There are plenty of tips and tricks to maximizing your retirement benefits, and more than a few are considered “loopholes” that taxpayers have been able to use to circumvent the letter of the law in order to pay less to the government.
But as often happens when too many people make use of such shortcuts, the government may move to close three retirement loopholes that have become increasingly popular as financial advisers have learned how to exploit kinks in the law.
1. 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.
Congressional gridlock, though, means action is not likely until the next administration takes over, said financial planner and enrolled agent Francis St. Onge with Total Financial Planning in Brighton, Michigan. He doubts any tax change would be retroactive, which means the window for doing back-door Roths is likely to remain open for awhile.
“It would create too much turmoil if they forced people to undo them,” says St. Onge.
2. The Stretch IRA
People who inherit an IRA have the option of taking distributions over their lifetimes. Wealthy families that convert IRAs to Roths can potentially provide tax-free income to their heirs for decades, since Roth withdrawals are typically not taxed.
That bothers lawmakers across the political spectrum who think retirement funds should be for retirement – not a bonanza for inheritors.
“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.
3. “Aggressive” Strategies for Social Security
Obama’s budget also proposed to eliminate “aggressive” Social Security claiming strategies, which it said 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. “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.”