When the election hoopla is finally behind us and Congress begins working with a new president, a recurring theme, i.e., tax simplification, will be on the agenda. Simplification of the rules and regulations pertaining to IRAs to put them on par with 401(k) plans is much needed and long overdue.
Retirement Plan Discrimination
The retirement system in the United States discriminates in favor of those who have access to 401(k) plans. Based on recent statistics that less than 50% of businesses with fewer than 100 employees offer 401(k) plans, ironic as it is, there are millions of individuals who are unable to accumulate meaningful savings for retirement in a retirement plan.
Unless you participate in a 401(k) plan, IRS rules limit your ability to make deductible contributions to traditional IRAs and nondeductible contributions to Roth IRAs. Even when contributions are permitted, the maximum allowable amounts are a fraction of 401(k) plan limits.
Two changes are needed to enable all individuals who aren’t participants in 401(k) plans to (a) contribute to the IRA of their choice and (b) accumulate a nest egg in a retirement plan comparable to what’s possible with a 401(k):
- Eliminate income testing for traditional and Roth IRAs
- Create a universal 401(k)/IRA contribution limit
Eliminate Income Testing for Traditional and Roth IRAs
Unlike a 401(k) plan, the ability to make deductible contributions to a traditional IRA and nondeductible contributions to a Roth IRA is subject to income testing based on modified adjusted gross income (MAGI). The income thresholds for making partial or fully deductible traditional IRA contributions and for calculating allowable Roth IRA contribution amounts vary depending upon tax filing status.
The rules are more complicated for making deductible contributions to traditional IRAs since participation in a retirement plan at work also comes into play. Furthermore, even if you aren’t covered by a retirement plan at work, you’re prohibited from making a deductible IRA contribution if you’re married and file jointly and your MAGI is $194,000 or more.
Income testing needs to be eliminated so that fully deductible contributions to a traditional IRA and nondeductible contributions to a Roth IRA can be made. Whether you’re single or married, you would be able to make contributions to both types of plans.
Create a Universal 401(k)/IRA Contribution Limit
As previously stated, IRA contribution limits are a fraction of 401(k) contribution limits. Per the 2002 – 2016 IRA and 401(k) Contribution Limits table, the disparity, which was $8,000 in 2002 for individuals under age 50, has increased to $12,500 if you’re under 50 and $17,500 if 50 or older.
Historical IRA contribution limits, as well as increases in those limits, have paled in comparison to 401(k)s. The maximum allowable contribution for IRAs, which was $3,000 (under age 50) or $3,500 (50+) in 2002, has increased by $2,500 and $3,000, respectively, to $5,500 and $6,500, respectively, as of 2016. 401(k) plan contribution limits, on the other hand, have increased from $11,000 to $18,000 and from $12,000 to $24,000 for under age 50 and age 50+ participants, respectively, during the same timeframe.
A universal 401(k)/IRA contribution limit is needed in order to equalize the playing field. Using the current 401(k) plan limits, subject to earned income, everyone would be able to make pretax contributions to traditional 401(k) plans and traditional IRA accounts and/or after-tax contributions to Roth 401(k) plans and Roth IRA accounts up to $18,000 if under age 50 or $24,000 if 50 or older in any calendar year with provision for inflation increases.
For those inclined to do so, the ability to make after-tax contributions of up to $35,000 a year that applies to 401(k) plans, should also be extended to traditional IRA accounts in order to achieve true contribution parity.
Consequences of Proposed Changes
The proposed changes, like all tax changes, would have various consequences. Six of the more significant ones are as follows:
1. Nondeductible IRA contributions and accounting would be eliminated in most cases.
With the demise of income testing, all contributions to a traditional IRA up to $18,000 or $24,000, as applicable, would be deductible in full. This would phase out and eventually eliminate the current onerous requirement of keeping records of nondeductible IRA contributions that are required to calculate taxable amounts of IRA distributions, with the exception of after-tax contributions in excess of the $18,000 and $24,000 limits.
2. More 401(k) plans will offer a Roth option.
Employers that currently have a 401(k) plan without a Roth option will be more inclined to add this alternative so that employees won’t need to contribute to private Roth IRAs.
3. More 401(k) plans will offer after-tax contributions.
Similar to #2, employers that currently have a 401(k) plan with no after-tax contribution provision will be more likely to add this option to compete with traditional IRAs.
4. SEP-IRA accounts wouldn’t be as prevalent.
If you’re self-employed and have a SEP-IRA, you can make deductible contributions up to the lesser of 25% of compensation or $53,000. Unless your net self-employment income exceeds $96,000 if you’re less than 50 or $129,000 if 50 or older and you have the funds to make larger contributions, the universal 401(k)/IRA contribution limits of $18,000 (less than 50) and $24,000 (50+) would be sufficient to meet your needs.
5. Solo 401(k) plans would generally be unnecessary.
As an alternative to a SEP-IRA, self-employed individuals are allowed to set up solo 401(k) plans that essentially duplicate the features and benefits available with 401(k) plans that are used by companies with hundreds of employees. With the exception of potential creditor protection under state law, solo 401(k) plans and their associated administration requirements would be unnecessary with the proposed rule changes.
6. 401(k) plan participants may choose to contribute to traditional and Roth IRAs.
401(k) plan participants may choose in some cases to allocate a portion or all of their contributions to a traditional and/or Roth IRA in order to achieve greater investment diversification, including access to fixed income annuities. While most 401(k) plans have a large number of investment choices, they’re typically limited compared to IRAs.
Tax Simplification and Level Retirement Playing Field
The two proposed changes, which are much needed and long overdue, would achieve IRA-401(k) contribution parity. If enacted, they would be a significant step toward simplifying tax law pertaining to retirement plans while providing non-401(k) plan participants with an opportunity to accumulate sizable nest eggs in a retirement plan which isn’t possible today with traditional and Roth IRA contributions.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.