UPDATED OCTOBER 28TH, 2021

Per the modified “Framework” for the Build Back Better Act presented by President Biden on October 27th, all proposed retirement plan changes have been dropped from the FY2022 Budget Act.  Until the final law is signed, there is remaining uncertainty, but it seems unlikely these proposals will become law.

On September 13th the House Ways and Means Committee released proposed language for the FY2022 Federal Budget that will impact IRA plans.  These changes will limit investor choice and may force some investors to sell or distribute investments they have already made in their IRA.

Following are the IRA related changes in the draft language for the budget bill.

 

Whether you are an IRA investor, an entrepreneur or real estate developer who relies on capital from IRA plans, or just someone who believes in the principles of investment diversification and choice, you should be concerned about these proposals.

What is the Reasoning?

The proposed changes to IRA plans are a reaction to some high-profile cases of wealthy individuals using IRAs for abusive tax avoidance schemes.

If you have heard how Peter Thiel amassed a $5 billion tax free Roth IRA starting in 1999 with a purchase of 1.7 million shares of PayPal for $1,700 in a sweetheart insider deal, you understand the motivation.

IRA plans were never intended to be a tax avoidance vehicle.  Rather, the tax-favored status of IRA plans is meant to facilitate the ability of average Americans to save for retirement.

The reasons and motivations for making changes are legitimate.  The proposed language in the bill does not exactly align with those stated intentions.

What are the Proposed Changes?

Many of the proposals apply only to individuals classified as being high-income.  This is defined as having taxable income over $400,000 if single, $450,000 if married filing jointly, or $425,000 if filing as head of household.  All such income thresholds will be adjusted for inflation over time.

No New Contributions for Large IRAs of High-Income Taxpayers (section 138301):  If an Individual has more than $10 million in IRA savings and is deemed high income, they cannot continue to make new IRA contributions to either a traditional or Roth IRA.

This change would take effect in tax years beginning after December 31^st, 2021.

Very few investors will be impacted.  Tax incentives are not necessary to encourage retirement savings in excess of $10 million.

Required Distributions for Large IRAs of High-Income Taxpayers (section 138302):  High income individuals with combined IRA, Roth IRA, and defined contribution retirement plan (i.e. 401(k)) balances over $10 million are required to take distributions in the amount of 50% of the balance over $10 million.

If the total plan savings is greater than $20 million a distribution from Roth accounts must be taken that meets the lesser of reducing to $20 million the total savings or the aggregate balance of Roth savings in in IRA and employer plans.  Once this has been accomplished, a distribution of 50% of the remaining amount over $10 million can be taken from either tax-deferred or Roth accounts.

This change would take effect in tax years beginning after December 31^st, 2021.

Very few investors will be impacted, though there could be a substantial tax bill for those who are.  Tax incentives are not necessary to encourage retirement savings in excess of $10 million.

Restrictions on Roth Conversions (section 138311):  The capacity to make Roth IRA contributions has always been limited by income.  For example, as of 2021 an individual with taxable income over $140,000 cannot make a Roth IRA contribution, though they can contribute to the designated Roth account in a 401(k) style employer plan.

In 2010 similar limits on making Roth conversions were removed.  This allowed anyone regardless of income to contribute to a Roth IRA by first making a non-deductible contribution to an IRA or 401(k) and then performing a Roth conversion.  This is referred to as a “back-door” Roth contribution.

This section of the bill will end such back-door strategies for high-income taxpayers by eliminating the ability to perform Roth conversions in either an IRA or a qualified employer plan.  Roth conversions will still be available to investors below the high-income thresholds.

The new rule will also prohibit after-tax contributions in qualified employer plans and, while still allowing for non-deductible contributions to an IRA, will prohibit Roth conversions of those amounts.  This restriction will apply to all individuals regardless of income.

While these changes may impact a slightly larger group than the prior sections, it will still be limited to high-income individuals.  At that threshold, Roth conversions could arguably be considered as tax avoidance strategies, not necessarily just enhanced savings techniques.

Prohibition of Investments Conditioned on IRA Account Holder’s Status (section 138312):  This section of the bill will prohibit an IRA from holding any asset that requires the IRA account holder have a minimum level of income, assets, or education, or hold special certifications.

Impacted investments will include most real estate syndications, crowdfunded ventures, and privately traded funds or REITS that typically required accredited investor or sophisticated investor status.  Private placements formed using rule 506(b) or rule 506(c) of SEC Regulation D will be prohibited.

No new investments of this type will be allowed after December 31^st, 2021.  Any such investments already held within an IRA will need to be sold or distributed in-kind from the IRA by December 31^st, 2023.

The impact of this proposal is significant and will be discussed below.

Extend Statute of Limitations for IRA Non-Compliance (section 138313):  The IRS will now have 6 years instead of just 3 to pursue violations of prohibited transaction rules or valuation related mis-reporting issues with IRA accounts.

Prohibition of Investments where IRA Owner has Substantial Interest or Control (section 138314):  This new rule will prohibit an IRA from investing in a corporation, partnership, non-incorporated business like an LLC, or trust where the IRA account holder has 10% or greater ownership stake – directly or indirectly.

Entity investments will also be prohibited if the IRA owner holds a position as a director, officer, or equivalent with the entity.

While meant to strengthen existing prohibited transaction rules against the type of insider self-dealing Peter Thiel engaged in when he controlled PayPal, this will also impact the popular and widely used Self-Directed IRA structure referred to as a Checkbook IRA.  The ability of an IRA account holder to act as a non-owner manager of an LLC owned by their IRA would be eliminated.

No new investments of this type will be allowed after December 31^st, 2021.  Any such investments already held within an IRA will need to be sold or distributed in-kind from the IRA by December 31^st, 2023.

The impact of this proposal is significant and will be discussed below.

Funding of the IRS (section 138401):  The IRS has been underfunded for some time, which hampers the ability to track down abuses.  In allocating nearly $80 billion specifically to tax enforcement and technology updates and $157 million to the tax courts, congress is looking to solve that problem.  The language specifies that none of the new enforcement budget is to be used to increase taxes on taxpayers with taxable income below $400,000.

What Impact Will This Have If Passed?

Most of the new proposals make sense.  While limitations on back-door Roth contributions for wealthier investors may result in some complaining, the average investor will not be impacted.  These regulations are in line with the goal of restoring the IRA to a savings mechanism rather than a tax-dodge.

Sections 138312 and 138314 will do real harm while producing little if any benefit in terms of generating revenue to support the larger aims of the budget proposal or reducing tax abuses.

By prohibiting investments in private placements and IRA-LLC structures, investor choice will be limited.  When IRA plans were created in 1974, only two asset types were prohibited: life insurance and collectibles.  The purpose of an IRA is to allow people to save responsibly for their future, and it is not the business of government to tell them where to hold that savings.  By taking a whole range of quality private placement opportunities off the table, investors are being forced into what Wall Street sells.  The ability to be truly diversified will be greatly diminished as a result.

This change represents a reversal of actions taken in the last 10 years to give more investors access to the high performing assets that have always been available to the wealthy.  The 2012 Jobs Act opened the door for accredited and some non-accredited investors to participate in commercial real estate, private equity, and non-traded funds.  In 2020, the SEC expanded the definition of an accredited investor to further this effort.

The more significant impact of these two proposals will be felt by those who have already made investments into what may soon become disallowed assets for an IRA.

IRA investors holding private securities will be forced to sell within 2 years or face disqualification of their IRA.  Most private placements are longer term in nature, often with 7–10-year maturity.  Selling out of such an illiquid asset early may not be possible or may require taking a significant discount in exchange for liquidity.  Ironically, it will be exactly those ultra-wealthy individuals the law is aiming to have “pay their fair share” that will be out scooping up these bargains.

If an investor cannot sell an asset, they may be forced to take a distribution of the asset in-kind.  This will produce a taxable event.  There is no mention of a waiver on the 10% penalty for early distribution if the IRA holder is under age 59 ½, so add some insult to that injury.

What about Checkbook IRA Holders?

The Checkbook IRA structure that has been in use since the early 1990’s will be impacted by section 138314 prohibiting the IRA account holder from acting as director for their IRA-owned entity.

A possible solution will be to appoint a trusted individual to act as the LLC manager.  Before the bill becomes law and the IRS has a chance to draft appropriate regulations, this solution is uncertain, as is the question of who might be able to fill that manager role.  It may be as simple as appointing a spouse or sibling, or it may be necessary to hire a 3^rd party corporate trustee like a law firm.

While a 3^rd party LLC manager might reduce some of the benefits of checkbook control, this alternative could at least provide a better exit path for plan holders than a 2-year forced exit.

If an IRA LLC is not holding prohibited investments per section 138312, the LLC could be dissolved and the assets held directly by an IRA custodian.  This is a less efficient way to operate, but again, better than an involuntary liquidation of the asset.

Other Economic Impacts

In addition to penalizing IRA account holders who made legal investments, the prohibition against holding private placements will impact the main street economy of builders, real estate deal sponsors, small fund managers, and innovative small businesses and startups that will lose access to this capital.

Proponents of the budget claim their proposals will decrease income inequality and force the ultra-wealthy to contribute more towards societal goals.  The IRA changes in sections 138312 and 138314 will accelerate the concentration of wealth.

Are Solo 401(k) Plans Impacted?

The problematic sections 138312 and 138314 specifically apply to IRA plans and do not mention employer qualified retirement plans such as a 401(k).

For some IRA investors who hold private placements or other newly prohibited IRA assets, there may be the option to rollover to a Solo 401(k).  A person will need to legitimately qualify for the Solo 401(k) by being self-employed and having no full-time employees in any business they control.

Unfortunately, even if someone can setup a Solo 401(k), they will not be able to rollover an existing Roth IRA.  A 401(k) cannot accept a rollover from a Roth IRA.

Section 138311 will impact Solo 401(k) plan holders and shut down the back-door Roth contribution strategy.

What Investments are Still Allowed?

Even if the bill passes, there will be many ways investors can choose to diversify into real assets that are decoupled from the stock market.  It will still be possible to hold:

• Real Estate that is directly held by the IRA
• Small real estate partnerships and joint ventures that do not involve a regulated security offering
• Mortgage notes, trusts deeds, and other lending instruments
• Closely held businesses and startups that do not involve a regulated security offering
• Cryptocurrencies
• Precious metals
• Tax liens & deeds
• Oil, gas and other mineral rights
• Commodities
• And many other assets

What Should You Do if You Already Hold Assets in your IRA that may be Prohibited?

Do not panic.  Do not call your plan provider and ask if you should sell investments.  Unless and until the sky actually falls, the sky is not falling.

It is very possible these proposals may get removed from the bill before final passage.  It is also possible that the whole budget bill fails if the Democrats cannot get every single Senator and all but 3 house representatives on board.

If these proposals become law, you will have two years to come up with a contingency plan.

If you are considering making a new IRA investment in a private placement, it may be better to hold off until the fate of these proposals is determined.  It is unlikely the legislative process will extend beyond early December before the bill passes – with or without these proposals – or fails.

The single best course of action right now is to advocate against these changes by contacting your legislators.

How Can I Make My Voice Heard?

Visit our Save Our IRAs page for resources.  Learn how to find out who your representatives and senators are and how to contact them.  We have also drafted sample letters you can use to template your own message.