Door Opens to Tax on IRA and 401(k) Gains

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From the beginning, questions have swirled around the future tax standing of retirement savings. In an age of soaring deficits, would Congress really be able to keep its hands off hundreds of billions of dollars of tax-advantaged growth? It appears not.

A Senate Finance Committee proposal slipped into a highway-funding bill would have forced those who inherit an IRA or 401(k) to empty the accounts within five years—almost certainly triggering income-tax payments. Let the encroachment games begin.

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Under current law, retirement accounts can be left to heirs who can then stretch out distributions across their lifetime. This provision has factored into estate planning for many years. It allows for smaller taxable distributions and a longer period of tax-advantaged growth. A 10-year-old inheriting grandma’s 401(k) could enjoy 73 years of tax-deferred compounding.

The proposed mandatory five-year distribution schedule wouldn’t directly levy against the growth of retirement savings. Withdrawals would be treated as they are now. But by speeding up the process heirs would be forced to take larger distributions and probably get shoved into a higher tax bracket. Their inheritance also would be more vulnerable to creditors and at risk of being frittered away by an immature beneficiary.

This sounds like a problem for the 1%. After all, most folks need to draw down their accounts in retirement—not focus on clever ways to preserve them for the kids. But once this door opens it would be hard to shut. In a sense, the door was opened 30 years ago with modest taxation of previously tax-free Social Security benefits. Now 85% of Social Security recipients pay some kind of income tax.

With about $10 trillion in IRAs and 401(k) plans, momentum to extract tax revenue from this pot will only build. Perhaps most vulnerable is the Roth IRA. The $265 billion in these accounts is growing tax-free—not tax-deferred—and multiple decades of untaxed growth presents a juicy target. Plenty people believe the Roth is untouchable. But lawmakers might justify taxing the gains, perhaps at the lower capital gains rate or through some sort of filter that targets the wealthy.

The money in 401(k) plans and traditional IRAs are subject to taxation as ordinary income upon distribution. Tax-deferred growth is more difficult to sort out. Still, the gains resulting from tax deferral could come under attack.

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For now, Congress is only talking about measures that would impact heirs—and even at that, nothing seems imminent. This proposal died in committee. But this is how encroachment starts. It makes sense to take precautions and start practicing tax diversification now.

You don’t know what the tax laws will look like in 10 or 20 years. So build your savings in a variety of accounts that get different tax treatment, including a 401(k) plan, Roth IRA, traditional IRA, taxable personal account and home equity (pay down the mortgage). That way you’ll end up with maximum flexibility and be able to draw income from whatever source makes the most sense at the time.