#SOTU Thread

[Matt]

I actually missed SOTU and have been catching up with the proposals. Some that struck me personally as concerning are:

Proposed changes to 529 plans -

• Limit upside-down education savings incentives and consolidate them into a single benefit. The President’s plan would consolidate education savings incentives into one vehicle and redirect the savings into the better targeted AOTC. Specifically, the President’s plan will roll back expanded tax cuts for 529 education savings plans that were enacted in 2001 for new contributions, and – like Chairman Camp’s tax reform plan – repeal tax incentives going forward for the much smaller Coverdell education savings program.

As I understand it, this rollback would potential make qualified 529 distributions (AKA college and related expenses) taxable. While they say the money would still grow tax free. I'll have to explore that further.

I think that this does present a strong case for the use of direct to education funding methods and sidestepping the 529, but that doesn't help a whole lot when it comes to those already funded.

Additionally, there is talk of closing the step up basis 'loophole'

The largest capital gains loophole – perhaps the largest single loophole in the entire individual income tax code – is a provision known as “stepped-up basis.” Stepped-up basis refers to the fact that capital gains on assets held until death are never subject to income taxes. Not only do bequests to heirs go untaxed, but the “tax basis” of inherited assets used to compute the gain if they are later sold is immediately increased (“stepped-up”) to the value at the date of death – making the capital gain income forever exempt from taxes. For example, suppose an individual leaves stock worth $50 million to an heir, who immediately sells it. When purchased, the stock was worth $10 million, so the capital gain is $40 million. However, the heir’s basis in the stock is “stepped up” to the $50 million gain when he inherited it – so no income tax is due on the sale, or ever due on the $40 million of gain. Each year, hundreds of billions in capital gains avoid tax as a result of stepped-up basis.

Sourced from WhiteHouse.gov

Other than these, I saw a lot of positive changes that looked good. Do any of you have concerns about the proposals, or plans to deal with them should they pass?

 

[Scotty342]

With regards to the 529 plan changes, I believe that should the proposal pass into law, many families would come to realize that a Roth IRA could be a better investment vehicle for college savings than a 529 plan.

Here is why:

• You are using after-tax funds to contribute to either plan so no advantage either way,
• Your investment earnings grow tax free in either plan,
• Withdrawals from the Roth IRA are exempt from penalties if used for higher education costs
• Earnings would now be taxed in either plan when used for higher education costs

Key Differences:

• If you child does not go to college or get a full scholarship, you can use the Roth IRA money for your retirement instead. However, in the 529 plan you will get hit with a 10% penalty for withdrawing funds not for higher education.
• You may get a state tax deduction for 529 plan contributions depending on your state but the value may not be that great to offset the risk of eating the 10% penalty.
• Also the Roth IRA is subject to annual contribution and income limits so you may need to use a strategy like the Backdoor Roth or Mega Backdoor Roth for contributions to the plan.

 

[Sunny]

Not a big fan of the changes, but I'm optimistic that a republican congress will not let these proposed changes pass.

The main problem with using Roth IRA for education is the relatively small limit compared to the cost of college. I don't know how much the average American stashes away in their Roth, but for me, I utilize both a Roth IRA and 529 to save for college.

I found these articles which seem to say that on average, Americans are not utilizing their entire Roth IRA contribution limit.
http://www.fidelity.com/inside-fidelity/employer-services/fidelity-average-ira
http://www.fa-mag.com/news/how-much-do-people-really-have-in-iras-10914.html

Please correct me if I'm wrong, but I thought that withdrawals of Roth IRA earnings for QHEE are only penalty exempt. Income taxes still apply. QHEE 529 withdrawals are tax free.

 

[Matt]

With regards to the 529 plan changes, I believe that should the proposal pass into law, many families would come to realize that a Roth IRA could be a better investment vehicle for college savings than a 529 plan.

Here is why:

• You are using after-tax funds to contribute to either plan so no advantage either way,
• Your investment earnings grow tax free in either plan,
• Withdrawals from the Roth IRA are exempt from penalties if used for higher education costs
• Earnings would now be taxed in either plan when used for higher education costs

Key Differences:

• If you child does not go to college or get a full scholarship, you can use the Roth IRA money for your retirement instead. However, in the 529 plan you will get hit with a 10% penalty for withdrawing funds not for higher education.
• You may get a state tax deduction for 529 plan contributions depending on your state but the value may not be that great to offset the risk of eating the 10% penalty.
• Also the Roth IRA is subject to annual contribution and income limits so you may need to use a strategy like the Backdoor Roth or Mega Backdoor Roth for contributions to the plan.

Yep, that's where I was going with my comment, thanks for laying it out so well. I'm also interested in looking at direct gifting of appreciated assets. Hope to get to that at some point!

 

[Matt]

Not a big fan of the changes, but I'm optimistic that a republican congress will not let these proposed changes pass.

The main problem with using Roth IRA for education is the relatively small limit compared to the cost of college. I don't know how much the average American stashes away in their Roth, but for me, I utilize both a Roth IRA and 529 to save for college.

I found these articles which seem to say that on average, Americans are not utilizing their entire Roth IRA contribution limit.
http://www.fidelity.com/inside-fidelity/employer-services/fidelity-average-ira
http://www.fa-mag.com/news/how-much-do-people-really-have-in-iras-10914.html

Please correct me if I'm wrong, but I thought that withdrawals of Roth IRA earnings for QHEE are only penalty exempt. Income taxes still apply. QHEE 529 withdrawals are tax free.

Yes, earnings are taxable. But you could put in the $5500 or so for 18 years and have a decent amount of money to put towards college.

I'll have to dig a bit more to confirm but I think the CSS wouldn't look at a Roth when determining needs, I'm pretty sure FAFSA doesn't - so one advantage is after 18 years you'd have $100K tax free to put towards costs, but you'd not be raising your EFC. The 529 would raise EFC by a small amount (5.64%?) so in that sense it is slightly inferior.

A combination approach might be best.

Of course, regarding your point on Roths, there are ways to get more into them too. I averaged I think 3x the annual limit for the first few years I was earning via rollovers.

 

[Sunny]

Yes, earnings are taxable. But you could put in the $5500 or so for 18 years and have a decent amount of money to put towards college.

But then you're foregoing the other use of the Roth IRA money which is for your retirement.

I'll have to dig a bit more to confirm but I think the CSS wouldn't look at a Roth when determining needs, I'm pretty sure FAFSA doesn't - so one advantage is after 18 years you'd have $100K tax free to put towards costs, but you'd not be raising your EFC. The 529 would raise EFC by a small amount (5.64%?) so in that sense it is slightly inferior.

A combination approach might be best.

Of course, regarding your point on Roths, there are ways to get more into them too. I averaged I think 3x the annual limit for the first few years I was earning via rollovers.

Were you rolling over 401k/Traditional IRA money? I would love to take advantage of the mega backdoor Roth, but alas, my company does not allow post tax contributions to our 401k.

 

[El Ingeniero]

Hmm. Mega backdoor Roth? My company just added a Roth 401k, and now I know why: for the senior execs.

Can you point me at a resource as to how it's done?

 

[Matt]

Hmm. Mega backdoor Roth? My company just added a Roth 401k, and now I know why: for the senior execs.

Can you point me at a resource as to how it's done?

Mega Backdoor Roth conversion occurs when you load up a 401(k) to the max and then roll it over to a Roth. The real max number for an IRA is $53K per year, it is the first $18K that is dedutible, and the remaining quota which holds the employer match portion - IE if you have a 100% match on $18K you'd be at $36K per year going in, and can deduct your half.

Some plans allow you to personally top up to the $53K with your own funds, anything you put in above $18K is not deductible, but is in your 401(k) so it can be later rolled into a Roth.

Your first challenge is having a plan that allows you to pay in after tax to top it up.
Your second challenge is having a plan that allows you to then make 'in service' distributions/rollovers. What that means is your employer needs to have a plan that allows you to rollover while employed. If not, you can still load up the 401(k) but you couldn't do the Mega roll until you leave that employer.

 

[Andres]

We should make a list of employers that offer 401k plans that allow Mega Backdoor Roths

 

[Matt]

We should make a list of employers that offer 401k plans that allow Mega Backdoor Roths

You'd be better off aiming for self employment than seeking out those employers - if you are going to go to such extremes

 

[El Ingeniero]

You'd be better off aiming for self employment than seeking out those employers - if you are going to go to such extremes

True dat. You'd have to be making a lot to be salting away $53K/year. Where I work, that's not a real possibility for a family man unless they are about 4 pay grades above me. That would put them 1 or 2 levels below the the C-suite.