Retirement Vehicle or Giveaway to the Rich?

The uproar over the future Social Security benefit cutbacks in the new White House budget proposal has overshadowed a little-known retirement tax break that, unlike Social Security, really does need trimming.

The first in an Inequality.Org series on the giant pool of assets in America that produce income not currently subject to  taxation

By Bob Lord

As currently structured, the Roth IRA ranks among the sweetest deals wealthy investors have going.

President Obama’s newly released federal budget includes a provision that would limit accumulations in IRAs and other tax-preferred retirement accounts to no more than the amount needed to finance a $205,000 annual payout during retirement.

The White House budget has no other details on how this provision would work. In all likelihood, the limit would prohibit additional contributions into an IRA if retirement account holders already have enough in their accounts to purchase a $205,000 annuity. But what would happen to existing accounts already in excess of that limit — or to accounts that cross over the limit through appreciation rather than contributions — remains totally speculative.

Whatever the specifics, Roth IRAs will hopefully fall within the President’s proposed limit. Any failure to apply this limit to Roth IRAs — and rein in their future growth —could prove profoundly unfortunate.

The reason why might as well start with America’s most famous IRA of 2012, the plush $100 million retirement account that belonged to GOP Presidential candidate Mitt Romney.

This huge IRA, Americans learned during the campaign, was enabling Romney to defer massive millions in income from income taxes. But this deferral won’t be perpetual. At some point in the future, unless Romney leaves the entire IRA to charity, the dollars in it will be distributed to Mitt or Anne or their children, and the distributions will be taxable.[pullquote]Taxpayers who make contributions to a Roth IRA don’t have to pay any tax on future distributions.[/pullquote]

But what if Mitt had been able to avoid tax entirely on his $100 million IRA? Actually, Romney could have manuvered this avoidance, if he had only waited a few years. Mitt established his IRA in the 1980s. In 1998, after Mitt had already realized enormous gains in his traditional IRA, Congress created a new savings vehicle — supposedly for retirement planning — called the Roth IRA.

If the Roth IRA had been available to Mitt at the time he established his traditional IRA, he likely would have been able to avoid tax entirely on all his IRA income.

Like traditional IRAs, Roth IRAs get funded every year by contributions from earned income by individual taxpayers. But contributions to Roth IRAs, unlike contributions to traditional IRAs, do not qualify as tax deductions — that is, the contributions do not reduce the taxable income of the contributor.

In exchange for foregoing this deduction, taxpayers who make contributions to a Roth IRA don’t have to pay any tax on future distributions from their Roth IRA. For those taxpayers whose Roth IRA investments pay off well, this can become an enormous tax benefit.

Roth IRAs do carry modest contribution limits, currently $5,000 per year, the same limit that applies to traditional IRA contributions. But various tax code provisions let taxpayers convert traditional IRAs and other retirement plan accounts to Roth IRAs by paying a one-time tax on the amount they convert to Roth IRA status.[pullquote]Roth IRA provisions rig the tax game in favor of the wealthy.[/pullquote]

Once this conversion takes place, any earnings in the new Roth IRA will be forever free from income tax.

The original logic behind the Roth IRA made some sense. Taxpayers in low tax brackets were gaining little from making contributions to traditional IRAs. To better encourage them to save for retirement, the Roth IRA would let them forego the modest tax benefit from deducting contributions in exchange for an exemption from tax for the Roth IRA’s eventual distribution, at a time when they figured to be in a higher tax bracket.

We had here, in effect, the opposite of the thinking behind the traditional IRA, where taxpayers make contributions that otherwise would be taxed in a high bracket, in hopes that they’ll be in a lower bracket when they receive their distributions.

Roth IRAs differ from traditional IRAs in another respect as well. Six months after Mitt Romney turns 70, he’ll be required to start making distributions from his gigantic traditional IRA. If he lives long enough, the IRA will be distributed entirely to him. Any post-distribution earnings on the IRA funds will be subject to current income tax.

But if Mitt’s gigantic IRA were a Roth IRA, he could forego distributions and allow the Roth IRA to accumulate throughout his golden years. He even could continue to make contributions to a Roth IRA well after reaching 70.[pullquote]Through a Roth IRA, wealthy taxpayers and their children may generate tax-free income for up to a century.[/pullquote]

Upon Mitt’s death, his children would be required to take distributions from the Roth IRA, but those distributions could be stretched out over their remaining life expectancies.

The bottom line? Through a Roth IRA, taxpayers and their children may generate tax-free income for up to a century, as long as they don’t need to tap into the Roth IRA funds for living expenses during their retirement years. And if taxpayers with Roth IRAs skip a generation and name their grandchildren as beneficiaries, they could stretch their tax exemption out even longer.

That’s where the Roth IRA provisions rig the tax game in favor of the wealthy. The tax benefits flowing from Roth IRAs run far greater for wealthy taxpayers. They alone in their retirement years can afford to forego distributions.

Roth IRAs, remember, are supposed to be retirement accounts. For wealthy taxpayers, they function as anything but. For the wealthy, Roth IRAs amount to tax-advantaged vehicles for wealth accumulation — and nothing else.

Indeed, dollars sitting in Roth IRAs may be the most precious of assets to the wealthy. The wealthy can use these dollars to fund high-yield investments like the private equity fund interests created by Mitt Romney’s Bain Capital. Alternatively, Roth IRAs of the wealthy can hold interests in offshore entities. These in turn can operate businesses at little or no tax cost.[pullquote]At some point in the not too distant future the aggregate Roth IRA balance of the wealthy will reach $1 trillion.[/pullquote]

Roth IRA funds can grow at a healthy clip for decades, simply because wealthy taxpayers don’t actually need their Roth IRA funds for living expenses.  In other words, the Roth IRA originally promoted as an alternative retirement planning vehicle for average Americans is developing into a giant tax-exempt pool of income producing assets for the benefit of wealthy Americans.

The measurable aggregate balance in Roth IRAs is now approaching $1 trillion, according to the Investment Company Institute’s 2012 annual report. And this balance doesn’t include the Roth IRA holdings of wealthy taxpayers invested in privately held entities that do not have to make public disclosures.

Free from taxation, and invested in hedge funds and other exotic assets available only to the wealthy, the Roth IRAs of the wealthy will no doubt grow even more dramatically in the coming years.

So what should we call the Roth IRA, a retirement planning vehicle or a Trojan horse for America’s rich?

Consider the math: At some point in the not too distant future the aggregate Roth IRA balance of the wealthy will reach $1 trillion. Assume that the overall investment return on the Roth IRAs of the wealthy runs 8 percent per year, a very modest assumption.

That would generate $80 billion in tax-free income for the wealthy in just one year, with an ultimate cost of almost $32 billion in lost tax revenue.

Each successive year, the giveaway will only grow larger. Each year, a larger portion of our national aggregate wealth will sit in the Roth IRAs of America’s wealthy. Each year a larger portion of our national income will flow, untaxed and never to be taxed, into these Roth IRAs.

Unless we shut this loophole. Really tight. Really soon.

Bob Lord, a veteran tax lawyer and former congressional candidate, practices and blogs in Phoenix, Arizona.