Why--And How--Congress Should Curb Roth IRAs - Forbes

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http://onforb.es/h6cijn Deborah L. Jacobs Forbes Staff I cover personal finance for baby boomers.

I ve written many articles and a book encouraging people to take full advantage of them. But lately I ve started thinking that Congress should seriously limit their use.

1 Deborah L. Jacobs Forbes Staff I cover personal finance for baby boomers. PERSONAL FINANCE 4:23PM 49,839 views Why--And How--Congress Should Curb Roth IRAs Comment Now Roth individual retirement accounts are the simplest, best tax planning tool around. I ve written many articles and a book encouraging people to take full advantage of them. But lately I ve started thinking that Congress should seriously limit their use. These are the main reasons why Roths are so great: Yelp Chairman Max Levchin s mega-roth IRA lets him take stock sales profits tax free. Photo: David Paul Morris/Bloomberg Although you pay income tax on the money as it goes into the account, doing that eliminates the requirement for you or your heirs to pay tax on future distributions. In other words, all future growth takes place inside a permanently tax-free wrapper. With a Roth you avoid the requirement to take yearly minimum distributions starting at age 70 1/2, and that can leave more for beneficiaries if you don t use the money yourself. Appealing as this is in theory, very few ordinary folks take full advantage of Roth IRAs. Why not? Because they don t want to or don t have the money to pay the income tax up front. It may also be hard for them to conceptualize that if the investments explode in value (and/or tax rates rise later) they will have paid off their IRA tax bill at a bargain rate. In contrast the super wealthy, who have no problem paying the tax, have taken this strategy to extremes. I bumped up against some striking examples in the course of reporting a recent article for FORBES magazine about tax strategies with pre-ipo stock. Perhaps the most dramatic one involves Max R. Levchin, chairman of social review site Yelp. In 2010 he sold 3.1 million shares of Yelp held in his Roth IRA. Most of the $10.1 million he received was profit. But Levchin, a 36-year-old serial entrepreneur who started PayPal with billionaire Peter Thiel in 1998, won t ever have to pay a penny of income tax on those gains. That s because all earnings in a Roth IRA are tax free so long as its owner waits until age 59 1/2 to take money out. 1 of 5 Moreover, Securities & Exchange Commission filings show Levchin still has 12/21/14, 1:18 PM

2 3.9 million shares of Yelp, which closed today at $24.6, in his Roth. So it appears his tax-free retirement kitty is worth at least $95 million and maybe a lot more. We don t know, for example, if Levchin s Roth owned stock in social app company Slide, which he started in 2004 and sold to Google for $182 million in If Levchin doesn t spend his mega-roth in retirement, he can leave it to his kids or grandkids, who can, under current law, stretch out income-tax-free growth and withdrawals for decades. Yelp shares in Levchin s Roth do raise a legal issue. Tax rules bar you from investing your IRA or Roth IRA in a business you control such a prohibited transaction can render the IRA immediately taxable and possibly subject to penalties. It s clear that if you own a small business, your IRA or Roth IRA can t invest in it. But what if you are chairman or CEO of a private firm with many investors and buy its shares for your Roth? SEC filings show that in 2001, while CEO of PayPal, tech investor Thiel bought 1.7 million shares of that company for 30 cents a share through his Roth. In 2002 ebay bought out PayPal for $19 a share an apparent $31.5 million tax-free profit for Thiel. It also appears from a letter we discovered in a federal court case that some of Thiel s early investment in Facebook was also through his Roth IRA. He now sits on Facebook s board. Is this kosher? FORBES has been told reward-seeking informants are filing claims with the IRS Whistleblower Office, flagging such transactions as improper. But IRA expert Noel Ice says it s a gray area, with little IRS or court guidance. Buying closely held stock for an IRA is probably okay, he says, so long as the IRA s owner doesn t have when all his investments are combined voting control of that company. Levchin, Thiel and the IRS wouldn t comment. Roths are really there for the big hitters not for the common schlep who is going to have a hard time funding the IRA, says John Buckley, former chief Democratic counsel to the House Ways and Means Committee, who is now a visiting professor at Georgetown University. After I wrote about how tech titans are using Roth IRAs to dodge mega millions in taxes, I received an from a reader named Eugene (he asked me not to use his last name), a 31-year-old computer programmer in New York, asking how Levchin and Thiel could accumulate so much in their IRAs given the annual contribution limits of $5,000 per person ($6,000 if you re 50-plus). 2 of 5 The most likely answer is that these entrepreneurs, who have had considerable career mobility, rolled over 401(k)s into Roth IRAs when they changed jobs, and then invested the funds in pre-ipo stock not just of their own companies, but in others as well. (For another route to a Roth see, How A High-Earning Couple Got Roth IRAs And You Can Too, by FORBES associate editor Ashlea Ebeling.) The same strategy would work for venture 12/21/14, 1:18 PM

3 capitalists or other people who have access to pre-ipo stock. Note: If you do want to put nonpublicly traded stock in an IRA or a Roth IRA, you ll generally need to use a special custodian who handles self-directed IRAs. (The big brokers, banks and mutual fund companies that hold most IRAs generally limit investments to publicly traded stock, bonds, mutual funds and bank CDs.) Levchin and Thiel have used San Francisco-based Pensco Trust Co. to hold their Roth IRAs. As part of its marketing efforts, Pensco called attention to a Wall Street Journal report in January that Mitt Romney held as much as $101 million in an IRA; we don t know for sure, but The Journal inferred that it was not a Roth. Speculation was that his IRA grew so large by investing in Bain Capital, the private-equity firm he helped start. The day after The Journal story ran, Pensco issued a press release noting that Romney s IRA would be even more valuable if it was a Roth account, because he would not have to pay income tax on withdrawals. In the same release, Pensco stated that it has more than 250 IRA accounts between $1 million and $100 million. Three accounts each have more than $100 million. Still, when Congress created the Roth, the lawmakers probably didn t envision thirtysomethings or presidential candidates accumulating mega million IRAs. In fact, the Roth IRA was a result of a conscious, contemptible manipulation of the budget rules, Buckley says. In 1997, then Senator William Roth (R-Del) wanted to restore the traditional IRA which had been repealed in 1986, and the upfront tax deduction that goes with it. Under congressional budget rules, which work within a 10 year window, the revenue cost of giving that tax break to everyone was too high. So his staff limited deductible IRAs to people with very low income, and made Roth IRAs ( initially with income limitations) available to others. That slid the revenue cost outside the 10 year window and got the legislation out from under the budget rules. Senator Roth, who died in 2003, left behind a generous legacy for taxpayers who could afford to pay the tax up front and then achieve outside rates of return. The legacy got even more generous in Since then, anyone, regardless of income, can convert a traditional IRA to a Roth. Another Roth strategy, for people who are about to change jobs or are approaching retirement is to roll the assets directly from a company plan into a Roth IRA, but they must pay income tax on the account balance. 3 of 5 Economists have warned about exploding future revenue losses associated with Roth IRAs. With these accounts, the government is bringing in more now, but giving up much more in the future, says economist and FORBES contributor Leonard Burman. In a study for The Tax Policy Center, Burman calculated that from 2014 to 2046, the Treasury would lose a total of $14 billion as a result of IRA-related provisions in the 2006 tax law. The losses stem from both Roth conversions and the ability to make nondeductible IRA 12/21/14, 1:18 PM

4 contributions and then immediately convert them to Roths. These revenue losses come at a time when the baby boomers are aging, placing greater demands on the federal government, Burman says. Passing on more financial problems to our kids is really irresponsible. We re leaving them a weak budget situation to begin with. Cutting off a major source of revenue makes no sense. What s more, he notes, the people for whom a Roth is the best deal are those who really don t need the savings for retirement they re the ones who plan to leave these tax-free accounts to their kids. For people who ve already set up Roths and those who inherit those accounts Congress shouldn t change the rules. People have done their tax planning with these rules in mind. (Full disclosure: I am one of them.) Going forward, here are two changes that would make sense from both an economic and a tax policy perspective: 1. For new Roth IRAs, cap the amount that can accumulate in the account. Once the balance in the account reaches more than $10 million, IRA owners should be required to withdraw the excess on an annual basis and pay tax on the earnings at ordinary income rates. 2. Limit tax-free inherited Roth IRAs to $1 million per beneficiary, adjusted for inflation. Inheritors should be required to withdraw the excess on an annual basis and pay tax on the earnings at ordinary income rates. What is Congress likely to do? Nothing, says Thomas L. Hungerford, a specialist in public finance at the Congressional Research Service, and co-author of a recent report on the complexities that surround IRAs. Tech titans with mega millions socked away in Roth IRAs are outliers, he says, and Congress shouldn t change tax policy for outliers. Presumably the likelihood of that happening will grow even more remote if the next president of the United States turns out to be one of them. Asked about his taxes, Mitt Romney told The Wall Street Journal: I can tell you we follow the tax laws, and if there s an opportunity to save taxes, we, like anybody else in this country, will follow that opportunity. We can bet he d like to keep it that way. Additional reporting by William P. Barrett and Janet Novack. You May Also Like Five Rules For Inherited IRAs Four IRA Deadlines Every Smart Investor (Or Advisor) Should Know 4 of 5 Archive of Forbes Articles By Deborah Jacobs 12/21/14, 1:18 PM

5 Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide. You can follow her articles on Forbes by clicking the red plus sign or the blue Facebook subscribe button to the right of her picture above any post. She is also on Twitter and Google+ This article is available online at: Forbes.com LLC All Rights Reserved 5 of 5 12/21/14, 1:18 PM

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