Huge Changes to IRAs and 401(k)s in New Budget Law that Affects Everyone

 

The Omnibus budget bill signed into law today, December 27, 2022, has significant changes that will affect everyone saving for retirement. From more Roth options, improvements on required minimum distributions, and increases to contribution amounts, IRA and 401(k)s will become even better vehicles to build long-term savings and wealth for retirement. Rules for prohibited transactions remain substantially the same. Prior language which would have fixed the death penalty on prohibited transactions for IRAs did not end up in the final version of the bill. There are some positive developments on fixing IRA mistakes in the final law through the DOL’s EPCRS.

MORE ROTH

One major theme in the bill is “rothification”. Congress loves Roth accounts because they don’t give up tax revenue today as there is no tax deduction for contributing to a Roth IRA or Roth 401k. Traditional accounts, on the other hand, result in a tax deduction today (although taxed on the way out) and that reduces taxes paid and the amount of money congress gets to spend. Here are the new Roth account rules that benefit investors.

  • Simple and SEP Roth IRAs – Under prior laws, SIMPLE and SEP IRAs could only receive traditional (pre-tax) dollars. Under the new law and beginning in tax year 2023, a SIMPLE IRA or SEP IRA can be a Roth account. In other words, you can have a Roth SEP IRA or ROTH SIMPLE IRA. Contributions to these accounts are not deductible but grow and come out tax free like Roth IRAs and Roth 401(k)s. This change is significant as the inability to do Roth dollars in SEP and SIMPLEs was a major disincentive to these account types and why we didn’t see many investors want them or use them at our company, Directed IRA.
  • 401(k) Employer/matching contributions can be Roth – Under prior laws, employer/matching contributions in a 401(k), including solo 401(k)s, must be traditional dollars. Under the new law, effective now, employer/matching contributions can be Roth (or they can be traditional if you want as well). The Roth employer/matching contributions are not deductible, and the amounts contributed by the employer for the employee are taxable income to the employee (likely to be included on W-2, waiting for guidance) but grow and come out tax-free similar to all other Roth accounts. This will likely require a plan amendment before employer Roth contributions are allowed but there may be transitional relief and we’re waiting on guidance from the IRS/DOL.
  • No RMD on Roth 401(K)s – Under prior laws, required minimum distributions (RMD) applied to Roth 401(k) accounts. Under the new law, and beginning in tax year 2024, Roth 401(k) accounts (including solo Roth 401ks) will not be subject to RMD rules. This will harmonize the rules between Roth IRAs and Roth 401(k)s as Roth IRA have always been exempt from RMD.
  • Unused 529 Plan Funds Can Be Rolled to a Roth IRA – Under the law, unused 529 plan funds can be rolled to a Roth IRA of the 529 account beneficiary up to a maximum aggregate of $35k. The 529 plan must have been maintained for 15 years. Also, the amount distributed cannot exceed the aggregate amount contributed.

RMD Age Improvement and More Catch-Up Contributions

  • RMD goes from 72 to 73 in 2023 and then 75 in 2033 – The age of required minimum distributions (RMD) will increase from 72 to 73. The age will then adjust over time up to age 75 by 2033. This will apply to traditional (pre-tax) IRA and traditional 401(k) and other pre-tax retirement accounts. RMD does not apply to Roth IRAs and under the new bill will not apply to Roth 401(k) funds either.
  • Increased Catch-Up Contribution for those 60-63 – Current catch-up contributions are allowed for those 50 or older and are in the amount of $6,500. Under the new law, and effective in 2025, an additional catch-up contribution is allowed between ages 60-63 as the $6,500 is increased in those four years to $10,000. This catch-up contribution must be Roth if the taxpayer’s adjusted gross income is $145k or greater.

Prohibited Transaction Rules Remain the Same

One significant part of the bill for self-directed investors was regarding the “death penalty” on prohibited transactions. Under the current law, if a prohibited transaction occurs in an IRA, then the entire account is distributed. A prior version of the bill included a fix to this and would have changed a penalty to be only on the amount involved in the prohibited transaction, similar to prohibited transactions on 401(k)s, but this fix was unfortunately removed in the final negotiations. There are changes in the bill to prohibited transactions, but they merely codify existing case law and guidance from the IRS/DOL and do not fix the death penalty on prohibited transactions that occurs if someone makes a prohibited transaction mistake with their IRA. One positive development is the ability to use the EPCRS for IRA mistakes. EPCRS is the employee plans compliance resolution system and was only allowed for employer-based plans. Under the new law, EPCRS will be available to IRA custodians who can seek relief for IRA account owners for “eligible inadvertent failures” in an IRA.

3 Critical Legal Tips When Buying a Business

Every buyer of a small business should consider the following three key legal issues when acquiring a business.

1. Buy Assets and Not Liabilities.

Most small business purchases are done as what are called “Asset Purchases”. In an Asset Purchase the buyer of the business acquires the assets of the business only. The assets include the goodwill, name, equipment, supplies, inventory, customers, etc. According to the terms of a properly drafted Asset Purchase Agreement, the assets do not include the prior owner’s business liabilities (the known or unknown). Under an Asset Purchase the buyer typically establishes a new company which will operate the business. This new company is free from the prior company’s liabilities and actions.

A “Stock Purchase” on the other hand occurs when the buyer acquires the stock or LLC units of the existing business. There are a few downsides to acquiring a business under a stock purchase. First, if you buy the stock or units of an existing company then you get the existing assets AND the existing liabilities of the acquired company. Since a new buyer hasn’t operated the business it is impossible for them to accurately quantify the existing liabilities. The second downside to a Stock Purchase is that the new owner of the company takes the current tax position of the departing owner when it comes to writing off equipment and other items in the company at the time of purchase. The downside to this is that the seller of the business may have already fully written off these items leaving the new business owner with little business assets to depreciate (despite a significant financial investment). If, on the other hand, the buyer acquired the “assets” in an Asset Purchase the buyer would depreciate and expense those assets as the new business owner chooses and in the most aggressive manner possible. Bottom line, an Asset Purchase has less liability risk and has better tax benefits that will allow the buyer to generate better tax write-offs and deductions over the life of the business.

2. Negotiate For Some Seller Financed Terms.

Many small business purchases include some form of seller financed terms whereby the seller agrees to be paid a portion of the purchase price over time via a promissory note. Seller financing terms are excellent for the buyer because they keep the seller interested and motivated in the buyer’s success since business failure typically means that the buyer wont be able to fully pay the seller. If the seller gets all of their money at closing then the seller is typically less interested in helping transition the business to the new owner as the seller has already been paid in full. Also, if the seller misrepresented something in the business during the sale that results in financial loss to the buyer, the buyer can offset the loss or costs incurred by amounts the buyer owes the seller on the note. In sum, the seller financed note gives the buyer some leverage to make sure the value in the business is properly and fairly transferred.

3. Conduct Adequate Due Diligence.

While it may go without saying that a buyer of a business should conduct adequate due diligence, you would be surprised at how many business purchases occur simply based on the statements or e-mails of a seller as opposed to actual tax returns or third party financials showing the financial condition of the business. A few due diligence items to consider are; get copies of the prior tax returns for the company, get copies of third party financials, make the seller complete a due diligence questionnaire where the seller represents the condition of the business to the buyer (similar to what you complete when you sell a house to someone). A lawyer with experience in business transactions can help significantly in conducting the due diligence and in drafting the final documents.

Buying an existing business is not only a significant financial commitment but is also a significant time commitment. Make sure the business is something worth your time and money before you sign. Oh, and make sure you get a well drafted set of purchase documents to sign.

Raising Capital in a Partnership LLC or Joint Venture

We’ve all heard the buzz words of crowdfunding, PPMs, and IPOs, but there are less complicated ways to raise money and start a business and one of the most reliable and most used methods is that of partnership LLCs or joint ventures.

If you ‘re raising money from others in an LLC, partnership, or joint venture, you must take specific precautions in structuring your documents so that the investment of money from any member, partner, or joint venturer does not constitute a violation of federal or state securities laws. Failure to comply with the securities laws can result in civil and criminal penalties. Many real estate investments and emerging companies rely on numerous strategies to raising capital that are outside of publicly traded stock and that do not require registration with a state securities division or the federal Securities and Exchange Commission. This article addresses those strategies and outlines some of the key issues to consider when raising funds through an LLC, partnership, or joint venture arrangement.

IS THE LLC MEMBER, PARTNER, OR JOINT VENTURER CONTRIBUTING MORE THAN JUST MONEY?

The courts have widely held that an investment in an LLC, joint venture, or partnership is a security when the investor is investing solely cash and has no involvement, vote, or say in the investment. In these instances where the cash partner just puts in cash (sometimes called “silent cash partner” arrangements), the investment will likely be deemed a security. In a famous securities law case called Williamson, the Fifth Circuit Court of Appeals held that a joint venture contract investment is a security if the investor has little say or voting power, no involvement in the business or investment, and no experience that would provide any benefit to the business or investment. Williamson, 645 F.2d 424. As a result, to avoid triggering these factors and having your investment or business deemed a security we strongly recommend that all cash partners, whether individuals or self-directed IRAs, in Joint Venture agreements, LLCs, or partnerships have voting rights and that they participate in the key decision-making functions of the investment or business. Cash partners do not have to be part of the management team but they do need to have voting rights and need to have real opportunities to use those voting rights. For example, they could have voting rights on incurring additional debt, on management compensation, and/or on buying or selling property.

DON’T GIVE YOURSELF UNLIMITED CONTROL AS MANAGER

In most LLCs with cash partners, the person organizing the investment and running the operations is often the manager of the LLC, partnership, or joint venture and has the ability to bind the company or partnership. When making this selection as the manager, it is key that you do not give yourself unlimited control and authority. If you do give yourself unlimited control as manager, your investors may be deemed to have purchased a security since their voting rights will have been extinguished by placing to much control and power in the manager/management. What is recommended is that the members have the ability to remove the manager by majority vote and that the manager may only make key decisions (e.g. incurring debt, selling an asset, setting management salaries, etc.) upon the agreement and majority vote of the investors. While key decisions and issues should be left to the members, day to day decisions can be handled by the manager without a vote of the members/investors.

DON’T COMBINE TOO MANY PEOPLE INTO ONE LLC, JV, OR PARTNERSHIP

The Courts have consistently held that even if a cash partner is given voting rights and has an opportunity to vote on company matters that the cash partners interest can be deemed a security if there are too many other cash partners involved in the LLC, JV, or Partnership. Holden, 978 F.2d 1120. As a general rule of advice, you should only structure investments and partnerships that include 5 or less cash partners as the securities laws and the involvement of more individuals than this could potentially cause the investment to be deemed a security. When there are more than 10 cash partners it is critical for clients to consider structuring the investment as a Regulation D Offering and that they complete offering documents and memorandums and make a notice filings to the SEC. Many people refer to this type of investment structure as a PPM.  When there are a lot of investors involved, a Regulation D Offering provides the person organizing the investment with exemptions from the securities laws and can allow someone to raise an unlimited amount of money from an un-limited amount of investors.

In sum, there are many factors and issues to consider when raising money from others in an LLC, JV, or partnership and it is crucial that you properly structure and document these investments so that they can withstand these challenges of securities law violations. For help in structuring your partnership LLCs and joint ventures please contact the law firm at 602-761-9798.

Back Door Roth IRA Rules and Steps

Roth IRAs can be established and funded for high-income earners by using what is known as the “back door” Roth IRA contribution method. Many high-income earners believe that they can’t contribute to a Roth IRA because they make too much money and/or because they participate in a company 401k plan. Fortunately, this thinking is wrong. While direct contributions to a Roth IRA are limited to taxpayers with income in excess of $137,000 ($206,000 for married taxpayers, 2020), those whose income exceeds these amounts may make annual contributions to a non-deductible traditional IRA and then convert those amounts over to a Roth IRA.

Examples

Here are a few examples of earners who can establish and fund a Roth IRA.

  1. I’m a high-income earner and work for a company that offers a company 401(k) plan. I contribute the maximum amount to that plan each year. Can I establish and fund a Roth IRA? Yes, even though you are high-income and even though you participate in a company 401(k) plan, you can establish and fund a Roth IRA.
  2. I’m self-employed and earn over $206,000 a year; can I have a Roth IRA? Isn’t my income too high? Yes, you can contribute to a Roth IRA despite having an income that exceeds the Roth IRA income contribution limits of $206,000 for married taxpayers and $137,000 for single taxpayers.

The Process

The strategy used by high-income earners to make Roth IRA contributions involves the making of non-deductible contributions to a traditional IRA and then converting those funds in the non-deductible traditional IRA to a Roth IRA. This is oftentimes referred to as a “back door” Roth IRA. In the end, you don’t get a tax deduction in the amounts contributed, but the funds are held in a Roth IRA and grow, then come out tax-free upon retirement (just like a Roth IRA). Here’s how it works.

Step 1: Fund a new non-deductible traditional IRA

This IRA is “non-deductible” because high-income earners who participate in a company retirement plan (or who have a spouse who does) can’t also make “deductible” contributions to an IRA. The account can, however, be funded by non-deductible amounts up to the IRA annual contribution amounts of $6,000. The non-deductible contributions mean you don’t get a tax deduction on the amounts contributed to the traditional IRA. You don’t have to worry about having non-deductible contributions as you’re converting to a Roth IRA, so you don’t want a deduction for the funds contributed. If you did get a deduction for the contribution, you’d have to pay taxes on the amounts later converted to Roth. You’ll need to file IRS form 8606 for the tax year in which you make non-deductible IRA contributions. The form can be found here.

If you’re a high-income earner and you don’t have a company-based retirement plan (or a spouse with one), then you simply establish a standard deductible traditional IRA, as there is no high-income contribution limitation on traditional IRAs when you don’t participate in a company plan.

Step 2: Convert the non-deductible traditional IRA funds to a Roth IRA

In 2010, the limitations on Roth IRA conversions, which previously restricted Roth IRA conversions for high-income earners, were removed. As a result, since 2010 all taxpayers are able to convert traditional IRA funds to Roth IRAs. It was in 2010 that this back door Roth IRA contribution strategy was first utilized, as it relied on the ability to convert funds from traditional to Roth. It has been used by thousands of Americans since.

If you have other existing traditional IRAs, then the tax treatment of your conversion to Roth becomes a little more complicated, as you must take into account those existing IRA funds when undertaking a conversion (including SEPs and SIMPLE IRAs). If the only IRA you have is the non-deductible IRA, then the conversion is easy because you convert the entire non-deductible IRA amount over to Roth with no tax on the conversion. Remember, you didn’t get a deduction into the non-deductible traditional IRA so there is not tax to apply on conversions. On the other hand, if you have an existing IRA with say $95,000 in it and you have $5,000 in non-deductible traditional IRA contributions in another account that you wish to convert to Roth, then the IRS requires you to covert over your IRA funds in equal parts deductible (the $95K bucket) and non-deductible amounts (the new $5K) based on the money you have in all traditional IRAs. So, if you wanted to convert $10,000, then you’d have to convert $9,500 (95%) of your deductible bucket, which portion of conversion is subject to tax, and $500 of your non-deductible bucket, which isn’t subject to tax once converted. Consequently, the “back door” Roth IRA isn’t well suited when you have existing traditional IRAs that contain deductible contributions and earnings from those sums.

There are two workarounds to this Roth IRA conversion problem and both revolve around moving the existing traditional IRA funds into a 401(k) or other employer-based plans. Employer plan funds are not considered when determining what portions of the traditional IRAs are subject to tax on conversion (the deductible AND the non-deductible). If you participate in an existing company 401(k) plan, then you may roll over your traditional IRA funds into that 401(k) plan. Most 401(k) plans allow for this rollover from IRA to 401(k) so long as you are still employed by that company. If you are self-employed, you may establish a solo or owner-only 401(k) plan and you can rollover your traditional IRA dollars into this 401(k). In the end though, if you can’t roll out existing traditional IRA funds into a 401(k), then the “back door” Roth IRA is going to cause some tax repercussions, as you also have to convert a portion of the existing traditional IRA funds, which will cause taxes upon conversion. Taxes on conversion aren’t “the end of the world” though as all of the money that comes out of that traditional IRA would be subject to tax at some point in time. The only issue is it causes a big tax bill initially, so careful planning must be taken.

The bottom line is that Roth IRAs can be established and funded by high-income earners. Don’t consider yourself “left out” on one of the greatest tax strategies offered to Americans: the Roth IRA.

Mat has been at the forefront of the self-directed IRA industry since 2006. He is the CEO of Directed IRA & Directed Trust Company where they handle all types of self-directed accounts (IRAs, Roth IRAs, HSAs, Coverdell ESA, Solo Ks, and Custodial Accounts) which are typically invested into real estate, private company/private equity, IRA/LLCs, notes, precious metals, and cryptocurrency. Mat is also a partner at KKOS Lawyers and serves clients nationwide from its Phoenix, AZ office.

He is published regularly on retirement, tax, and business topics, and is a VIP Contributor at Entrepreneur.com. Mat is the best-selling author of the most widely used book in the self-directed IRA industry, The Self-Directed IRA Handbook: An Authoritative Guide for Self-Directed Retirement Plan Investors and Their Advisors.