The True “Insanity” of the Build Back Better Act: IRA Tax Punishment to Non-Wealthy

Estate Planning, Recent News, Self Directed IRA, Tax, Uncategorized

Sen. Joe Manchin, D-W.Va. (9/29/21): “What I have made clear to the President and Democratic leaders is that spending trillions more on new and expanded government programs, when we can’t even pay for the essential social programs, like Social Security and Medicare, is the definition of fiscal insanity.”

Rep. Ilhan Omar, D-Minn (9/30/21): “Trying to kill your party’s agenda is insanity.”

With all the infighting between the Democrats as they desperately try and push through the $3.5 trillion “Build Back Better Act” (BBB), the true “insanity” of the bill is lurky in the shadows. In the eyes of the Biden administration and most Democrats in Congress, the selling point for the massive spending measure is that it will only affect corporations and “the wealthy” (e.g., individuals making more than $400,000 per year). Unfortunately for many unsuspecting “non- wealthy”, the hammer is about to drop, with the result being tax and financial burden that far outweighs that which will be felt by the wealthy.

Several provisions within the bill will have profound consequences to IRA investors, both large and small. For example, the bill prohibits investments into entities that require the IRA’s owner to be an “accredited investor”. This category of individuals is far greater and more diverse than people with income above $400k per year. IRA investments that would be banned by this rule include a vast array of “funds” (e.g., Limited Partnerships), which are an organizational hallmark of real estate and private equity structures. If an IRA is already holding these types of investments (countless of accounts are), they must exit the investments by the end of 2024 (two years). The problem, which should be obviously to legislative drafters, is that it’s virtually impossible to exit these investment structures. [Side note: it has been perfectly legal to invest into “funds” ever since IRAs were first created, September 2, 1974].

Example. Jane Smith has worked hard and contributed to her 401(k) Plan for many years. In 2019, she changed jobs and decided to “roll” her $600,000 401(k) balance to an IRA. She also decided to use some of her IRA funds ($200,000) to invest into a Limited Partnership (“LP”) that was building a large apartment building in Jane’s hometown. The real estate investment, Jane believed, was a good way to help protect her retirement savings from another stock market crash. The LP investment was executed in 2020 and was expected to last 5-10 years. Jane’s IRA originally had to contribute $50,000, with the remaining $150,000 due at a later time. The LP’s documents did not allow for any ability to transfer or sell the ownership early.

BBB Consequences. As a result of the BBB, Jane’s IRA investment will no longer be allowed to hold the LP interest (unfortunately for the LP, many other IRA investors will be in the exact same situation). If Jane does not exit the investment by 12/31/24, her IRA will be completely invalidated, resulting in taxable income equal to the IRA’s total value (not just the LP’s ownership value). This could easily result in $250,000 of tax, not to mention no more retirement funds for Jane! What is Jane to do? One option is to try and sell the LP interest to someone else. Unfortunately, prior to the investment running its course (e.g., the building getting built and rented), it has very little value. Also, when the next “capital call” occurs (i.e., the LP asking its investors for more contributions), the IRA investors will not want to continue plowing cash into an investment now deemed illegal. This series of events could not only jeopardize economic ruin for Jane, but also the LP, and thus, all its other investors. This pattern will repeat itself across vast industries.

There are many other provisions in the BBB that will destroy investment techniques that have been widely used within IRAs for decades. Although congressional Democratic believe they are punishing the sins of Peter Thiel (who allegedly holds a Roth IRA worth $5 billion), the reality is the IRA changes in BBB are incredibly broad and will cause tax and financial pain to Americans of all ages and economic means. Ironically, the one provision in BBB that will supposedly damage Peter Thiel the most (forced distributions of IRAs worth more than $10 million), he will easily dodge by keeping his personal income under $400,000 until he’s 60 years old (he’s currently 53), at which point he can take his entire $5 billion out of his Roth IRA entirely tax free. Artificially keeping his income low for seven more years is a small price to pay to avoid a forced taxable distribution of $4,990,000,000. [Sweet sweet justice, don’t you think?!]