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On Sept. 16, 2014, the Government Accounting Office (GAO) released a report on IRA balances. The report indicated that, as of year-end 2011, 43 million taxpayers had socked a total of $5.2 trillion into IRAs. Some 99% of these IRAs had balances of less than $1 million, with the mean balance coming in just under $100,000. However, the figure in the report that garnered the most attention was the GAO’s estimate that as many as 314 Americans hold IRAs worth north of $25 million.
In a Wall Street Journal opinion piece shortly afterward titled “How to shelter hundreds of millions in an IRA account: That’s what the wealthy do, even though it violates the spirit of the law,” Marketwatch Assistant Commentary Editor Rex Nutting seized on the large IRA statistic as an example of how the wealthiest 1% are able to dodge taxes in ways that ordinary Americans cannot. Nutting cited Mitt Romney as the poster child for such abuse, noting that, in his 2012 presidential campaign disclosure documents, Romney listed his traditional IRA value between $20.7 million and $101.6 million. Nutting’s piece is summarized in a quote he included from Oregon Democratic Senator Ron Wyden: “Something is out of whack. The IRA was never intended to be a tax shelter for millionaires.”
Looking at It Another Way
While debates over social equity and class division in America are all well and good, what struck me was that, amid the author’s populist rallying cries for IRA reforms and his condemnation of Romney’s alleged “sweetheart” business deals, no consideration was given to the possibility that having large sums of money tied up in an IRA might actually be a financial boon for the federal government and a burden for the wealthy account holder. As a financial planner, that possibility seems obvious to me based upon the current federal income and estate tax code, and it may be illustrated using Romney’s circumstances.
As cited in the article, Romney ostensibly accrued his IRA millions by participating in private equity deals during his time at Bain Capital. Purchasing shares in distressed companies at pennies on the dollar clearly produced huge gains when the companies’ fortunes turned. The question that begs asking, however, is whether Romney’s net worth would have been even better served by making these deals outside of his IRA. Had Romney done so, he would have experienced the same huge gains. These gains would have been tax-deferred until the positions were sold, and, assuming a holding period of longer than one year, would be subject to a maximum long-term capital gains tax rate today of just 20%. Further, if Romney were to hold some of these positions indefinitely, upon his death, capital gains tax might be avoided entirely, as his heirs would receive a step-up in basis.
Taxes Will Come Due
In contrast, while it is true that Romney can buy and sell in his IRA to his heart’s delight without incurring any capital gains tax, in three years, when he turns 70½, he will be subject to the same required minimum distributions (RMDs) from his IRA as every other American who reaches that milestone. These distributions will be subject to ordinary income taxes, and based upon both his reported ordinary income and the size of the RMDs, they will likely be taxed at the highest marginal federal rate of 39.6%—almost exactly double the long-term capital gains rate. Even if Romney leaves his IRA to his progeny and they take advantage of IRS-permitted stretch provisions, it is reasonable to assume that the size of the RMDs to the IRA beneficiaries will still likely result in the distributions being taxed at the highest marginal income tax rate.
Further, upon his death, if Mr. Romney’s estate does not have enough liquidity to pay federal estate tax (40% in 2014) on the portion of his estate over $10.68 million, distributions from his IRA may be subject to both estate and income tax in the same year, resulting in a veritable windfall for Uncle Sam.
The tax-planning challenges of accumulating disproportionate wealth in one’s IRA are well-known among estate planning attorneys, CPAs and financial planners, and the potential pitfalls of Romney’s particular IRA strategy were previously referenced in a Wall Street Journal piece titled “Romney’s Unorthodox IRA,” which came out shortly after Romney’s 2012 campaign disclosure.
In sum, the social equity debate over whether Mr. Romney had unfair access to so-called “sweetheart deals” is entirely unrelated to the issue of large IRAs. If one considers the issue from the perspective of what is best for Uncle Sam, creating incentives for investors to accumulate large sums in traditional IRAs may actually be more of a tax trap than a tax shelter. It is entirely possible that calls to limit wealth accumulation in IRAs by Sen. Wyden and other social-reform-minded legislators might actually result in less tax revenue collected. Whether such revenue is better spent by the government or its citizens is a debate for a different day.