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How a middle-class retirement plan became a tax dodge for the rich

House Democrats unveil new tax plan
House Democrats unveil plan to increase taxes for corporations and wealthy Americans 06:29

The Roth IRA was designed more than two decades ago as a way for middle-class workers to set aside money for retirement. People earning less than $95,000 at the time could sock money away, then let it grow tax-free until they retired, when they could make withdrawals without owing taxes.

"I wanted to make these IRAs available to many, many people," Senator William Roth, who worked on the retirement plan's design, said when Roth IRAs debuted in 1998. 

Since then, Roth IRAs have indeed been used by millions — including some of America's wealthiest citizens, a far cry from the middle-income worker for whom the retirement plan was designed. But that may soon come to an end if Democratic lawmakers are successful in passing their budget reconciliation proposal. That effort includes a provision that would close a loophole that now allows wealthy people to sidestep the income limits on Roth IRAs.

That strategy, while legal for now, is viewed by critics "as a way to beat the system to avoid paying taxes," said Charisse Mackenzie, president of Saturn Wealth, a Gilbert, Arizona-based financial advisory firm.

Democratic lawmakers are taking aim at the wealthy and corporations with proposals to boost taxes on both groups, part of a strategy to fund their $3.5 trillion plan to bolster social safety-net programs. That approach includes cracking down on tax avoidance and evasion by the rich.

Two tax codes

The Roth IRA loophole allows investors to avoid paying taxes on investment gains accrued over years and even decades. That can provide a huge benefit since participants in traditional IRAs must pay ordinary income tax on their gains once they withdraw the money. 

The loophole is now facing increased scrutiny after ProPublica recently reported that PayPal co-founder Peter Thiel tapped a Roth IRA to amass a $5 billion fortune. Because of the Roth IRA's tax structure, Thiel won't have to pay tax on that $5 billion as long as he keeps it in the plan until he turns 59 and a half in 2027, according to the investigative journalism outfit.

Thiel isn't the only wealthy person who has tapped Roth IRAs to grow fortunes virtually tax-free. Almost 500 taxpayers held at least $25 million each in their Roth IRAs in 2019 — up from about 300 taxpayers in 2011, according to data compiled by the Joint Committee on Taxation in July and the Government Accountability Office. 

By comparison, the typical Roth IRA saver has far less than that stashed in their account. The average balance stands at less than $49,000, while the typical annual contribution to either Roth or traditional IRAs is about $3,900 per year, according to the Employee Benefit Research Institute. 

The data tell a "tale of two tax codes," said Senate Finance Committee chair Ron Wyden, a Democrat from Oregon, in a July statement about the Joint Committee on Taxation's findings. "IRAs were designed to provide retirement security to middle-class families, not allow the super wealthy to avoid paying taxes."

By design, the Roth IRA is geared toward modest annual contributions by middle-income workers. To that end, the retirement plan has income and contribution limits — for instance, young single workers who earn less than $125,000 are eligible to save up to a maximum of $6,000 in after-tax dollars in a Roth IRA, according to IRS regulations

Because of their pay-taxes-now, avoid-taxes later feature, Roth IRAs are often recommended to young workers who expect to be in higher tax brackets as they get older and their incomes rise. 

Backdoor loophole

So how are wealthy taxpayers able to squirrel away millions in these modest plans? That's partly due to a loophole called the "backdoor" Roth IRA. 

People who earn above the income cutoffs for Roth IRAs — about $200,000 for married couples — can use this strategy to access the accounts. It works by allowing investors with a traditional IRA to convert some of those funds into a Roth IRA, even if they earn over the income threshold for contributing to a Roth account. 

Investors who use a backdoor Roth IRA must pay income tax on the money they converted into a Roth, because only after-tax money can be put into these accounts. But the assets can grow tax-free until the investors withdraw funds without penalties after they turn 59 and a half.

While regular backdoor Roth conversions are limited to $6,000 per year, there's also another type of conversation called a "mega backdoor" Roth that allows people to convert up to $38,500 from their 401(k)s into a Roth IRA. However, people must work at companies with 401(k) programs that allow mega-backdoor conversions, with the Wall Street Journal reporting that between 20% to 30% of 401(k) plans allow the practice.

Wealthy investors can use backdoor Roth IRAs to stash valuable stocks, like Tesla or Apple, or even to sock away pre-IPO shares that owners believe could eventually appreciate in value. For high-income workers who expect those assets will appreciate — or that they'll be in a higher tax bracket once they hit 59 and a half — it's a lucrative tax strategy. 

"How the law works"

"For tax guys like me, that's brilliant," said Rob Cordasco, founder of Cordasco & Company and a CPA. "There is nothing illicit, illegal — it's how the law works."

While these strategies may be legal, they are coming under fire because of the perception that they allow the wealthiest taxpayers to build their assets virtually tax-free. Interestingly, Thiel didn't actually use the backdoor Roth IRA conversion. Instead, because he earned less than $74,000 the year that he started his Roth IRA, below the income threshold at the time, he could open a Roth IRA, ProPublica reported.

But he used the Roth IRA to buy shares of his startup, which would later become PayPal and wasn't yet publicly traded. Thiel paid $0.001 per share to purchase 1.7 million shares — a sweetheart deal, according to ProPublica. Within a year, the value of his Roth IRA jumped from $1,700 to almost $4 million, the publication reported. That's a strategy that most investors aren't able to tap into, since they don't have access to shares in private companies or special pricing.

Some lawmakers say such strategies are gaming the system in favor of the rich while robbing the federal government of tax revenue. 

Biden goes after corporations, wealthy in speech on economy 16:32

The proposal by Democratic lawmakers would inhibit the use of Roth IRAs by the rich in two ways. First, all Roth IRA conversions would be banned starting in 2032 for single taxpayers who earn more than $400,000 and married taxpayers with incomes over $450,000. On top of that, the "mega" backdoor Roth IRA conversion would be banned starting in January 2022. 

To be sure, that means wealthy investors could use the regular Roth conversion strategy until 2032. After that, as an example, married taxpayers who earn between the Roth IRA income limit of $200,000 and the new restriction of $450,000 could still use a backdoor conversion. But taxpayers above that $450,000 limit would be cut off from Roth conversions. 

Second, the proposal takes aim at retirement accounts with assets of more than $10 million. Investors with more than that amount in a traditional or Roth IRA would be required to take a withdrawal of 50% of the assets above that $10 million. Investors with more than $20 million would be required to withdraw as much as needed to bring down the balance to $20 million. 

Of course, these latter rules would only impact a group of rarified investors, since about 3,600 people have more than $10 million invested in either a Roth or traditional IRA, according to data from the Joint Committee on Taxation. If enacted, the plan would hinder some wealthy investors from using the strategy. But it could also make it harder for some upper-income workers who have relied on Roth conversions to sock away money, experts said.

"The main impact for the backdoor is for those earning between $200,000 and maybe $1 million, somewhere in that range, that are still looking to save for retirement," Cordasco said. Eliminating the backdoor strategy could make it "harder for someone like that to put away more money."

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