Reflections as the IRA Turns 40

Fire up the Way Back Machine to 1974. Richard Nixon became the first US president forced to resign from office, Mikhail Baryshnikhov defected to the USA, Patty Hearst was kidnapped by the Symbionese Liberation Army and French acrobat Phillippe Petit walked across a high wire slung between the twin towers of the World Trade Center in New York. Popular television shows included All in the Family and M*A*S*H and Time in a Bottle by Jim Croce and Barbra Streisand’s The Way We Were played on the radio. On the financial front, the Dow ended the year at 616, the average cost of a new house was $34,900, and the Individual Retirement Account (IRA) was born.

That makes the IRA 40. And with more than 43 million Americans owning at least one IRA, now seems like an appropriate time to review how the IRA has changed over four decades and how it figures into investing today.

In a recent Forbes article, Alicia H. Munnell, director of the Center for Retirement Research, points out that the bulk of IRA assets are now invested in Rollover IRAs. That trend will certainly continue as Boomers continue to retire and rollover their 401(k)s. In fact, assets in IRAs already dwarf pension plans and 401(k) accounts. According to the Federal Reserve, in 2014 $3.1 trillion was invested in pensions, $5.3 trillion in 401(k)-type plans and $7.2 trillion in IRAs (mostly rollover IRAs).

As for other changes, Munnell notes that when IRAs were introduced in 1974, they were only available to workers who weren’t covered by employer-sponsored retirement plans and the maximum annual contribution was $1,500. It wasn’t until 1981 that anyone under age 70 ½ could contribute to an IRA. The next milestone came with the Tax Reform Act of 1986 which phased out the deduction for IRA contributions among higher-income workers covered by employer-sponsored plans. And in 1997, the nondeductible Roth IRA, where withdrawals are tax-free, made its debut. While the Roth set income limits for opening an account, anyone can convert a traditional IRA to a Roth. In 2015, the annual contribution limit for both traditional and Roth IRAs is $5,500, and $6,500 for people age 50 and older.

This timeline illustrates that a once simplistic savings vehicle has become quite complicated. In fact, there are a few very recent rulings and strategies worth noting:

1. The Supreme Court has ruled that “inherited IRAs” are not protected from creditors. The Supreme Court likely reasoned that because beneficiaries of the inherited IRA did not save the funds themselves, the account should not be afforded the same protection from creditors as qualified retirement accounts. Importantly, the Supreme Court’s ruling does not mention anything about spouses who inherit an IRA. Note that these “spousal IRAs” also have different rules than IRAs, so their protection may also be challenged one day.

This ruling impacts estate planning because parents often leave IRAs to their children and/or grandchildren in the hopes of extending the tax-deferral benefits over many years. The fact that these assets were safeguarded from creditors was often seen as a nice bonus, that was, in most cases, secondary to potential continued tax-deferred growth.

If protection from creditors is something you still want to hand down (let’s say your child is a trauma surgeon who has already been sued once – or even a very poor driver who has been found at fault in a number of small accidents), we might consider naming a trust, rather than a person, as the beneficiary of your IRA. Using a trust also allows us to use the oldest beneficiary’s life expectancy to stretch out the tax-deferred growth and gives the IRA owner more control over when the beneficiary can receive distribution

2. The IRS recently ruled that after-tax money in a 401(k) can be rolled into a Roth IRA where it will grow and be distributed tax-free.

Talk about tax-friendly. This new rule provides a great way for individuals who have been prohibited from opening a Roth IRA due to their high incomes, or who resisted converting a traditional IRA to a Roth IRA due to the taxes due on the conversion to open a Roth.

Previously if you moved after-tax money from your 401(k) to a Roth IRA, you had to pay conversion tax on any earnings associated with the after-tax money. Now, you can move any after-tax contributions directly into a Roth IRA. Basically, this amounts to a tax-free Roth conversion.

Remember, there are no taxes due on Roth distributions and no minimum required distributions. Those features combine to allow us to more effectively manage your marginal tax rate in retirement. That’s even more important given the range of capital gains rates and the 3.8% Medicare surtax on high wage earners. 

3. There’s new life for non-deductible IRA. The non-deductible IRA was long ignored because there was no immediate tax benefit. However, because retirement accounts are not subject to the 3.8% Medicare surtax on passive investment income, the non-deductible IRA has emerged from the sidelines as a way to avoid the surtax. The non-deductible IRA is especially appealing to those in the peak income years of their career, where tax deferral would be beneficial, but a Roth conversion would be unappealing due to the high current tax bracket and a Roth contribution is not an option due to the income limitations. Again, the IRA contribution limit is just $5,500 in 2015 (plus another $1,000 in catch up provision for investors over age 50), but decades of tax-deferred compounding can add up and result in tax savings.

More changes are ahead for the IRA! The Obama administration’s MyRA plan is set to begin this year. It provides people whose employers don’t offer retirement plans the opportunity to open a no-fee investment account that will operate like a nondeductible Roth IRA. The MyRA will be limited to individual investors with income below $129,000 and couples with incomes under $151,000. Also, some states are developing their own versions of IRAs where residents without an employer-sponsored retirement plan can save automatically. So, stay tuned as the IRA continues to adapt to meet American savers’ needs. So, Happy 40th Birthday, IRA. Of course, we wish you many happy returns!

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