2021 could be the year of the Roth IRA. The Biden administration has made it clear that it intends to raise income taxes and the capital gains rate for the wealthy. The Biden capital gains tax increase could steer more investors towards the tax-free gains of the Roth. What is the proposal and what should investors be prepared for?
Biden Capital Gains Tax Proposal
President Joe Biden has proposed almost doubling the capital gains tax rate for wealthy individuals earning over $1 million dollars from 20% to 39.6%. This means the federal tax rates for some investors could be as high as 43.4%; the top federal capital gains rate would go from 20% to 39.6% for amounts over $1 million. A 3.8% net investment tax for those making more than $200,000 ($250,000 married filing jointly) per year would effectively bring the top rate to 43.4%! In addition, wealthy residents in New York and California can expect to pay a capital gains tax rate of over 50% because of the state income tax on capital gains investments.
According to an article in Fortune, “the proposal could reverse a long-standing provision of the tax code that taxes returns on investment lower than on labor.” The big winner if this proposal passes is the Roth IRA.
What is the Roth IRA?
The Relief Act of 1997 introduced the Roth IRA. The Roth IRA is an after-tax IRA which allows any US person with earned income under a set income threshold to make after-tax contributions up to $6,000 (or $7,000 if at least age 50) for 2021. The income limits for 2021 are under $140,000 if single or $208,000 if married and filing jointly. So long as any Roth IRA has been opened at least five years and the account holder is at least age 59 1/2, all Roth IRA distributions would be tax-free.
Further, the Roth IRA does not have required minimum distributions. You never have to withdraw from the account unless you need to. In other words, if you made an investment into any capital asset, such as stocks, real estate, and even cryptos, all gains would be tax free. You would be able to pull money out of the Roth IRA tax free if you are over the age of 59 1/2 and the Roth has been opened at least five years.
As a bonus, all contributions made to a Roth can be withdrawn at any time, for any reason. There is no early distribution penalty and no taxes to be paid. However, if you pull any earnings early, you will get hit with taxes and a 10% penalty.
If a 62 year old bought Tesla stock in 2020 and wished to sell it in 2021 after twelve months and had over $300,000 in gains. The gains would be subject to a capital gains tax rate of 15% (or 20% if the individual has income over approx. $496,000), plus a s 3.8 percent net investment tax for individuals with modified adjusted gross income over $200,000.
Whereas, if the individual owned the Tesla stock in a Roth IRA all gains would be tax-free. Moreover, if the individual sold the stock after the Biden proposal passed and has more than a $1 million in earnings, the individual could owe over 50% tax on the Tesla gains depending on what state they resided in. The same tax principles would apply to whether the individual owned real estate or even cryptocurrencies.
Funding a Roth IRA
There are three ways one can fund a Roth IRA: (i) contributions, (ii) rollovers, or (iii) Roth conversions.
- Roth IRA contributions. For 2021, one can contribute up to $6,000 or $7,000 if age 50+. Note – only individuals with income below $140,000, if single, or $208,000, if married filed jointly, can make Roth IRA contributions. However, there is a legal work-around. Since 2010, there is no longer any income limitations on conversions. Enter the Backdoor Roth IRA conversion strategy. Now, one who earns more than the Roth IRA income limitations, can make an after-tax IRA contribution and then immediately convert to Roth. There would be no tax on the conversion from after-tax to Roth, although, if the individual had other pretax IRAs at the time of the conversion, the amount converted to Roth could be limited based on the pro rata conversion requirement.
- Rollovers. One can rollover a Roth IRA between different institutions, as well as Roth 401(k) funds into a Roth IRA. Rollovers from one Roth to another are not taxable events.
- Roth IRA conversions. One can convert pretax IRA assets to a Roth IRA. Income tax would be due on the amount of the Roth IRA conversion. Depending on the taxpayer’s age, ability to pay the tax, long-term investment expectations, Roth IRA conversions can become a popular retirement tax planning tool if the Biden capital gain proposal passes.
In sum, if the capital gains tax rate is significantly increased as proposed by President Biden, I expect the Roth IRA to become an extremely popular retirement and tax planning tool for the wealthy. Roth conversions will also become a very widely used strategy to attempt to evade the capital gains tax, especially during bear markets.
Overall, The Roth IRA will become the best legal tax shelter for the wealthy. We have already seen a number of wealthy investors begin to explore ways to get more out of their savings and investments in a Roth IRA and I believe this trend is just beginning. This is especially true of savvy investors looking to take advantage of the hot alternative asset market, by sheltering all their future gains from tax with a Self-Directed Roth IRA or Roth Solo 401(k) plan.