By Dr. James M. Dahle, Emergency Physician, WCI Founder
I went away to go canyoneering for a week, and I returned to find that Congress has been thinking about messing around with the Backdoor Roth IRA and Mega Backdoor Roth IRA. To make matters worse, that was only the beginning. Today we're going to talk about what's happening in Congress. While we're at it, why don't you send a message to your Congressperson expressing your thoughts about the proposed changes? I've already emailed mine (not that he would ever vote for this particular bill).
The Big Picture
The big picture is that the White House and both houses of Congress are controlled by a single party. When that happens, there is usually a significant change to the tax code. In 2017-2018, it was all controlled by Republicans, and taxes went down. In 2021-2022, it's all controlled by Democrats so we shouldn't be surprised to see taxes go back up. Democrats in Congress are very interested in spending a lot of money on what they are calling “infrastructure”. To pay for that, taxes need to be raised or deficit spending must be increased. President Biden has promised that people making less than $400,000 a year are not going to have their taxes raised. So all of the tax increases are theoretically going to be aimed at the demographic that reads this blog (i.e. high earners).
Just a Bill
While it is good to be informed and to try to make an impact on your elected representatives, be careful making any changes to your own financial plan and, especially, your estate plans until bills actually become laws. Only a small percentage of what is ever proposed actually becomes law. If you made a change every time someone proposed something, you would be whipsawed all over the place and pay lots of extra fees and taxes for zero benefit.
So unless there is a really good reason to do something right now, it's usually best to wait until the bills actually pass. Most of the time, changes are not retrospective. But retrospective taxes seem to be starting to show up from time to time these days, including at least one in this bill. See the end of this article for a few suggestions on things you may want to do before this bill passes.
What's Not Changing
There has been lots of talk in Congress and in the media about all kinds of changes. In my opinion, one of the worst proposals was to get rid of the step-up in basis at death. I think eliminating the step-up is bad policy for various reasons. Apparently, even the Democrats in Congress agree with me on this point. So that isn't in the bill.
Another proposal was to equalize capital gains and ordinary income tax rates (i.e. pay 37% instead of 20% on capital gains). Again, I think this is bad policy and the Democrats in charge of the Ways and Means Committee agree with me. That isn't in the bill either. Yet another proposed change that doesn't seem to be there is eliminating 1031 exchanges on like-kind real estate.
Increased Ordinary Tax Brackets
While the title of this post talks about potential changes to the Backdoor Roth IRA process, that's not actually the biggest deal in the bill. The biggest deal is the increased tax brackets. While politicians are saying, “We're just going back to the way it was before the Trump tax cuts,” that doesn't appear to be true at all. This is a bit nuanced, but the “top bracket” is going back to 39.6% from 37%. However, that top bracket is going to start at a taxable income of $400,000 ($450,000 married). Right now, the top bracket doesn't start until $523,600 ($628,300 married). So in reality, many people are going from 35% to 39.6%, not from 37% to 39.6%.
To make matters worse, the proposal will create a new bracket, even if it isn't called “a new bracket”. It's being called a 3% surtax. It starts at $5 million. While almost no doctors have a taxable income of more than $5 million, our new top tax bracket may be 42.6%. And yes, that's before the 0.9% Obamacare tax and the 2.9% Medicare tax and state taxes as high as 13.3% that would all still apply.
Increased Capital Gains Tax Brackets
Under this bill, many people who are currently in the 15% and all people in the 20% long-term capital gains bracket would see their LTCG tax rate increase to 25%. Basically, the 25% bracket will start at a taxable income of $400,000 ($450,000 married). Thankfully, Katie and I don't pay capital gains taxes because we don't sell anything with gains (we give appreciated shares to charity) and have many years' worth of tax losses saved up. However, this will presumably also apply to dividends, which we do get and on which we do pay taxes. Yes, the 3.8% NIIT will still apply.
QBI Deduction Changes
The qualified business income (QBI) Deduction may not be very well understood, but it's a really, really important deduction for some of us. It rivals our charitable deductions as our largest deduction. In our income situation, it's basically 20% of our ordinary business income, although it is often much less or even eliminated completely for those whose income is primarily clinical. Under the proposed changes, there would be a cap put on this deduction. The cap is $400,000 ($500,000 married). I'm not sure which would personally cost me more money—the higher tax brackets or this cap—but they're both going to hurt a lot.
NIIT Changes for S Corp Owners
To make matters worse, Congress also could be going after S Corp distributions. Right now, you don't have to pay the 3.8% NIIT tax on S Corp distributions (nor the 2.9% Medicare tax, nor the 0.9% Obamacare tax). Avoiding these taxes was the whole point of doctors forming an S Corp. Now, once your taxable income hits $400,000 ($450,000 married), you will have to pay 3.8% on S Corp distributions.
Corporate Tax Rate Increases
If you own a C Corp (and most of us do, at least via our mutual fund investments), the top tax rate there may go up from 21% to 26.5%. That potential 26.5% beats the 35% it was before, but it's going to impact your investment returns at a minimum. Most doctors haven't formed their practice as a C Corp, but there is even less incentive to do so now. Once you add on a state corporate income tax, the country's corporate income tax will again be among the highest in the world, encouraging big corporations to once more go overseas as best they can.
Death of the Backdoor Roth IRA and Mega Backdoor Roth IRA
One of the proposals would eliminate the ability to do a Roth conversion on after-tax money in retirement accounts like IRAs and 401(k)s. In effect, that means no more Backdoor Roth IRAs or Mega Backdoor Roth IRAs starting in 2022. What to do? Make sure you convert all after-tax money to Roth before the end of 2021. Then your additional savings after maxing out your other retirement accounts will probably go into taxable as non-deductible IRAs without the conversion. That's usually not an awesome deal.
Elimination of Roth Conversion for High Earners
In fact, high earners will not even be allowed to do any Roth Conversions at all under the proposed legislation, similar to how it was prior to 2010. Luckily, this provision would not go into effect until 2032. Again, the cut-off for defining high earner is a taxable income of $400,000 ($450,000 married).
Elimination of Accredited Investor Investments in Retirement Accounts
No more putting real estate syndications and private funds in your self-directed IRAs and 401(k)s. In fact, this will be a huge hit on the self-directed IRA and 401(k) industry.
New RMD Rules
If you weren't mad at Peter Thiel before, you may be now. No more $20 million-plus IRAs. Basically, if you have a high income (again, $400,000/$450,000) AND more than $10 million in retirement accounts, 50% of the amount over $10 million must come out every year and taxes must be paid. You also cannot put any more money into retirement accounts if you have more than $10 million in those retirement accounts.
There is an additional rule for Roth accounts. If you have more than $20 million in retirement accounts, the lesser of everything in Roth accounts (IRA or 401(k)) or everything over $20 million must be withdrawn.
These RMDs apply at any age, not just over 72. Luckily the 10% penalty for withdrawals prior to age 59 1/2 won't apply to these RMDs.
Defective Grantor Trust Elimination
This one is a lot more complicated to explain, but the bottom line is that this strategy (putting something in a defective grantor trust in order to get it out of your estate) is going to go away. This could also affect some irrevocable life insurance trusts. However, already existing trusts are going to be grandfathered in.
Lowered Estate Tax Exemption
Instead of being lowered in 2026, the estate tax exemption would be halved in 2022. This does create an opportunity to give a whole bunch of stuff away this year without it affecting your future exemption.
Family Limited Partnerships Become Less Useful for Estate Planning
They'll still work fine for real family businesses, but you're no longer going to get a “discount” on the value for non-business assets put in there. This technique was used to reduce estate taxes. Planning opportunity? Get those assets in before the end of 2021.
Child Tax Credit Becomes More Generous
Don't worry, many doctors will still be phased out of it! But if not, you could get as much as $3,600 per kid under 6.
Wash Sale Rules Become More Inclusive
Apparently, you could get around the wash sale rules when tax-loss harvesting cryptocurrencies and commodities and foreign currencies. Previously, they only applied to stocks and mutual funds. That will probably change.
What Should You Do About All This?
Overall, this bill should be very concerning for any high earner. You're almost surely going to be paying more taxes. However, there are a few opportunities with a deadline to be thinking about. Let's recap them:
- Get your Backdoor Roth IRA completed before the end of the year.
- Get your Mega Backdoor Roth IRA completed before the end of the year.
- Convert any other after-tax money in retirement accounts to Roth this year.
- If you want a defective grantor trust or irrevocable life insurance trust, get it before the end of the year.
- Get any nonbusiness assets you want in your FLP before the end of the year.
- Don't bother tax-gain harvesting. It sounds like LTCG rate changes will be retroactive.
- Remember that this is just a bill. The final law will likely be very different.
What do you think about this proposal? What, if anything are you planning to do about it? Comment below!