Revised May 15, 2006
PROVISION IN TAX CUT BILL EFFECTIVELY
ELIMINATES INCOME LIMITS ON ROTH IRAS
Establishes Major New Tax Shelter for High-Income Households
By Aviva Aron-Dine and Robert Greenstein
The tax reconciliation bill conference agreement
gives the appearance of retaining the current income limits on who can make
contributions to Roth IRAs. In reality, however, the legislation changes the
Roth IRA rules in a way that effectively eliminates the income limits on these
contributions. As a result, all income limits on the use of Roth IRAs would
in effect be dismantled by the legislation.
[1]
Currently,
taxpayers may not convert traditional IRAs into Roth IRAs if their incomes
exceed $100,000 and may not contribute to Roth IRAs if their incomes exceed
$160,000 (for married couples filing jointly) or $110,000 (for singles and heads
of household). Households may contribute to non-deductible traditional IRAs,
however, regardless of their income level.
The reconciliation bill conference agreement
would eliminate the income limits on Roth IRA conversions starting in 2010,
while leaving the income limits on Roth IRA contributions in law. But by
lifting the income limits on conversions, the conference agreement provision
effectively eliminates the income limits on contributions to Roth IRAs as well,
by making possible a two-step process that circumvents those limits.
High-income households first would be able to contribute several thousand
dollars every year to a non-deductible traditional IRA, for which there is no
income limit. Then, starting in 2010, they could convert their non-deductible
IRAs to Roth IRAs.
Consider a
married couple with income above the $160,000 Roth IRA contribution limit. Each
year, beginning in 2006, the couple could contribute $8,000 to a non-deductible
traditional IRA.
[2] The amount that the couple could
contribute would rise to $10,000 a year in 2008 and increase with inflation
thereafter (assuming the pension provisions of the 2001 tax cut are made
permanent, as they very likely will be). Then, beginning in 2010, the couple
would be able to “roll over” the amount that had accumulated in its
non-deductible IRA into a Roth IRA (paying tax only on the returns the IRA
account had earned to that point), and all earnings on the Roth IRA from that
point forward would be forever tax free.
Moreover, in every year after 2010, the couple
could deposit $10,000 in a non-deductible IRA, roll over these funds into its
Roth IRA the very next day, and pay no tax on the amount converted (since the
conversion would be from a non-deductible IRA containing contributions made with
after-tax dollars). This process could be repeated every year. Over time, the
couple could build its tax-protected Roth IRA to a very substantial level, with
the account being permanently sheltered from taxation.
It is in large part because of this rather
stunning aspect of the Roth IRA provision that it ultimately would carry a
significant cost. The Joint Committee on Taxation’s official cost estimate of
the conference agreement shows that this provision will raise about $6.4 billion
through 2015. But the Urban Institute-Brookings Institution Tax Policy Center,
while concurring with the Joint Tax Committee’s estimate for the period through
2015, projects that the provision will lose $100 billion through 2049.
(The projected loss through 2049 equals between $14 billion and $15 billion in
“net present value;” this represents the amount that, if set aside today and
allowed to collect interest for the next 45 years, would offset the cost of this
tax cut.) The TPC estimate also indicates that roughly two-thirds of this
revenue loss, measured in net present value, would be due to the effective
elimination of the income limits on contributions to Roth IRAs.
Moreover, TPC Director Leonard Burman points out
that “these revenue estimates may turn out to be wildly optimistic”[3]
— that is, the provisions could cost substantially more than this. First, these
estimates assume that the pension provisions of the 2001 tax cut, which raised
contribution limits for IRAs, are allowed to expire. Virtually all observers
expect that these provisions will be extended. If they are, this will increase
substantially the cost of the new Roth IRA provision. In addition, larger
revenue losses are likely if financial firms heavily advertise and promote the
new option for high-income households to place funds in non-deductible IRAs and
then roll the funds over immediately into a Roth IRA.
End Notes:
[1] For a more detailed discussion of the
issues addressed here, and for the Tax Policy Center’s detailed revenue
estimates, see Leonard E. Burman, “The IRA Conversion Provision in the 2006 Tax
Reconciliation Bill: Smoke and Mirrors,” Tax Policy Center, May 11, 2006,
http://www.taxpolicycenter.org/publications/template.cfm?PubID=9736.
[2] For purposes of this example, the
couple is assumed to have no other traditional IRA accounts.
[3] Burman, op cit. |