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Mega IRAs: A Crackdown Is Coming

Venture capitalist and early tech investor Peter Thiel made headlines over the summer when it was discovered that he had turned a small investment into a $5 billion fortune. While the returns were speculative, what really caught people’s eye was that Thiel would never have to pay taxes on that fortune. The gains and returns were located in the billionaire’s Roth IRA.

It turns out, Theil isn’t alone. New reports and findings have shown that many others have made similar transactions.

And with the attention now being paid to so-called mega-IRAs, new legislation is at hand. A crackdown on these sorts of vehicles is almost assured. Depending on how it’s worded and written, some middle and upper-middle class investors may be snared in the wrath of Congressional proceedings.

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The Growth In Mega-IRAs

The humble Roth IRA was originally designed to spur retirement for middle class savers. In exchange for no tax benefits today, savings in a Roth could grow and then be withdrawn later in life tax-free. The problem is that the humble Roth has been potentially hijacked by wealthier savers and could be costing taxpayers a bundle.

That’s the gist behind an investigative report by news agency ProPublica. The agency examined documents through an IRS leak and discovered that the vehicle is being used by very wealthy investors to hide assets, avoid any taxation and grow their balances beyond a normal size. The series of articles in ProPublica, including the one that exposed Peter Theil, were so glaring that members of key Congressional committees have started to look into the issue.

Part of their investigation was examining new data from the Joint Committee on Taxation (JCT). According to the JCT’s data, more than 28,600 taxpayers had more than $5 million in Roth IRA accounts, including 500 taxpayers with IRA balances of $25 million or more. The average aggregate account balance for these folks was more than $150 million each.

The numbers were more than triple the figures released in 2011 looking at the same issue.

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How Did They Do It?

It turns out that there’s a few ways people exploit their IRAs. In Thiel’s case, it comes down to his ability to buy PayPal stock, as founder, of less than $0.001 per cent. At the time, Theil was legally able to contribute to a Roth account and use the proceeds to buy the company’s shares pre-IPO. Self-directed IRAs allow individuals to buy assets and investments outside the norm and shove them into the account.

The other option is using a provision in a 401(k) account to convert savings into tax-free money.

401(k) plans are known for their ability to shield savings before taxes. But some 401(k) plans – and it depends on the issuer/company – allow savers to contribute after-tax money as well. Pre-tax savings are capped at $16,000. However, plans that allow after-tax fund contributions are capped at $58,000 or $64,500 if you’re age 50 or older minus the company match. It’s this piece of the tax code that allows for company, which allows you to contribute after-tax money as well.

The kicker is that some 401(k) plans will allow you to conduct so-called in-service withdrawals in which you can then stash this after-tax money into a Roth IRA or conduct a rollover to a Roth 401(k) account, allowing you to skirt income limit rules on who can contribute to a Roth in the first place. Now, if you own a small business, are a partner in a law firm or a physician in a practice group, you can set up your plan accordingly to do this sort of transaction.

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The Crack-Down Is Coming

With the numbers growing and ProPublica series sparking outrage, Congress is looking to act. Senate Finance Committee Chair Ron Wyden and House Ways & Means Committee Chair Richard E. Neal have already expressed the need for legislation and changes to the IRA system. In a statement, Neal wrote “The Ways and Means Committee is already looking at strategies to ensure that this retirement savings tool isn’t misused as a tax shelter for folks at the very top.”

The problem is that we could be looking at a fundamental shift in how Roth IRAs are used – if they even survive as a viable account option.

For example, some of the proposals would eliminate self-directed IRAs and limit the kind of assets that could be placed inside them. The Government Accountability Office has already begun looking at these sorts of accounts. While that would limit transactions like Thiel’s, it could spell the end of placing physical real estate, baseball cards, private equity, gold coins or other alternatives into a Roth plan. It’s not just multi-billionaires that use self-directed IRAs to save.

Another proposal would limit “the total amount of money that can be saved in tax-preferred retirement accounts.” The problem here again is the actual number. Depending on what Congress and new legislation decides, smaller investors could be in trouble. It could be possible for younger investors taking advantage of compounding, steady savings and long-term growth investing to hit those upper limits. Additionally, some advisors have stressed concerns that clients who take advantage of regular backdoor Roth conversions or 401(k) rollovers could hit limits and be forced to pay taxes twice – once on the conversion, and then again as they hit savings limits a few years later.

Perhaps the biggest death knell to the Roth investors is the suggestion to end the account type all together and prevent new contributions to existing accounts. This would force all savers into traditional IRAs, and deferred taxes later on.

Still in the Early Innings

With light being shed on the world of mega-IRAs and the ability for upper income earners to use the account type to avoid taxes, changes are coming to the individual retirement account. The question is just what Congress will do with the plan. The hope is that loopholes are closed without hurting the cohorts of savers that the plans were originally designed to help.

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Sep 03, 2021