Free-standing Roth individual retirement accounts and annuities (IRAs) are subject to less stringent distribution rules than employee benefit plans or other IRAs. It seems appropriate to harmonize the Roth IRA distribution rules with those of all other retirement vehicles in concert with the current Congressional proposals to:
- use Roth IRAs to provide more retirement savings opportunities to those with inadequate retirement resources, and
- compel individuals whose employee benefit plans and IRAs, including Roth IRAs, have large balances to distribute excess balances.
In order to encourage retirement savings, income tax incentives are provided to employee benefit plans, including 401(k) plans, 403(a) plans, 403(b) plans, 457(b) plans, and to their participants and beneficiaries. It would be reasonable to make such incentives available only if annual plan benefit distributions must begin when a participant retires, and the amounts must be sufficient to expect to liquidate the participant’s accounts by the first year in which both the participant and the participant’s spouse, if any, have died. It would also be reasonable to require that if a participant’s account were not liquidated by the end of such year, the account must be liquidated soon after the end of such year.
If such requirements were not in place, the retirement tax incentives would be more focused on post-death planning rather than on retirement savings. Their absence would further exacerbate the wealth and racial inequities that result from the current retirement tax incentives.
Retirement tax incentives, in fact, are only available if employee benefit plans meet those rules with slight modifications. Tax code Sections 401(a)(9), 403(b)(10), 404(a)(2), and 457(d)(2). In particular, those plans qualify for income tax exemptions.
First, lifetime distributions may be made to certain dependents of the participant—called eligible designated beneficiaries—for more than a brief number of years. Section 401(a)(9)(E)(ii). This provision recognizes that retirees often support individuals other than their spouses.
Second, those annual distributions need not begin immediately following a participant’s retirement but must begin on or before the April 1 of the calendar year after the participant attains the age of 72. Section 401(a)(9)(C)(i). This provision recognizes that some individuals who retire early need not access their retirement plan assets immediately, but will do so when they reach a broadly accepted retirement age, such as 72, which is two years after the age when an individual may obtain the individual’s maximum Social Security benefits.
Third, a participant who owns at least 5% of the plan sponsor must begin annual distributions on or before the April 1 of the calendar year after attaining the age of 72. Section 401(a)(9)(C)(ii). Presumably, this last modification is made because the participant’s sponsor control makes it difficult to determine if the participant has retired and thus is able to avoid ever taking any “retirement benefits,” despite having retired many years before the participant’s death.
Traditional IRAs and Roth-designated accounts that are part of 401(k) plans, 403(b) plans, or 457(b) plans are all subject to the above tax qualification rules, called the “required minimum distribution (RMD) rules.” Free-standing Roth IRAs are subject to the same RMD rules after the death of the participant and the participant’s spouse, if any. It makes sense to treat IRA participants’ accounts in the same manner as accounts of 5% owners of sponsors of employee benefit plans, and require annual distributions once the participant attains age 72, because in both cases it is difficult to determine when the owner retires. This is the case for traditional IRAs. Free-standing Roth IRAs, unlike designated Roth accounts in a 401(k) plan, however, need make no participant distributions.
The failure to require lifetime distributions from all Roth IRAs is inconsistent with the thrust of the recent Ways and Means proposal to encourage more retirement savings. On Sept. 9, Rep. Richard Neal (D-Mass.), the Chair of the Ways and Means Committee, declared that the new proposal—to require many employers who lack retirement plans to establish and automatically enroll employees in IRAs or simple 401(k) plans and enhance savings tax credits for participants in such plans—would “dramatically expand retirement savings in the United States” and “address inequities in retirement savings.” The automatic IRA contributions by default would go into Roth IRAs. The savings credits for low-income employees would have to be paid into a Roth IRA. Budget Reconciliation Legislative Recommendations Relating to Retirement (Sept. 9. 2021).
These provisions make no sense unless one expects the Roth IRA participants, like the traditional IRA participants, to use the IRA benefits for their retirement purposes, i.e., they would expect to withdraw funds during their own lifetime and that of their spouse, if any. Requiring lifetime distributions from both accounts would reinforce the retirement savings message. Moreover, permitting different distribution rules to apply to the different kinds of IRAs introduces undue complexity into the employee’s decision of which IRA to choose as the employee’s retirement vehicle for automatic contributions.
The failure to require lifetime distributions from all Roth IRAs is also inconsistent with the thrust of the recent Ways and Means proposal to prevent taxpayers from continuing to obtain tax incentives to the extent their tax-favored retirement vehicles have funds that are far in excess of their retirement needs.
If a high-income taxpayer has at the end of a calendar year an aggregate balance in applicable retirement plans, which include both traditional and Roth IRAs, in excess of $10 million, a portion of the excess must be distributed in the following year or be subject to the same 50% penalty that is imposed to the extent a taxpayer now fails to withdraw RMDs. The portion depends on whether the aggregate balance exceeds $20 million and to the extent to which the excess is attributable to IRA balances. Why take into account Roth IRAs when determining the required excess balance distributions during the participant’s lifetime, but disregard Roth IRAs when determining the participant’s lifetime RMDs? Distributions in both cases would focus retirement tax incentives on retirement savings.
In conclusion, Congress is now considering how to better implement the commonsense principle that tax incentives that are intended to encourage retirement savings must focus on retirement savings. Subjecting all Roth IRAs to the same required distribution rules that now govern all other tax-favored retirement vehicles, including Roth-designated accounts in 401(k) plans, would do so. Such harmonization would permit Congress to make more funds available in the long-term to encourage retirement savings, such as larger savings credits to low-income tax payers who make contributions to tax-favored retirement plans.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Albert Feuer is the principal attorney in the Law Offices of Albert Feuer, Forest Hills, N.Y. The firm focuses on employee benefits, executive compensation, estate planning and administration, and related tax issues.
Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.
Albert Feuer © 2021
Albert FeuerLaw Offices of Albert Feuer
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