IRA Cap Gives Rise to New Funding Strategies

with 7 Comments

We wrote about Obama’s fundamentally flawed financial planning model in “Is A $3 Million IRA Sufficient For Retirement?” John Sullivan of AdvisorOne wrote a nice article entitled “IRA Cap Gives Rise to New Funding Strategies” which confirms much of what we advise. It read,

“Curbing the growth of retirement plans in a nation where 91% have less than $100k saved is insanely ignorant,” financial planner, author and speaker Rick Kahler tweeted upon news of the plan, summing the sentiment of many in the advisor industry.

Many average middle income investors are near the $3 million limits. It isn’t all that rich. It is just the time value of money of consistently saving coupled with the incredible devaluation of the dollar by the mismanagement of the federal government as they debase the currency. Sullivan’s article continued:

She said she heard from “dozens” of financial planners, estate-planning lawyers and savers themselves whose savings “hover close to that level” and are asking questions about how it would work.”

They include:

  • How would this be administered when you have hit the cap, but then the market value dips and you’re below it and can contribute again?
  • Would public employees face the same upper limit on their pensions? If they already have reached the $205,000 limit, could we stop making contributions for them? Or could they stop getting pension raises?
  • What if you have a pension and other tax-deferred accounts? Who is responsible for aggregating the information? Who will pay that administrative cost?
  • How many people will be voting on this who have a pension greater than $205,000 a year?

The discrimination against the private sector in favor of public employees is outrageous. And the point is it wouldn’t work. But with great obfuscation and complexity comes great opportunity. And advisors were already mulling strategies for dodging yet another government money grab if it ever came to pass. The article suggested two interesting proposals:

“Advising your children to fund Roth IRA accounts, on which tax is paid upfront and withdrawals are generally tax-free after meeting holding requirements, early in life till they reach the cap, giving their investments more time to grow beyond the cap.”

The second is setting up a Roth IRA trust to follow another provision of the budget proposal, “emptying inherited accounts within five years of the IRA owner’s death. The IRA could be emptied into the trust, and then you could still require your heirs to take withdrawals over a longer period of time, if you’d rather them do that than be hit with a one-time windfall.”

Here is an article on funding a teenager’s Roth IRA in order to gain a million-dollar retirement in which we wrote,

Contributing just $615 each year for seven years and earning 11% will translate to investments worth a million dollars at the end of 56 years. If the process begins at age 14, the value of the Roth IRA will reach a million dollars at age 70.

Starting early makes a huge difference. At the end of the first seven years of saving and investing $615 a year with an 11% rate of return, the portfolio should be earning and reinvesting over $615 per year without any additional contributions. Funding a Roth IRA for 7 years and then stopping actually results in more money than waiting 7 years and then funding it with the same annual amount for the rest of your life. The difference gets more pronounced the longer you delay. Thus contributing $615 between ages 14 and 20 and then stopping is more profitable than starting at age 40 and contributing the maximum $5,000 a year until age 70.

As we wrote in our article, “Although there is little chance of it becoming law, there is also less outrage and backlash than there ought to be.”

Be Outraged And Fund Your Roth

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.

7 Responses

  1. David

    I have been contributing to my Roth IRA for 5 years now and am only 25. I have been able to max out 4/5 times. I am very nervous about these new tax regulations and am concerned that our current president does not have the slightest grip over fixing the current economic crisis. His resolution is campaigning for rich people to pay more taxes. So sad we’re stuck with him for 3 more years.

  2. Doug

    I read that only 0.1% of the population would be affected by this right now…

    • Megan Russell

      You’re referencing the back-of-the-napkin current estimation for how many people over 60 are currently already over the limit. There is no way to definitively tell how many people it will effect, since it depends on their saving and spending behavior. Many of the people who will likely breach the limit are currently 25 and haven’t even yet made any of their saving choices. Many more do not currently hit the limit, but with their savings growing at 4% over inflation they may still be in danger of hitting the inflation-adjusted cap.

      Market Watch reported as follows:

      People over 60, of course, tend to have the biggest retirement savings and are more likely to have multiple IRAs; looking at combined IRA and 401(k) balances within that cohort, the team figures that about 0.107%, or roughly one of every thousand, would exceed the cap. EBRI also assumes that even if the cap is adjusted for inflation, today’s younger workers would have a bigger chance of breaching it by age 65: It estimates that the cap could affect 2.2% of savers currently age 26 to 35.

      …As Bloomberg’s Richard Rubin and Margaret Collins point out, the people most likely to be hit by an immediate cap would be higher-earning self-employed business owners, including independent contractors like some doctors and lawyers, who can contribute up to $51,000 a year to their IRAs.

      Credit Union Times reported:

      Small business owners, a core customer for credit unions, would be significantly impacted by the proposal, according to Brian H. Graff, executive director and CEO of the American Society of Pension Professionals & Actuaries. He warned of the potential devastating impact if the proposal was enacted on small-business people.

      He said that is “grossly unfair” that under the cap proposal a small business owner will be limited to retirement benefits that are nowhere near as valuable as executives’ at large corporations.

      …Robert Smith, president of the National Association of Insurance and Financial Advisors, added another concern. “The current tax code already has contribution limits to retirement savings programs, including IRAs, and, therefore, limits on account balances is detrimental to conscientious taxpayers who have made current sacrifices for future security.”

      A 25 year old starting with a balance of $0 and saving the the contribution limit annually in their IRA and 401(k) will have saved $3,000,000 around age 56, with their savings growing at a market rate of return. When the cap is adjusted for inflation, even if they retire at age 65 and begin pulling out as much as they had previously annually contributed, our supposed 25 year old will hit the inflation-adjusted cap at age 73 at modest assumption of 4%. At the average equity return of 6.5% over inflation, they will hit the inflation-adjusted cap at age 60.

      Even a 50 year old beginning the same saving and spending pattern as the above 25 year old will hit the inflation-adjusted cap before reaching age 100.

      • John Q.

        Funny how anti-government people insist that they should be given an unlimited tax deduction on retirement savings. A 60 year old who hits the cap can also invest into taxable accounts, real estate, etc. Last time I checked the Constitution, there was nothing that guaranteed you an unlimited amount of tax-free or tax-deferred retirement accounts.

        • Megan Russell

          There is nothing in the Constitution that gives you a right to income either. Using that logic, the government could have a 100% income tax and, you at least, should not be allowed to complain.

          The point is that contributions to tax-preferred retirement accounts are already capped. As of 2013 the maximums for IRA and 401(k) accounts are:

          Under 50 Over 50
          IRA $5,500 $6,500
          401(k) $17,500 $23,000

          So this proposed cap on retirement account balances will only effect the growth of money already capped on contribution.

          An individual who obeyed all the rules for contributions, yet invested their assets wisely and started saving for retirement early, will be guaranteed to hit the cap. Then, their savings will be stolen off the top. There is no way to avoid this tax except by saving for most of your retirement in taxable accounts from the start or investing your retirement money badly.

          Funny how pro-government people insist that others should be taxed just because they saved and invested their money wisely.

        • David John Marotta

          The government doesn’t have the right to do whatever it wants, there are at least 4 things wrong with your support of this power and money grab:

          (1) The rationale behind the money grab is just bad financial planning.

          (2) It breaks the implied contract. If you think Social Security is a contract with citizens why aren’t the rules about contributions a contractual obligation? Government enforces all contracts except their own, and those it feels free to chance on the whim of wanting more money. If this were a private company trying to change the rules we would be rightfully outraged.

          What you are saying by suggesting that this is “no big deal” is that government intentions and promises when legislation is put in place are absolutely worthless because government ought to change the rules whenever it feels like there is an advantage to change them.

          (3) It discriminates against people just because they have their savings in a retirement account. As we said in the article, government workers such as the President himself, have much more tax free value in their pensions and yet they are allowed to have both. This is primarily a discrimination against private sector businesses who use defined contribution accounts exclusively.

          (4) If the only rights we have are enumerated in the constitution, the Ninth Amendment is meaningless.

  3. Doug

    Hey Megan,

    Thank you, that makes more sense. I hope this does not get passed