Senate Finance Committee Chairman Ron Wyden, D-Ore., told the Internal Revenue Service and the Treasury Department on Tuesday to crack down on “mega IRAs” after a Government Accountability Office report found holders of large IRAs were using alternative investment strategies such as excess contributions and undervalued assets as tax dodges.
The GAO report, released Tuesday, found that for tax year 2011, roughly 600,000 taxpayers had IRA accounts worth more than $1 million – and about 9,000 taxpayers had IRAs worth more than $5 million. “Those figures stand in stark contrast to most Americans, who had a median IRA account balance of about $21,000,” Wyden told IRS Commissioner John Koskinen and Treasury Secretary Jacob Lew in a letter.
According to the GAO report, a “small number of taxpayers has accumulated larger IRA balances, likely by investing in assets unavailable to most investors — initially valued very low and offering disproportionately high potential investment returns if successful.”
Individuals “who invest in these assets using certain types of IRAs can escape taxation on investment gains,” the office says.
For example, “founders of companies who use IRAs to invest in nonpublicly traded shares of their newly formed companies can realize many millions of dollars in tax-favored gains on their investment if the company is successful,” the GAO explained. “With no total limit on IRA accumulations, the government forgoes millions in tax revenue. The accumulation of these large IRA balances by a small number of investors stands in contrast to Congress’s aim to prevent the tax-favored accumulation of balances exceeding what is needed for retirement.”
Wyden says the state of retirement savings in the U.S. “is completely out of whack. On one hand you’ve got people sheltering millions of dollars in mega IRAs, while at the same time nearly a third of Americans have nothing set aside for retirement. It’s abundantly clear that America needs a better system and tax code that supports retirement planning for all Americans.”
Besides “mega IRAs,” Wyden told the GAO to review self-directed IRAs, which he said “may be a growing target for fraud.”
Wyden said that he’s “committed to working with Treasury and the IRS” to implement GAO’s recommendations and help prevent additional abuse and fraud in the tax code.
The GAO reported notes that the IRS plans to collect data identifying nonpublicly traded assets comprising IRA investments, so that it can identify potential IRA noncompliance. However, GAO said, “research on those taxpayers and IRA assets at risk will hinge on getting resources to effectively compile and analyze the additional data. IRS officials said IRA valuation cases are audit-intensive and difficult to litigate because of the subjective nature of valuation.” Also, “the three-year statute of limitations for assessing taxes owed can pose an obstacle for IRS pursuing noncompliant activity that spans years of IRA investment,” GAO said.
IRA guru Ed Slott, who runs IRAhelp.com, told ThinkAdvisor that “the roots” of the GAO analysis of large IRAs goes back to 2012, when, during the presidential campaign, it came out that Mitt Romney supposedly had $100 million in his IRA. “Either these few people with the mega IRAs ($25 million and more) are consistently fantastic investors or the assets going in were extremely undervalued. The undervaluation is probably more likely.”
In 2014, the GAO said the federal government will forgo an estimated $17.45 billion in tax revenue from IRAs, which Congress created to ensure equitable tax treatment for those not covered by employer-sponsored retirement plans. “Congress limited annual contributions to IRAs to prevent the tax-favored accumulation of unduly large balances,” GAO said. “But concerns have been raised about whether the tax incentives encourage new or additional saving.” Congress is re-examining retirement tax incentives as part of tax reform.
Wyden commended the IRS for better enforcing IRA rules regarding hard-to-value assets with its Form 5498, which, starting in tax year 2014, will require IRA custodians to include the fair market value of nonpublicly traded assets and information on the type of asset.
Form 5498 is effective now, Slott says, but is optional. The new reporting rules under Form 5498 “will be mandatory in 2015,” Slott says, and the “IRS will require valuations on these assets. Hard-to-value IRA assets are generally non-traditional investments (alternative IRA investments), such as non-publicly traded stock, partnership and LLC interests, real estate, options and similar items that are not traditionally offered by your average bank or IRA custodian. These assets are usually held in self-directed IRA accounts.”
The “better move for these undervaluation schemes, which some investors are doing, is to use the Roth IRA, where the true value will escape income taxation forever,” Slott continues. “We’ll have to see whether these new hard-to-value IRA investment reporting rules will really catch the mega IRA owners undervaluing their holdings.”
While valuations of these assets will soon be required, Slott says, “these high-end IRA investors can still obtain valuations to their favor. The question is whether the IRS will be able to pursue theses cases and prevent further abuse of the retirement tax rules. IRS does have a few tools at their disposal that could heavily penalize these undervaluations.”
To improve IRS’s ability to detect and pursue noncompliance associated with undervalued assets sheltered in IRAs and prohibited transactions, GAO recommended that the IRS commissioner:
• Approve plans to fully compile and digitize the new data from electronic and paper-filed Form 5498s to ensure the efficient use of the information on nonpublicly traded IRA assets;
• Conduct research using the new Form 5498 data to identify IRAs holding nonpublic asset types, such as profits interests in private equity firms and hedge funds, and use that information for an IRS-wide strategy to target enforcement efforts.
• Work in consultation with the Department of the Treasury on a legislative proposal to expand the statute of limitations on IRA noncompliance to help IRS pursue valuation-related misreporting and prohibited transactions that may have originated outside the current statute’s three-year window.
• Building on research data on IRAs holding nonpublic assets, identify options to provide outreach targeting taxpayers with nonpublic IRA assets and their custodians, such as reminder notices that engaging in prohibited transactions can result in loss of the IRA’s tax-favored status.
• Add an explicit caution in Publication 590 Individual Retirement Arrangements (IRAs) for taxpayers about the potential risk of committing a prohibited transaction when investing in nonpublicly traded assets or directly controlling IRA assets.
— Check out IRS Clarifies IRA-to-IRA Rollover Guidance on ThinkAdvisor.