President Barack Obama’s budget proposal seeks to impose a limit on the prolonged tax deferrals and tax-free growth that high-income clients can achieve on their qualified retirement accounts.

Under current law, all income tax is deferred on a traditional IRA until the year after the participant turns 70½, when minimum required distributions commence.

Assets in the account after the participant’s death can continue to grow free of income tax, through the lifetimes of spouses and beneficiaries.

If a participant starts his retirement account at age 25 and names his spouse and children (or grandchildren) as beneficiaries, it is possible to stretch the tax deferral out for as long as 100 years.  Roth IRAs permit an even longer stretch period because minimum required distributions are unnecessary during the participant’s lifetime.  

These advantages have made IRAs powerful estate planning tools. Because high-income individuals can typically fund their retirements through taxable assets, they can continue to enjoy tax deferrals on what’s left of their qualified account assets after they take their minimum distributions. Estate plans can be structured so that these tax-deferrals can continue for their descendants for as long as possible.  The untaxed growth in these accounts—and the tax benefits of the deferral—can be staggering. The tax-free growth in Roth accounts can be even more impressive.

The first proposal would cap the amount that can be contributed to individual qualified retirement accounts. The cap would be determined by a complicated formula used to determine the value of a pension plan and would vary annually based on several variables. Under current values, it would be about $3.4 million for a 62 year old.  

If the value of a participant’s account has reached the cap at the end of a year, the participant would not be able to contribute additional funds in the following year. Although there has been speculation that this cap is aimed at professionals who have been able to build significant wealth in their retirement accounts because of access to unique investments, this proposal does not limit the growth that can occur in the account after the cap is reached. While additional contributions would not be permitted, the tax-deferred growth in these large accounts could continue during the participant’s lifetime.

The second proposal generally would require IRAs and other tax-deferred retirement accounts to terminate no later than five years after the death of the participant. There would be a few exceptions to this rule, the most notable of which is a provision that would allow the surviving spouse to roll over the IRA into his or her own name and continue to defer income tax based on the surviving spouse’s life expectancy. After the surviving spouse’s death, the beneficiaries would have to terminate the account within five years.

This proposal would eliminate the estate planning benefits of stretch IRAs on the theory that IRAs and other retirement accounts receive preferential tax treatment because they are savings vehicles for retirement, not for estate planning.

Bobbi J. Bierhals is a partner in the law firm of McDermott Will & Emery LLP and is based in the firm’s Chicago office. She focuses her practice on tax and business planning for high-net-worth business owners and executives.