IRA owners’ investment decisions may have tax risks

Washington is fond of studies and reports. There are reports and studies issued every day by the various agencies and departments in Washington in addition to those issued by Congressional committees. One of these reports grabbed my attention recently.

On Sept. 16, the Governmental Accountability Office published a report on Individual Retirement Accounts. The report was less than 20 pages and indicated additional reports may be coming.

IRAs have been available in the U.S. for more than 40 years and are a common retirement savings vehicle. It is common for many individuals retiring from their employer to rollover their 401(k) or similar retirement account balance into an IRA. The recent Governmental Accountability Office report on IRAs indicated that, as of 2011, there were approximately 43 million taxpayers with IRA accounts.

Those accounts held assets of more than $5 trillion. What received some press coverage in the report was that nearly 8,000 taxpayers had $5 million to $10 million of assets in their IRA account, nearly 800 had $10 million to $25 million, and 300 had $25 million or more. Approximately 600,000 taxpayers had IRA asset balances of between $1 million and $5 million. The GAO report also indicates 99 percent of taxpayers with an IRA had an asset balance of under $1 million. The GAO report indicates some of the totals are based on statistical sampling estimates and are not necessarily exact numbers.

Many of us who are currently working may not own an IRA account as of the moment. Many of us will likely hold an IRA when we retire and roll over our 401(k) or other retirement plan balance into an IRA account. So it is likely there are many other millionaire retirement accounts that are not accounted for in the GAO study.

The data in the report is 2011 data, so it is a bit dated. Taking a step back and thinking about the past three years, one can envision the balances have grown significantly. Most of the market indices have risen 50 percent or more since the end of 2011. Applying that factor to the gross account balances in 2011 may indicate the asset value in such accounts is more than $7 trillion in 2014.

The number of IRA millionaires has also likely grown since the 2011 data. In fact, the number of retirement plan millionaires may also be larger than in the report when one adds to the IRA amount the number of 401(k) or other retirement accounts with large balances.

Large retirement account balances have been in the news in the past. We all can recall some of the hype around the reported size of Mitt Romney’s IRA during the 2012 presidential campaign. I viewed those reports, at the time, as an indication of how the impact of retirement saving and the rates of return could create significant wealth. The recent GAO report confirms this in some part.

The fact that there are trillions of dollars sitting in retirement accounts has not gone unnoticed in Washington. Such large numbers are like a bank safe with an open door: It is tempting to many with bad motives. The large balances accumulating in these retirement accounts are seen by some as an attractive source of potential tax revenue.

President Obama has proposed in recent budgets to limit the amount an individual can accumulate in an IRA account. That amount is based on some actuarial assumptions regarding payouts and rates of return, and the proposed limit is approximately $3.4 million for an individual It is expected that by capping retirement plans, additional tax revenue can be obtained from that notorious 1 percent group that always seems to be the target of recent proposed tax legislation. The result may be that saving too much for retirement will have a tax cost.

There have been other proposals to require a quicker payout period for inherited IRAs. If a non-spouse beneficiary receives an IRA on account of death of a relative, the beneficiary will be required under one of the proposals to distribute the assets in the IRA within five years of the IRA owner’s death. This allows the federal government to receive tax revenue in a quicker fashion than if the beneficiary defers a payout or has a payout schedule longer than five years. This proposal projects to raise billions in tax revenue over the next 10 years.

The large retirement balances coupled with other assets can find many in a taxable estate situation, even though the estate tax exemption for assets has been raised to more than $5 million. Retirement accounts, insurance, homes and other investments can quickly run up a large amount.

The president also has proposed reducing the estate tax limitation for assets to a lower amount. The amount proposed is $3.5 million. This amount is still large, but certainly the reduction could catch more taxpayers with taxable estates given the recent run-up in retirement account and portfolio balances and the rebound in the housing market. 

IRAs allow tax-free growth in account assets in most cases. Given the growth in retirement assets and the various investment choices for the plans, many IRA owners have made investment decisions that may have tax relevance and possible filing requirements. The investment opportunities may require consideration of taxes with respect to the account assets.

Since an IRA is considered a tax-exempt entity for income tax purposes, care must be taken when looking at the account investments. Tax-exempt entities can be subject to unrelated business income tax, or UBIT, if an investment is considered subject to this tax. The most common investment that may trigger UBIT considerations is an investment in a publicly traded partnership, or PTP (also referred to as Master Limited Partnership). The number of PTPs has grown in recent years as many natural resource related businesses have used this structure to operate and raise capital.

An investment in a PTP may trigger a tax filing requirement in addition to a possible tax liability for the IRA. It has been estimated that as many as 35 percent of the owners in PTPs are IRAs or other qualified retirement plans. Not every PTP generates income subject to UBIT, so looking at the company’s public filings and website before investing may assist in identifying whether the PTP generates any unrelated business income. IRA holders don’t need to be surprised about a UBIT tax liability issue.

For many Americans, IRAs and other retirement accounts may be the single biggest asset the individual owns. The IRA asset value may be larger than the value of their home. Understanding the investment and tax risks are critical in maintaining this asset.

Bill Roth is a tax partner with the local office of BDO USA LLP. The views expressed are those of the author and not necessarily those of BDO. The comments are not to be considered specific tax or accounting advice and cannot be relied upon for the purposes of avoiding penalties. Readers are advised to consult with their professional advisers before acting on any items discussed herein.

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