Last week, President Obama released his proposed government budget for the coming 2014 fiscal year. Of course, the reality is that the budget itself is just proposed and has not yet been approved, and many of the suggestions contained in the budget may be reformed before being set forth in actual legislation (or fall by the wayside entirely, or be written into legislation that ultimately doesn't pass). Nonetheless, proposals in the President's budget often signal areas that the Administration may be targeting for reform, and/or line items that could end out as a bargaining chip in future legislation.

In the 2014 budget, the Administration reiterates several reforms that have been suggested in the past, including an array of high-net-worth estate planning crackdowns, and even a reversion back to the 2009 estate tax exemption and rates. However, the proposal also includes several notable new provisions, including a potential tax credit for establishing automatic enrollment retirement plans, a shift to chained CPI that could impact everything from Social Security benefits to income tax brackets to the return on TIPS, a series of estate planning crackdowns on GRATs, IDGTs, and dynasty trusts, and in what has already been picked up by the media as a controversial provision, a potential "cap" of $3.4 million on retirement accounts beyond which no further contributions would be allowed.

In addition, surprising new proposals outside of gift and estate planning were included, including favorable relief allowing inherited IRA rollovers and an extension to the tax-free treatment of mortgage debt cancelling in a short sale, and the elimination of Required Minimum Distributions for those with less than $75,000 in retirement accounts. On the other hand, the proposals also include an increase to Medicare Part B and Part D premiums, especially for higher income individuals, a potential cap on itemized deductions at a 28% tax rate (even if the individual has a higher tax bracket), and a new requirement that all stocks in the future must use average cost (eliminating the ability to make lot-level gain and loss harvesting decisions).  

The reality at this point is that information and details on many of these provisions are still limited; nonetheless, we highlight all of the most important proposals that would impact financial planners and their clients, and consider their feasibility and the potential planning implications. 


$3 Million IRA Cap

The proposal for "a $3 million cap" on IRAs is part of the budget section "Strengthening The Middle Class And Making America A Magnet For Jobs" and the summary reads as follows:

Prohibit Individuals from Accumulating Over $3 Million in Tax-Preferred Retirement Accounts. Individual Retirement Accounts and other tax-preferred savings vehicles are intended to help middle class families save for retirement. But under current rules, some wealthy individuals are able to accumulate many millions of dollars in these accounts, substantially more than is needed to fund reasonable levels of retirement saving. The Budget would limit an individual’s total balance across tax-preferred accounts to an amount sufficient to finance an annuity of not more than $205,000 per year in retirement, or about $3 million for someone retiring in 2013.

A slightly more expanded version of the explanation from the budget details is:

Limit the total accrual of tax-favored retirement benefits. The Administration proposes to limit the deduction or exclusion for contributions to defined contribution plans, defined benefit plans, or IRAs for an individual who has total balances or accrued benefits under those plans that are sufficient to provide an annuity equal to the maximum allowable defined benefit plan benefit. This maximum, currently an annual benefit of $205,000 payable in the form of a joint and survivor benefit commencing at age 62, is indexed for inflation, and the maximum accumulation that would apply for an individual at age 62 is approximately $3.4 million. The proposal would be effective for taxable years beginning after December 31, 2013.

As written above - and confirmed in a further explanation from the Treasury Green Book - the currently proposed implementation of the rule would not actually force money out of retirement plans over the cap; it would merely prevent new contributions to the plan. If the end-of-prior-year balance exceeded the threshold, the maximum contribution for the current year would be $0, and any contributions would have to be unwound under the "normal" rules that apply to excess contributions above the maximum limits. On the other hand, if the account dipped below those levels, contributions would again be permitted. Think of it as though your retirement accounts were a partially funded pension account; in a similar manner, you can add contributions when it's underfunded, but have to stop once it's fully funded, and then can add again if market declines cause it to be underfunded again.

Notably, the proposal actually suggests the cap would apply across all tax-preferred accounts - and by tax-preferred (as opposed to tax-deferred), would impliedly cover all types of retirement plans, from IRAs to 401(k)s and including both traditional and Roth accounts (which both fall into the category of "tax-preferenced" either by being tax-deferred or being tax-free). Account balances across all plans would need to be aggregated to determine if the individual is over the cap.

The details also reveal that the $3.4 million cap itself is based not on an arbitrary account balance, but the estimate of the amount of money that would purchase an annuity of $205,000/year for a retiree (the $205,000 amount is the IRC Section 415 limit on the maximum Defined Benefit pension amount, as indexed for inflation in 2013).

Notably, though, converting a $205,000/year annuity amount into an estimated lump sum equivalent is difficult, as it is sensitive to interest rates and annuity pricing; for instance, according to ImmediateAnnuities.com, an annuity of $17,083/month (which is $205,000 per year) costs just under $3.3M for a 62-year-old male, is $3.45M for a 62-year-old female, is over $3.7M for a married couple, and is over 3.8M if the couple wants a 20-year period certain. On the other hand, an initial response by the Employee Benefit Research Institute on the impact of a retirement savings account cap notes that as recently as 2006, the actuarial equivalent of a $205,000 annuity was only $2.2M, not $3M+. And if longevity increases significant, it may also turn out that all these amounts are too low, at least until the annuity mortality tables are updated. In addition, it's notable that the $3M cap is estimated based upon how much it would take to buy an annuity for $205,000; if an individual preferred the flexibility of a 4% safe withdrawal rate approach, the necessary cap would be $5,125,000 instead, some of which would have to be accumulated with outside assets if this proposal were implemented.

Given that the new rules would simply prevent new contributions for those over the cap, it's unlikely there will be able grandfathering provisions; if the client's retirement accounts add up to more than the threshold amount, their ability to make new contributions will drop to $0. On the other hand, it's not entirely clear how that will be effectively tracked, as technically this means a large IRA would even prevent 401(k) contributions, even though an employer has no legal right to ask how much money you have invested outside the plan. It may be that all account balances are simply reported to the IRS, which separately determines if the client overcontributed, and if that's the case then an excess contributions penalty can be applied at that time. 

It's also a little unclear how the rules would be applied over time; the details in the Green Book imply that the cap would continue to be recalculated over time, both as the Section 415 limit rises, and as annuity rates change over time. Which means people who might be close to the cap could have to wait each year until the IRS publishes the latest formulas for re-calculating the cap to see if they are or are not over the line. 

Of course, the bottom line is that at this point, the proposal is just that - a proposal, and not necessarily a highly impactful one from the budget perspective, as it is estimated to raise "only" $9.3 billion of tax revenue over the next decade, in part because EBRI estimates that fewer than 1% of people even have enough in retirement accounts to be subject to the rule. And even if it's ultimately implemented, the rule doesn't make retirement accounts undesirable; it just means that future contributions may be limited (although ironically, the reality is that once someone has $3M in retirement accounts, the bulk of the annual increases are growth, not $17,500 to a 401(k) or a $5,500 to a catch-up 401(k) or IRA contribution). On the other hand, it is notable that with a cap in place, many small business owners may be disincentivized to continue offering an employer retirement plan to employees once the owner themselves reach the cap and are no longer able to contribute. Similarly, the cap could ultimately limit how large of an IRA can be bequeathed as a stretch for the next generation - although as discussed below, there is also a proposal on the table to eliminate stretch IRAs for non-spouse beneficiaries entirely (a reprise of the potential stretch IRA limit previously discussed on this blog!).

If the rule ultimately does come to pass, it will be interesting to see what other rules are subsequently adopted to keep high net worth individuals from simply sheltering money elsewhere. For instance, non-qualified annuities also enjoy tax deferral - and in fact are becoming increasingly popular as a tax-deferred asset location vehicle - even though the treatment is remarkably similar to non-deductible IRAs that would be capped. In addition, the life insurance industry has already suggested that cash value life insurance strategies may become more appealing with an IRA cap for high income individuals, although given that the tax-deferred build-up of cash value has already been repeatedly proposed as an "abusive loophole" in Congress, it seems highly likely that if a maximum dollar amount for the tax-preferences of IRAs really does come to pass, a maximum dollar limit on the tax-preferences for permanent life insurance may not be far behind!

The bottom line, though, is simply this: just as the IRC Section 415 limit prevents individuals from accumulating more money in a defined benefit plan than what is necessary to fund a pension of up to $205,000/year, so too does this proposal prevent "over-funding" defined contribution accounts beyond the same Section 415 limit. In other words, it simply applies the "cap" that already exists for defined benefit plans to an "equivalent" amount for defined contribution plans. And as in both cases, it doesn't force excess funds out of the account, but merely prevents new contributions to the account as long as they are "over funded" beyond the "necessary" amounts.

Gift and Estate Tax Reform

In addition to the potential IRA cap, the budget proposals also recommend several notable changes to the gift and estate tax system, including a change to stretch IRAs.

The first recommendation is a return to the estate tax exemption and rates that were in place in 2009, which would mean a return to the $3.5 million exemption amount and a 45% top tax rate, with a delayed implementation of 2018. It would also include a return to a decoupled $1M gift tax exemption. Whether this will really come to pass remains to be seen; the President proposed the 2009 rates and exemption as a part of the original fiscal cliff legislation, but the negotiations and conclusion under the American Taxpayer Relief Act set them to the current levels, and the reality is that the estate tax exemption hasn't actually been allowed to decline since the Great Depression. On the other hand, if it does occur - especially with such a delayed implementation date - there will at least be ample time and opportunity to engage in gifting strategies to take advantage of the current exemption before its decline, not unlike the frenzy of 2012 year-end gifting when many feared the exemption was about to drop back to lower levels. On the other hand, it will be much easier to plan with a 5-year advance notice; in fact, arguably it's of little use to reduce the exemption with such advance notice, as ultra-high-net-worth individuals can simply gift today's $5.25M exemption (plus inflation adjustments through 2017) before the new rules take effect, and only those close to the $3.5M exemption, who can't afford to give away all their money (because they need it to live!) would be impacted (which makes the proposal oddly harsher for the "moderately" wealthy than the extremely wealthy).

Other proposals to limit "a number of loopholes" are under consideration as well (with supporting Budget Summary Tables), including a:

- Restriction that would require valuation on assets at death to be the same for both estate and income tax purposes, which prevents people from getting two valuations, a low one for calculating estate tax and a high one for the step-up in basis for income taxes. Instead, the estate tax valuation would be required to be used for income tax purposes as well when determining step-up in basis, and required reporting to the IRS would allow them to track that the step-up was applied properly by the beneficiaries in the future;

- Minimum term for GRATs, which would be 10 years (with a maximum of 10 years more than the annuitant's life expectancy), and would make the currently popular "rolling GRAT" strategy far less appealing and effective (but notably, the proposal would only apply to future GRATs created after the enactment date);

- Limit to the maximum duration of the GST exemption, which would become 90 years, preventing unlimited-duration dynasty trusts in states that have no law against perpetuities (in fact, the rule is being proposed specifically because so many states have eliminated their Rule Against Perpetuity laws that have allowed this planning technique to come into being);

- Crackdown on Intentionally Defective Grantor Trust (IDGT) rules, which would require that any sale or exchange with a grantor trust causes that property to be includable in the grantor's estate (although notably, this is actually narrower and more favorable than a similar IDGT crackdown proposal last year that would have arbitrarily included all grantor trusts in a grantor's estate);

- Requirement for non-spouse beneficiaries to liquidate inherited retirement accounts within 5 years of death, with limited or no opportunity to stretch over life expectancy. Exceptions would apply for disabled children, beneficiaries within 10 years of age of the decedent, and minor children (who wouldn't have to begin the 5-year distribution period until they reached the age of majority); 

Notably, though, none of these proposals are actually new; proposals to crack down on GRATs were discussed previously on this blog last year, and the potential crackdown on IDGT strategies was actually discussed last year as part of the President's 2013 budget proposals as well. Similarly, the proposal for limiting stretch IRAs for non-spouse beneficiaries was also covered on this blog; in fact, the current proposal is an exact restatement of the version from last year, when it was first attached as a proposal to the Highway Investment, Job Creation and Economic Growth Act of 2012.

Given the reality that none of these proposals are new - and despite having been proposed in the past, none of them have ever been passed into law! - it's not clear whether any of them will gain momentum now, and their financial impact is not significant (outside of the potential decrease in the exemption and increase in the rate itself, the cumulative value of these proposals is only $10B over the next decade). On the other hand, with the scope of the estate tax system narrower than ever due to the current inflation-indexing $5.25M exemption, it may actually be even more likely these latter "crackdowns" come to pass, as they now affect even fewer people and outside of the stretch IRA rule, are viewed even more as just being ultra-high-net-worth loopholes.

Chained CPI And Other Notable Highlights

Other notable provisions in the budget proposal with financial planning implications (beyond the wide array of general spending reforms and budgetary adjustments) include:

- A proposal to adopt chained CPI as a "more accurate" measure of inflation, as a part of the strategies for "Reducing The Deficit In A Smart And Balanced Way," which would impact everything from the inflation adjustments used for Social Security benefits, to the inflation adjustments used under the tax code (from the income tax brackets to the estate tax exemption and more), to the inflation measure that applies to the growth rate for TIPS and I-Bonds.

- A proposal that any employee not covered by an employer retirement plan would be automatically enrolled into an IRA through the payroll tax system, given the overwhelming success of automatic enrollment in boosting participation in employer retirement plans. The contributions would be voluntary - although employees would have to opt out to avoid participating - and contributions would effectively be "matched" by the Saver's Tax Credit where eligible. A tax credit of up to $500 in year one and $250 in year two for small employers to defray administrative costs would be made available, and separately the proposals would also double the existing $500/year for 3 years tax credit for small employers who start up new employer retirement plans.

- An expansion of the Child and Dependent Care Tax Credit, boosting the point at which the percentage begins to phase down from $15,000 to $70,000.

- The often-repeated proposal to change to tax treatment of carried interest to be all ordinary income.

- A cap on the value of itemized deductions at a maximum 28% tax rate, even for high-income individuals who would otherwise claim deductions against a higher tax bracket. Notably, the 28% cap rule is also proposed to apply to tax-exempt bonds, which would effectively cause them to become partially taxable for those in top tax brackets, and if high-income individuals contributed to retirement accounts for which the cap applied the non-deductible portion of the contribution would be treated and tracked as a partial after-tax contribution. The proposals also include a version of the Buffett Rule - a so-called "Fair Share Tax" (FST) that would require millionaires to pay no less than 30% of income (less the value of 28% of charitable contributions) in taxes; this "FST tax" would become a surtax that applies in addition to the regular tax liability, in a manner similar to the AMT, and would phase in as AGI rises from $1M to $2M (indexed annually for inflation).

- An increase to the additional Medicare Part B and Part D premiums for high-income individuals; currently, the premiums are set at levels that cover 35%, 50%, 65%, or 80% of the expected per capital Part B costs, and these targets would be increased by 5 to 10 percentage points (up to 40% at the low end and 90% at the high end). This would raise the marginal tax rate impact of Medicare Part B and D premium increases for high income individuals. Notably, a separate proposal would also apply an additional Medicare Part B premium surcharge of up to 30% for individuals who, beginning in 2017, purchase "particularly low cost-sharing" Medigap policies.

- Flexibility for the Pension Benefit Guaranty Corporation to increase PBGC premiums beginning in 2015 to help shore up currently projected shortfalls.

- Extend tax-free treatment for cancellation of mortgage indebtedness (which impacts the income tax consequences of short sales) from the current 2013 expiration through 2015 instead 

- IRA relief, including the elimination of Required Minimum Distributions for those with less than $75,000 in retirement accounts (with a phase-in of RMD requirements from $75,000 to $85,000 of retirement assets) if the account is below the threshold in the year the individual turns age 70 1/2 (even if the account grows above that amount later), and a modification to IRC Section 408(d)(3) that would allow inherited IRAs to complete a 60-day rollover (under current law, an inherited IRA is irrevocably withdrawn if a distribution occurs, and "rollovers" can only be done via trustee-to-trustee transfer). 

- Eliminate the opportunity to select tax lots when selling investments and any choice regarding a default method of accounting, and instead require that any sales from identical investments must use average cost if they are held for more than 1 year (eligible for long-term capital gains treatment). This would remove the ability for firms to add value with lot-level accounting decisions when buying/selling client investments. 

Ultimately, it remains to be seen which changes in the President's budget are proposed or adopted in legislation. Nonetheless, this is hopefully a helpful look at what might be coming in the future! For further reading, you can see the full details of the budget on the White House's own website here.

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  • http://www.ekglaw.com Evan Guthrie

    Thanks for the update and analysis on the budget proposal. Especially on the Gift and Estate Tax Reforms that you highlighted that may be cracked down on.

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