Big, occasionally gargantuan, retirement plans are walking the plank in Democrats’ plans to raise taxes. So are millions of far more modest IRAs.
The emerging tax bill would ban individual retirement accounts of all types and any size from holding alternative investments intended only for investors whom securities regulators consider “sophisticated.” That means shares in anything other than publicly-traded stock, bonds or mutual funds — such as private businesses, startups, private equity-backed firms, real estate, hedge funds and peer-to-peer lending networks.
President Joe Biden has promised not to raise taxes on Americans making less than $400,000 a year. The pledge is part of his plan to raise taxes on the wealthy to pay for his $3.5 trillion social spending plan.
But tax writers’ proposal to ban alternative assets in IRAs “would essentially create a wealth tax on millions of middle-income Americans,” said Eric Satz, the founder and CEO of Nashville, Tennessee-based Alto Solutions, a digital service for self-directed IRAs that lets people invest their retirement plans in alternative assets. Unlike a traditional IRA, a self-directed IRA lets its owner invest in alternative assets.
Under an SEC rule that equates wealth with enlightenment, only investors who are “financially sophisticated” are a so-called accredited investor and thus allowed to invest in non-publicly traded securities. Accredited investors must have income exceeding $200,000 ($300,000 with a spouse or “spousal equivalent”) over two prior years, or a net worth of at least $1 million (not including their home), or certain licenses to trade securities.
Retirement account ‘poison’
Under the House tax bill, investors would be prohibited from holding in their IRAs any investments that are only available to accredited investors starting next year. Affected investors would have two years to sell their investments or forfeit the tax-advantaged status of their IRA.
That latter outcome could create what retirement expert Ed Slott called a “poison” that could translate into immediate tax bills and early withdrawal penalties (for younger investors).
“This net was created to catch big fish like Peter Thiel, but the net catches the smaller fish,” Slott said.
The Thiel effect
Peter Thiel, a co-founder of PayPal, grabbed lawmakers’ attention last June when ProPublica reported, citing leaked documents, that he had seeded his account with less than $2,000 worth of stock in PayPal, Facebook and other then-tiny startups. The stakes skyrocketed in value when the fledgling companies went public, making Thiel’s retirement account now worth $5 billion.
Most people aren’t Peter Thiel. But advisors say that like the Silicon Valley behemoth, many solidly middle-income and high middle income people own alternative investments in their IRAs, such as a stake in a single-family rental home located close to where they live.
The difference: While their net worth on paper might be $1 million, their annual income can be a far more modest $150,000 or so — well below Biden’s $400,000 threshold. Meanwhile, advisors say, other retirement savers make a notch over the $200,000 accredited investor limit but don’t have a seven-figure net worth. Or they once earned that much money but don’t any more, and also don’t have a $1 million net worth that doesn’t include their home.
Satz said that there are “millions of accredited investors who make more than $200,000 but less than $400,000 who invest in alternative assets.” A 2016 Government Accountability Office report said there were 2 million IRAs with unconventional holdings, with one in five missing fair-market valuations, a sign of potential tax evasion.
Because unconventional assets aren’t publicly traded, they’re often hard to value and more difficult to sell, particularly on short notice. Satz said the tax proposal would “force liquidations on a massive scale of illiquid investments, and this will hurt not just the investors but the companies.”
‘Wealth tax on middle Americans’
The threat to IRAs held by investors of relatively modest means is overshadowed by the tax bill’s crackdown on big retirement accounts.
In what might be dubbed the Thiel rule, the House bill would end mega Roths by imposing dollar limits on their size.
Thiel’s account became huge because the low-value stock it initially held exploded in value. But there are other ways to accumulate a sizable IRA, and the House bill aims to stop them.
One method involves simply converting a long-held additional IRA to a Roth. There are no IRS limits on how much in a traditional IRA can be converted to a Roth. Advisors say clients have gone wild in recent years for the strategy.
Another strategy involves 401(ks) retirement plans. An investor takes advantage of a benefit that allows her to put as much as $58,000 into her company-sponsored 401(k) plan, then converts the account to a Roth.
The bill effectively nukes Roth strategies for all earners over time. Come 2022, it would ban after-tax contributions in 401(k)s and IRAs contributions from being converted to a Roth regardless of the person’s income level.
Later, come 2032, the bill would prohibit people with income over $400,000 ($450,000 for couples) from converting any IRA to a Roth. That would put an end to so-called “backdoor” Roth conversions, which is when a high earner sidesteps — that’s the backdoor part – the income limits for a Roth plan by morphing a traditional IRA into its Roth cousin. The investor pays taxes, at ordinary rates, on the amount converted, but the pot’s subsequent gains are tax free.
In a backdoor deal, the investor opens up a traditional IRA and funds it with after-tax dollars that are then invested in stocks or other assets. Because the plan is not an employer one, the money kicked in is by definition dollars on which taxes have already been paid. Then the investor converts the traditional plan to a Roth. There’s no tax bill on the conversion, because the taxes have already been paid. Unlike for Roth IRAs, there are no income limits for contributions to traditional IRAs. Slott called the ban on regular conversions, not backdoor ones, “a bigger deal — that’s where the money is” for most investors.
But it’s the bill’s separate aim at investors who use their IRA to put money into alternative assets that has many advisors upset.
Henry Yoshida is the co-founder and CEO of RocketDollar, a company in Austin, Texas, that enables investors to set up self-directed IRAs and solo 401(k)s.
He said that most of his clients are middle-aged, mid-career people who amassed six-figure 401(k)s through their employers and rolled those plans into an IRA. They typically put anywhere from 5% to one quarter of their IRA into alternative investments, like early-stage companies, private businesses, single-family rental homes and cryptocurrency funds.
If the ban on alternative investments becomes reality, “It’s going to curtail the ability of savers who aren’t millionaires or billionaires,” said Yoshida, a CFP who co-founded robo-advisor Honest Dollar, which Goldman Sachs bought in 2016. “The majority of these people may be taking advantage of a local real estate opportunity, as opposed to investing in a Facebook.”
Referring to reports in 2012 that former presidential candidate Mitt Romney had a giant Roth IRA estimated at over $100 million, Yoshida added that “I don’t know that the extreme edge cases of Peter Thiel and Mitt Romney should eliminate the ability for millions of people to invest in private assets.”
The IRS defines an IRA as large if it’s worth at least $5 million. Just over 24,000 Americans have such plans — what Satz called less than 0.7% of all retirement account holders. “In the haste to punish those with so called mega IRAs,” he said, tax writers in the House of Representatives and the Senate “have drafted provisions which essentially create a wealth tax on middle income Americans.”
“They’ve taken a paint brush the size of Texas,” Satz said, “to an island in the Pacific, and hit millions of people elsewhere.”