth IRA, but not listing these restrictions from the contributions to the accounts.
People whose incomes are too high to put after-tax money directly into a Roth, where the growth is tax-free, can instead fund a traditional IRA with a nondeductible contribution and shortly thereafter convert the IRA to a Roth.
Taxes are typically due in a Roth conversion, but this technique will not trigger much, if any, tax bill if the contributor does not have other money in an IRA.
President Obama’s 2016 budget proposal suggests that future Roth conversions be limited to pre-tax money only, effectively killing most back-door Roths.
However, the gridlock in Washington makes it unlikely that such a change will not happen until the next administration takes over or some type of “grand bargain” budgetary deal is struck. It is also doubtful that any tax change would be retroactive, which means the window for doing back-door Roths is likely to remain open for at least a little while.
The Stretch IRA
People who inherit an IRA or other qualified account (i.e. – 401(k)) have the option of taking their “require minimum distributions” (the amount the IRS forces you to take out each year) from such accounts over their lifetimes. Although the rules are complex, the beneficiaries of a retirement account have the right to take their required minimum distributions based upon their life expectancy, not the life expectancy of the person from whom they inherited the account. Even better, surviving spouses, have the right to rollover such retirement accounts into their own name and wait until they are 70 ½ years old before they have to take out anything from such accounts.
In addition, under current laws, taxpayers have the ability that convert IRAs to Roths and potentially provide tax-free income to their heirs for decades, since Roth withdrawals are typically not taxed.
Both of the above rules, amongst others relating to retirement accounts, bother lawmakers across the political spectrum who think retirement funds should be for retirement – not a “windfall” (theirs words not mine) for beneficiaries who inherit them. The IRS wants to get its pound of flesh sooner not later.
“Congress never imagined the IRA to be an estate-planning vehicle,” said Ed Slott, a certified public accountant and author of “Ed Slott’s 2015 Retirement Decisions Guide.” Most recent tax-related bills have included a provision to kill the “Stretch IRA” and replace it with a law requiring beneficiaries other than spouses to withdraw the money within five years.
Anyone contemplating a Roth conversion for the benefit of heirs should evaluate whether the strategy makes sense if those heirs have to withdraw the money within five years, Slott said.
“Aggressive” strategies for Social Security
Obama’s budget also proposed to eliminate so-called “aggressive” Social Security claiming strategies, which the administration says allow upper-income beneficiaries to manipulate the timing of collection of Social Security benefits in order to maximize delayed retirement credits.
Obama did not specify which strategies, but retirement experts said he is likely referring to the “file and suspend” and “claim now, claim more later” techniques.
Married people can claim a benefit based on their own work record or a spousal benefit of up to half their partner’s benefit. Dual-earner couples may profit by doing both. People who choose a spousal benefit at full retirement age (currently 66) can later switch to their own benefit when it maxes out at age 70 – known as the “claim now, claim more later” approach that can boost a couple’s lifetime Social Security payout by tens of thousands of dollars.
The “file and suspend” technique can be used in conjunction with this strategy or on its own. Typically one member of a couple has to file for retirement benefits for the other partner to get a spousal benefit.
Someone who reaches full retirement age also has the option of applying for Social Security and then immediately suspending the application so that the benefit continues to grow, while allowing a spouse to claim a spousal benefit.
People close to retirement need not worry,” said Boston University economist Laurence Kotlikoff, who wrote the bestseller Get What’s Yours: The Secrets to Maxing Out Social Security. “I don’t see them ever taking anything away that they’ve already given,” Kotlikoff said. “If they do something, they’ll have to phase it in.”