Introduction
Since individual revenue accounts (IRAs) are commonly used to supplement savings through employer-sponsored plans, it is very important to understand them in detail. Some assets, like stocks, can be owned without any problem, but other assets, like real estate, become a bit trickier. Sometimes investors will resort to publically traded real estate investment trusts (REITs), but other investors are desperate for direct real estate ownership with retirement assets. The self-directed IRA can help meet this need, but it has many serious potential pitfalls that should be fully understood.
The potential usefulness of traditional IRAs, Roth IRAs, and Roth IRA conversions will depend upon taxpayer’s unique financial situation. You will be introduced to these issues in this chapter.
Learning Goals
•Describe the two instruments that can be used to fund an IRA
•Understand the uses and pitfalls of a self-directed IRA
•Identify prohibited investments within an IRA
•Discuss when a traditional IRA or a Roth IRA might be a better choice for a taxpayer
•Describe the Roth IRA conversion process and its usefulness
IRA Funding Instruments
In general, an IRA is a non-employer-sponsored retirement savings plan. There are two different methods for funding an IRA. Both involve the same rules and limits. Both also involve taking a contribution and depositing it into a “container.” The two different methods are really just a question of packaging and not so much about function or purpose. One of the selling features for an IRA is that, unlike employer-sponsored plans, the IRA owner always has access to withdrawals at any time and for any reason. As you will learn in Chapter 24, the catch is that most withdrawals taken before the IRA owner has reached age 59½ will be subject not only to ordinary income tax rates but also to a 10 percent early withdrawal penalty. It is also important to understand that whichever funding “container” is used, the actual IRA account must be operated for the exclusive benefit of the IRA owners or their ultimate beneficiaries, or both. The beneficiaries come into play if the IRA owner indicates to their advisor that they do not need the IRA for their own living expenses, and the IRA should be managed with the beneficiaries in mind. This could have the effect of increasing the risk level of the investments in an IRA being managed for the beneficiaries.
The first method is the individual retirement account (hereinafter IRA). This is the type of account that most people think of when they hear the term IRA. In this method, a trustee (or custodian) will physically hold the investments in the IRA and manage the account within the rules and provisions that the Internal Revenue Service (IRS) stipulates for the IRA category. The custodian could be a bank (like Bank of America), a mutual fund company (like Vanguard or Fidelity), a brokerage house (like Merrill Lynch), or a discount broker (like TD Ameritrade or Charles Schwab). It is expressly forbidden for individuals to act as their own IRA custodian.
IRAs can hold numerous types of investments. An IRA owner could hold certificates of deposit (CDs), individual stocks, individual bonds, open-end mutual funds, closed-end mutual funds, exchange traded funds, and listed options contracts. There are also other assets that could be owned within an IRA, but it will be easier to describe what cannot be held in an IRA. You will learn about prohibited assets later in this chapter.
The second method is called an individual retirement annuity. The individual retirement annuity must meet all of the regular rules and limitations as a straight IRA, with the primary difference being what it invests in. Instead of investing in stocks, bonds, and mutual funds, an individual retirement annuity invests only in an annuity. It could be either a fixed or a variable annuity contract, but either way, the premiums cannot exceed the annual contribution limit for a straight IRA. For 2014, the annual contribution limit is $5,500. One attractive feature of the individual retirement annuity is that the owner is not required to select any investment options. All they need to do is make contributions, and the insurance company that holds the individual retirement annuity will make all of the investment selections. This is a hands-free option, but it provides very little flexibility in terms of investment management. This method is best for someone who does not know what he or she is doing and does not want to hire a manger for help.
Self-Directed IRAs
In modern markets, investors are searching for alternative investment opportunities. Investors can own hedge funds, commodities, and REITs within their IRA, but if they want more direct alternative assets, they will not be able to hold those investments within a traditional (or Roth) IRA. For those opportunities, investors will need to consider self-directed IRAs. A self-directed IRA is a unique type of IRA, which may hold investments whose valuation is not easy to ascertain. Traditional IRA custodians only want to hold assets for which a fair market value is easily discernable.
You already learned in Chapter 17 that investors cannot be their own custodians or trustees. With a self-directed IRA, investors will need to find an IRA custodian who will allow them to hold nonstandard investments. There are little-known custodians who specialize in self-directed IRAs, and these special custodians typically charge more for their special service.
The most common nonstandard investment that is typically held within a self-directed IRA is investment real estate. Some investors might also hold self-storage facilities and investments in franchises within a self-directed IRA. The catch is that all costs must be paid for using IRA assets. That includes any down payments, any monthly mortgage payments, any maintenance costs, or any property taxes. Investors must be careful to not comingle self-directed IRA assets with non-IRA assets. Or they could end up with an IRS problem on their hands.
This can be a great way of diversifying investment exposure into alternative asset classes. The investor will run into regulatory problems under two circumstances. First, if any expenses or investments are made in an asset held within a self-directed IRA, the investor will encounter problems with the IRS. The second area of issue is known as self-dealing, which is using the self-directed assets for personal gain and not retirement account gain. You might be thinking that investors should be able to benefit personally from their own retirement account. While this logic is correct, the IRS is trying to prevent abuses like a wealthy investor with a substantial IRA balance using a self-directed IRA to purchase a primary residence with tax-deferred money and then being able to sell the primary residence and escaping the applicable capital gains rules for selling a primary residence. This is an example of a violation of the self-dealing rule associated with a self-directed IRA. Because of all of the inherent conflict possibilities involved with self-directed IRAs, the regulators are beginning to scrutinize self-directed IRAs with greater regularity and vigor.1
Prohibited Investments and Emerging IRA Opportunities
In general, an IRA provides the investor with a great deal of choice in investment selection. Whereas an employer-sponsored plan will typically limit the investment selection pool to no more than 10 to 15 options to choose from (usually mutual funds), the IRA provides access to any mutual fund, exchange-traded fund (ETF), individual stock, or individual bond that the investor is interested in.
There are, however, certain types of investments that are expressly prohibited within an IRA environment. The first prohibited investment is life insurance. Investors can still purchase an annuity (in an individual retirement annuity), which is only offered by an insurance company, but life insurance, such as term life or whole life insurance, is not allowed like it is in many employer-sponsored plans. Another prohibited investment category is collectibles. Collectibles specifically refers to investments in artwork, stamps, rare coins, fine wines, antiques, sports memorabilia, and many other types of tangible collectibles. There is an exception to the collectible prohibition for precious metals (gold, silver, platinum, etc.) and for certain government-issued gold and silver coins.
There are also certain types of transactions that are specifically prohibited within an IRA. An investor cannot borrow any money from an IRA (no plan loans). If the custodians were to permit a plan loan, then the entire IRA would cease to be a tax-qualified account retroactive to the beginning of the calendar year. This would create a potentially large tax liability. For this reason, IRA custodians do not permit plan loans.
It is also prohibited to sell property to an IRA. All contributions must be in the form of cash. The IRS is trying to eliminate a potential dispute between the IRS and a taxpayer on the valuation of an asset contributed in kind to an IRA. To avoid haggling over how to value assets to ensure compliance with the annual contribution limits, the IRS simply mandates that all contributions must be in cash.
Another prohibition relates to paying investment management fees for managing an IRA. If a professional manages an IRA, then the fees for such management can be paid out of the IRA account. Normally, a distribution from an IRA is taxable for the IRA owner and it may even generate a 10 percent penalty if it occurs before age 59½. Payment of investment management fees is not taxable for the IRA owner. Some IRA owners have tried to pay themselves for managing their own IRA. The IRS says “Nice try, but no.” IRA owners are not permitted to pay themselves a fee to manage their own account.
An IRA also cannot be used as collateral for a loan. Some IRA owners have tried to use their IRA as collateral for either a business loan or even a personal loan for a mortgage or other personal assets. This is expressly prohibited. Any form of self-dealing is also prohibited.
Despite the prohibitions, there are several recent opportunities within the world of IRA planning. The contribution limits have been rising steadily and are expected to continue to rise further in the future. Another recent opportunity is the availability of a spousal IRA. They were available as recently as 1981, but with a greatly reduced contribution limit relative to a normal IRA contribution limit. The Taxpayer Relief Act of 1997 extended the full contribution limit to spousal IRAs and they have been increasing the limit whenever the normal IRA contribution limit is increased.
Another advance in IRA planning is the high income threshold for Roth IRAs. This higher limit puts IRA savings within reach of almost all Americans. However, as you learned in Chapter 17, a married couple filing a joint tax return cannot contribute to a Roth IRA after their income rises above $191,000. Those who fall into this very high earning range can still make a nondeductible traditional IRA contribution and then convert that money into a Roth IRA. This little twist is known as a backdoor Roth conversion and is a very interesting planning tool for wealthy clients.
If an employee has a traditional IRA, perhaps resulting a rollover from a previous employer’s 401(k), and they now work for an employer who sponsors a SEP plan, then they have a special relatively new benefit. Normally, a traditional IRA has a contribution limit of $5,500 (2014 limit) with potentially an additional $1,000 if the IRA-owner is over at least 50 years old. However, if the employee is covered by a SEP plan through their employer, then the employer can now contribute the SEP contribution into the participant’s traditional IRA. This works because a SEP is funded with an IRA. Why is this a benefit? The participant can now contribute up to the significantly higher SEP contribution limit into their traditional IRA. This will enable them to consolidate their holdings into one account and trade with relatively few restrictions within their traditional IRA.
Roth IRA Versus Nondeductible Traditional IRA Contributions
How should an investor pick between making a Roth IRA contribution and a nondeductible traditional IRA contribution? They both sound conceptually similar, but they are not. With a nondeductible traditional IRA contribution, the actual contribution amount is never taxed again, just like a Roth IRA. However, the earnings (growth) on the contributions in a Roth IRA are also never taxed while the earnings on a nondeductible traditional IRA contribution are taxed at ordinary tax rates. There is a complicated formula for determining how a nondeductible traditional IRA factors into the taxable picture for the larger traditional IRA when there are also deductible contributions involved. You will learn about this calculation in Chapter 23, but for now, understand that it is not as straightforward as a Roth IRA.
At the end of the day, a Roth IRA has better tax treatment than a nondeductible traditional IRA contribution. However, this assumes that a taxpayer falls below the income limit that will enable him or her to make a Roth IRA contribution.
There is a back door to making a Roth IRA contribution for an investor who is above the income limit. There is no telling how long Congress will leave this loophole open, but a wealthy client can make a nondeductible contribution to a traditional IRA and then immediately (before there is a chance for any earnings to accrue) convert the nondeductible traditional IRA into a Roth IRA without any tax liability. This only works if there are no deductible contributions made to the traditional IRA, and the conversion occurs before any earnings amass on the nondeductible traditional IRA.
If a wealthy investor is not planning on converting to a Roth IRA, then he or she is better off investing in a non-IRA, non-tax-deferred account known as a nonqualified (individual, joint, or trust) account. Within this type of account, there is no tax-favored status, but all gains are now capital gains instead of ordinary income. The investor will also have the right to choose when to realize any gains and receive tax deductions for any losses. At death, any holdings in a taxable (non-tax-deferred account) will receive a stepped-up basis. This is a very important benefit that may outweigh the tax deferral available to wealthy investors in an IRA.
Stepped-up basis means that if an investor dies while holding an asset in a nonqualified account, their actual purchase price will no longer be applied for calculating capital gains taxes. The person who inherits the asset will have a new basis equal to the value of the asset on the date of the death of the previous owner. An exception exists for accounts that are jointly owned. The new basis equals 50 percent of the original cost and 50 percent of the value on the date of death. This planning tool may benefit wealthy clients with substantial assets and no need for income out of their retirement accounts.
Consider an example where a taxpayer dies with $200,000 in a non-IRA account. His or her cost basis is $50,000 and he or she is the sole owner of the account. The stepped-up basis rules will mandate that this person’s heir will receive a cost basis of $200,000 for the inherited assets if they are in a taxable (non-IRA) account. Notice that 100 percent of the otherwise capital gains taxes are forgiven. This is a tremendous benefit! What if the account had been registered in a joint name with the decedent’s spouse? In this case, 50 percent of the capital gain would be forgiven instead of 100 percent. The joint owner’s new basis would be $125,000 [(50% × $50,000) + (50% × $200,000)].
Roth IRA Versus Deductible Traditional IRA Contributions
The question of whether a client should make a Roth IRA contribution or a deductible traditional IRA contribution comes down to an estimate of both current tax rates and applicable tax rates in retirement. If tax rates for a client are expected to be higher in retirement, then the Roth IRA is clearly better. If tax rates are expected to be lower in retirement, then a traditional IRA is clearly better. Retirement savers will want either the tax deduction or the tax-free income in the period in which taxes are expected to be the highest.
Figure 18.1 comes from the retirement calculators on Bankrate.com. You can see the various assumptions made, and that in this instance, a traditional IRA may be a better choice. The result is entirely dependent on the accuracy of the assumptions made, and real-world decisions should be made with all of these variables carefully considered.
Figure 18.1 An Internet calculator to pick between a traditional IRA and a Roth IRA
Source: Bankrate.com
Abbreviation: IRA, Individual retirement account.
In general, a Roth IRA is better than a traditional IRA in terms of mandatory distributions. If a taxpayer has no need for distributions out of their retirement savings account to fund their retirement lifestyle, then the Roth IRA presents an advantage. Unlike traditional IRAs, they have no mandatory distributions. You will learn all about this process in Chapter 24.
Even though the traditional IRAs may be more appropriate for a taxpayer, based upon the calculators shown, the Roth IRA may still have a place in planning. It is advisable to diversify the sources of income in retirement. Some sources from taxable accounts and some from nontaxable accounts. This will provide those with the ability to plan the greatest level of flexibility.
Roth IRA Conversions in Greater Detail
Before an investor can consider whether a Roth IRA conversion makes sense for them, they must consider both current and projected future tax rates. There is an easy online calculator available in the retirement section on money.msn.com.
When someone decides to convert a traditional IRA into a Roth IRA, he or she will be taxed in the current year for the full amount of the conversion. This is because the traditional IRA originally generated a tax deduction and Roth IRA contributions must come from after-tax money. The calculator on money.msn.com is very good because it factors in how long someone has before he or she plans to retire and how long he or she plans to be in retirement. It is important to understand if the investor will have time to let the investment growth make up for the taxes paid up-front.
One key to a conversion working effectively is that all conversion taxes must be paid from sources other than the IRA assets. It would be counterproductive for the conversion taxes to be withheld as the assets are transferred from the traditional IRA to the Roth IRA. This would result in a much smaller investable amount in the new Roth IRA, which would need to be invested more aggressively to make up for the taxes withheld. By paying the taxes from assets outside of the Roth IRA, the taxpayer is theoretically reducing the taxable estate. The reduction comes from the money paid to the government for taxes.
Who might be an ideal candidate for a Roth IRA conversion? Those taxpayers who are in the top tax bracket and expect rates to rise might be good candidates for Roth IRA conversions in the current year. The other end of the tax rate extreme also has good potential. Those in temporarily low tax brackets could take advantage of a Roth IRA conversion. I had a client who was the comptroller of a company and had significant income and a substantial traditional IRA. Due to business conditions, her employer began to struggle and sold itself to another firm. Through the process, my client lost her job and found herself on extended unemployment. Her tax rate suddenly dropped from a high range to the lowest bracket. She had substantial savings and was able to survive just fine for roughly two years until she was able to find gainful employment once again. During the period of unemployment, she elected to convert sections of her traditional IRA into her Roth IRA. She made the temporary decrease in tax rate work in her favor from a retirement planning perspective. Converting a Roth IRA is not an all-or-nothing proposition…it is possible to strategically convert the traditional IRA in sections, and you can convert shares (in kind), there is no requirement that conversions must be in cash like contributions must be in cash.
Another individual who might be a good candidate for a Roth conversion is someone who does not need to take withdrawals from their IRA for retirement income. Obviously either this person has planned VERY well or has significant resources outside of the IRA on which he or she plans to live. The Roth conversion could meet this individual’s needs because there are no mandatory distributions from a Roth IRA, which would allow the money to remain tax deferred until his or her heir eventually inherits the account. This investor sees the Roth IRA not as a retirement funding instrument but as an estate asset. As you learned in Chapter 17, those seeking to diversify the taxability of their retirement income sources might also consider converting to a Roth IRA.
Who would not be a good candidate for a Roth IRA conversion? Those for whom a Roth conversion is not the best idea include investors with little financial means. If someone does not have enough cash available outside of the Roth conversion process with which to pay the conversion taxes, they should not attempt a conversion. There are also some taxpayers who will use a Roth conversion calculator and based on their unique situation decide that it just is not best for them. A Roth conversion can be a great tool, but it is not right for everyone.
Discussion Questions
1.There are two different types of accounts that are both known as an IRA. Discuss their differences.
2.Why would an investor choose to invest in an individual retirement annuity?
3.Is it true that individual retirement annuities enable a retirement saver to save more money than using an individual retirement account?
4.Why would a retirement saver want to go through the hassle of using a self-directed IRA?
5.A 49-year-old retirement saver has decided to use a self-directed IRA to purchase a self-storage unit. There are 100 units in the facility, and the owner uses one unit to store rental unit supplies and one to store the owner’s Porsche during the winter months. They deposited their entire IRA balance into the asset. A tree falls on one corner of the unit and does $10,000 worth of damage. The owner does not want to file an insurance claim, which would raise their insurance rates, so they simply write a check out of a personal checking account. Are there any issues with this scenario?
6.A 35-year-old taxpayer is planning on contributing the maximum amount to her IRA this year. Assume that she is eligible to do so. She is planning on contributing shares of a technology company that she owns in a taxable (non-IRA) account because she thinks that this company will appreciate substantially and within the IRA, the appreciation will be tax deferred. Are there any issues with this scenario?
7.A client of yours has spoken to their long-time bank about receiving a loan to start a small business. Their only collateral that is large enough to secure the loan is their IRA. The bank is not willing to use their IRA as collateral. Your client is very frustrated and is planning on changing banks. What counsel would you give your client?
8.What choice should investors make if they are given the option of choosing a Roth IRA contribution or a nondeductible traditional IRA contribution?
9.What is one advantage of using a taxable account as a repository for savings?
10.A married taxpayer recently died, leaving his surviving spouse with a taxable account balance of $424,000. The original cost basis was $78,000. What is the surviving spouse’s new cost basis in this account?
11.A taxpayer is expecting the tax rate to increase during retirement due to an expected inheritance. Should he be saving with a Roth IRA or a traditional IRA?
12.What type of client might be a good candidate for a Roth conversion?
13.A client of yours has a taxable account, a 401(k), and a traditional IRA, which was the result of a rollover from a previous employer’s profit sharing plan. They are thinking about converting their traditional IRA into a Roth IRA. They are concerned about realizing a substantial amount of additional taxable income in one tax year. What would you tell them?
14.A different client approaches you about converting $30,000 from their traditional IRA into their Roth IRA. They have a 15 percent effective tax rate. They only have $1,500 in savings that could be used to pay the conversion taxes. They are planning on withholding the remainder of the taxes from the assets that are being transferred. How would you advise them?