This will not be an easy request, but can we, for a moment, put aside our furor and frustration with billionaires who used Roth IRAs as their personal tax-free piggybanks? It’s hard not to get riled up about a billionaire who managed to put a couple grand into a Roth IRA and have it now worth over $5 billion, tax-free. For some this just doesn’t seem right. However, the reason to put ire aside momentarily is that there is an opportunity to glean some retirement planning lessons from this tale of excess profit.
When late last month ProPublica revealed the amount of taxes paid by the wealthiest of the wealthy, a firestorm of criticism erupted. As the information became more granular and exposed the unimaginable leveraging of the popular Roth IRA planning tool, especially by billionaire Peter Thiel, condemnation from some quarters intensified. We learned that wealthy individuals were able to contribute privately held stock to a Roth IRA, sell the stock when it paid off in an IPO, reinvest that gain into yet another private transaction, reap even more profits – and accomplish it all inside a tax-free wrapper. This is all legal. The money usually gets into the Roth IRA through a Roth conversion, the buying and selling of the pre-IPO securities occurs within the qualified account, and as long at the investor waits until age 59 ½, the entire amount comes out income tax free. Just to add some sweetener to the mix, the account is creditor-protected and, once the participant is 59 ½, there’s the option to access the funds tax free or let them continue to grow. There are no required minimum distributions (RMDs) for Roth IRAs.
The numbers are staggering in the cases of these billionaires, but the question is whether there is anything that we, who don’t reside in the financial stratosphere, can learn from these stories? Surprisingly enough, yes, there are lessons to be learned, both positive and negative.
Roth IRAs Have Tax Advantages
It’s not that Roth IRAs are some kind of tax loophole. They’re supposed to be tax free. Arguably, the size of the gains allowed for billionaires is unintended by Congress, but the tax advantaged nature of the Roth IRA is a known commodity. If you need proof that you can save taxes with a Roth IRA, look no further than how these captains of industry have profited. To review, you can deposit after-tax dollars into a Roth IRA, and those funds not only grow tax-deferred, but pay out tax-free. Once you’ve owned the account for at least five years and have experienced a triggering event (reaching age 59 ½, death, disability, etc.), you have tax-free access to the account. Further, if you still have funds in your Roth IRA account when you reach age 72, different from traditional IRAs, you’re not required to take minimum distributions. Your retirement account can grow and be left to your heirs as a legacy. The result is that a Roth IRA is both a great retirement tool and useful means for wealth transfer.
Roth Conversions Allow For Large Transactions
Contributing directly to a Roth IRA is largely limiting this benefit to the middle class. The maximum contribution for 2021 is $6,000; if you’re age 50 or over, it is $7,000, and even that amount is limited if you make too much income. For example, a married couple earning $208,000 or more would not be allowed to contribute to a Roth IRA. The magic for the affluent and wealthy is the ability to convert a traditional IRA to a Roth IRA. No matter how many zeros are on your 1040, you can take your tax-deferred traditional IRA, pay tax on the account and convert it to a Roth IRA. Several of the stories exposed about the billionaires’ accounts involved leveraging an IRA by funding it with privately held stock, converting that account to a Roth IRA, and watching it build tax-free. There simply are no limits on this transaction.
Because of this lack of limits, the Roth conversion can be a useful retirement tool for the affluent. In a previous post this year, I pointed out that you can lower overall taxes by spreading out the conversions of your IRAs to Roth IRAs. The systematic Roth conversion technique helps spread out income taxes over several years. In many cases, you can convert just enough of an IRA account to your Roth IRA to stay in your same marginal tax bracket. This benefit can be enhanced if the conversion is made when the value of the underlying investment is depressed. A Roth conversion of IRA stocks in March of 2020, when the market was reeling from the pandemic, would have efficiently moved assets at a low tax cost. This approach is potentially even more powerful currently because tax rates are likely to increase.
When viewing the use of IRAs for wealth transfer, the changes wrought by the 2019 SECURE Act make Roth IRAs even more appealing. Because the stretch IRA approach no longer applies for most beneficiaries of inherited IRAs, Roths offer an after-tax way to limit the tax consequences to adult beneficiaries. The accounts generally must be paid out within 10 years of the participant’s death, but with the Roth IRA, the amounts being paid are coming out income tax-free. If it’s good enough for the likes of the billionaire’s club, it’s worth a look in your own retirement and estate planning.
Your Roth Strategy Is In Your Control
Like it or not, the law has baked in certain tax favored transactions, and a lesson learned from the rich and famous is that tax planning pays off. Rather than assuming only the rich can benefit from tax planning, do some for yourself. An example with Roth planning is the so-called “Roth 401(k)” which has become widely popular in the defined contribution qualified plan world. Many employers allow their employees to direct their contributions to a taxable Roth Account versus their regular tax-deferred 401(k) account. The contribution potential is larger than with a traditional IRA or Roth IRA. A 401(k) involves as much as a $19,500 annual contribution (without an income limit) versus a $6,000 contribution for a Roth IRA. The advantage of this strategy for many is that you pay tax on the seed (the contribution) but not on the harvest (the account when you retire). If you expect taxes to rise, specifically your taxes to increase, electing a Roth Account in a 401(k) can mirror, in miniature, what the billionaires have done. Mixing this with targeted Roth conversions, you have it within your control to strategize retirement fund contributions and drawdowns to maximize your tax savings.
Negative Lessons Learned
If your parents ever asked, “just because your friends jump off a bridge, would you?”, you can anticipate my next question. Just because the rich aggressively leverage Roth IRAs to secure millions in tax-free gain on high growth stock plays, should you? The answer is no. A Roth IRA is not a good vehicle for investing in a flier. An aggressive stock pick entails the risk of a loss. With a billionaire, that loss can be absorbed in other transactions. With the rest of us, a capital loss is something we could use on our tax return. By buying a stock on a tip and putting it in a Roth IRA, the gain on sale is sheltered. But if the possible, even probable, happens and the stock loses, you can’t write off the loss. More importantly, that means less money available for your retirement.
Another issue is the risk of legal expenses. Many of the transactions detailed with the billionaires involved IRS audits, SEC threats, and exposure in the press. These attacks mean legal expenses that often cannot be justified when the numbers are small. If you’re not talking about millions in potential upside gain, then it’s not worth incurring thousands in professional costs. Do what’s right for you.
You can get mad, get envious, or do whatever is your emotional reaction to the news that some billionaires have worked the system with Roth IRAs. In the meantime, however, I suggest you first focus on you and your retirement. There are lessons to be learned about Roth IRAs. Use them.