OK, let's unpack this. We're doing a deep dive
today into one of the most essential, yet I think
surprisingly complex financial instruments in
the American savings landscape, the individual
retirement account or IRA. It's an interesting
beast for sure. On the surface, it seems so simple.
It's just a tax advantaged box to save money
for retirement. Right. But the legislation that
governs it. I mean, it covers everything from
who can contribute to what happens when you die.
It is incredibly specific and often pretty counterintuitive.
Our mission today is pretty straightforward.
We want to give you the shortcut to being well
-informed. We're going to try to cut through
some of that confusion, understand the different
flavors of IRAs, where their tax advantages truly
lie, and maybe most importantly, we're going
to look at the surprising things you can and
cannot invest in, how you take the money out,
and what happens when creditors try to get in.
Yeah. And we've pulled together a really comprehensive
set of sources for this. We're going from the
basic foundational definition right through to
Supreme Court rulings on bankruptcy and some,
I mean, some truly mind boggling statistics on
wealth concentration that these accounts can
enable. So let's start right there with the core
definition. What exactly is an IRA? At its heart,
an IRA is a trust. It's an arrangement that financial
institutions offer, and it's designed specifically
to hold investment assets. A trust. Right. And
crucially, these assets have to be purchased
using a taxpayer's earned income, so money they've
made from working. And it's all designated for
that person's benefit later in life. The whole
point is the tax advantage, allowing those assets
to grow without being taxed immediately. And
here's a quick negative insight right off the
bat before we get into the mechanics. Most people...
Myself included. When we say IRA, we think of
the account itself. That's natural. Yeah. But
the IRS, specifically in its guidance, like Publication
590, they clarify the terminology. The IRA, the
individual retirement account, is technically
just one type of individual retirement arrangement.
Oh, it's the most common type by far. But that
umbrella term also covers other less common things
like individual retirement annuities and certain
employer established trusts. So when we talk
about the IRA, we're really talking about the
star player in a much larger family of arrangements.
That distinction is important for context. Now
let's jump into the core choice that every single
saver has to make. This is the one that determines
the entire tax future of their savings. This
is the difference that most people, rightly so,
focus on first. The traditional versus Roth debate.
It's fundamental. And it all boils down to a
single question. When do you want to pay tax
on this money? Now or later. Exactly. Do you
want the break now or do you want the break later?
And that decision can shape your financial life
for, I mean, for decades. Let's start with the
traditional IRA. It's the historical standard,
right? Yeah. The elder statesman of retirement
savings. It is. The traditional IRA came out
of some landmark legislation back in 1974. And
initially, it was pretty restrictive. It was
designed specifically for self -employed people
or for workers who didn't have access to a retirement
plan through their employer. So it started as
a way to kind of create parity for the unprotected
worker. Precisely. And its key function was and
still is tax deferral. The contributions you
make are mostly tax deductible. You put the money
in, you immediately reduce your taxable income
for today and you get an upfront tax break. And
then the money grows inside and you don't pay
taxes on, you know, dividends or capital gains
year to year. That's the deferral mechanism at
work. All those transactions inside the IRA are
shielded from tax. But that deferral doesn't
last forever. No, the government only defers
the tax. It doesn't forgive it. When you eventually
withdraw those funds in retirement, those withdrawals
are taxed as ordinary income, just like a paycheck.
Which makes the traditional IRA a great choice
if you think you'll be in a lower tax bracket
in retirement than you are right now during your
high earning years. That's the classic calculation.
Yeah. Now, what really changed the landscape
was legislation in the early 80s. This feels
like an example of Congress seeing a good idea
and just making it available to everyone. That's
right. Starting in 1981, they dramatically expanded
the scope of the traditional IRA. They opened
it up to all taxpayers. Didn't matter if you
had an employer plan or not. It was a massive
democratization of access. There's a catch there,
right? There is. It's important to note that
later legislation scaled back that universal
deductibility for higher earners who also had
employer plans. So they introduced all this complexity
around income thresholds. But the account itself,
the ability to open one, became accessible to
everyone. Which brings us to the newcomer on
the block. The Roth IRA. Here, the tax calculation
is completely flipped. And it's why the Roth
is often so appealing, especially for younger
savers. The Roth is a mirror image. The contributions
are strictly non -deductible. So post -tax dollars.
Post -tax. Money you've already paid tax on.
You get absolutely no tax break today. But the
incentive for paying that tax up front is, well,
it's unparalleled. The growth inside the account
is entirely tax -free. And the really crucial
benefit, the thing that makes the Roth so flexible.
The earnings can be withdrawn completely tax
free in retirement as long as you meet a few
basic requirements on age and how long the account
has been open. But here's the major liquidity
point. The original contributions, what we call
the basis, can be pulled out at any time. Any
time without penalty. At any time without penalty
or tax. This flexibility is what makes the Roth
structure feel like a hybrid savings and emergency
fund vehicle. And just to clear up a common misunderstanding,
Roth is not an acronym. No, it's not. It was
established in 1997 and it was simply named after
its champion, Senator William V. Roth Jr. of
Delaware. It's just a surname, not some secret
code. So before we get to the funding rules,
let's just briefly clarify those other more specialized
IRA types that you sometimes hear about, usually
for businesses. Sure. The first one is the SEP
IRA. That stands for Simplified Employee Pension.
This is used by small business owners or self
-employed folks to make contributions directly
to an employee's traditional IRA or their own.
It's popular because it has a really low administrative
burden compared to setting up a 401k. And then
there's the one that kind of. forces the employer
to step up? That would be the simple IRA, the
savings incentive match plan for employees. It's
structurally a bit closer to a 401k, but like
the name says, it's designed for simplicity.
The key feature is that it requires employer
matching contributions when an employee contributes.
Ah, so it's not optional. Right. Although the
overall contribution limits are typically a bit
lower than a full 401k. And finally, a little
footnote in history, the myRA. Yeah, that was
a short -lived federal initiative from 2014.
It was aimed at entry -level savers who didn't
have workplace plans. It used the Roth structure,
but it was super conservative. It could only
invest in government bonds. And it didn't last
long. No, it was phased out in 2017. It really
just illustrates how difficult it is for the
government to make these complex arrangements
accessible at the lowest tier of saving. So whether
you've picked the traditional path for today's
tax break or the Roth path for tax -free growth
tomorrow, picked your structure. Now we have
to talk about the really uncompromising rules
of the game. Funding and limits. This is where
the IRS gets very, very particular. There are
strict rules on how much money you can put in
and, critically, what kind of money is even eligible
to fund these accounts. And it's important to
appreciate the history here because the limits
have grown a lot over time. Yeah, looking at
the history of the limits really shows how the
government's thinking on this has evolved. When
IRAs were introduced back in 74, the maximum
was, what, a very modest $1 ,500? And that low
cap stayed in place for seven years. $1 ,500,
wow. Wow. Yeah. After the rules opened up to
everyone in the early 80s, the limit went up
to $2 ,000 and it just held steady there for
two decades. And then starting in the early 2000s,
things started to climb a lot more rapidly. We
went from $2 ,000 to $3 ,000. Then it hit $5
,500 by 2013. That rapid increase reflects rising
costs and the realization that, you know, $2
,000 just wasn't going to cut it for a full retirement.
For this year, 2024, the maximum contribution
limit is at $7 ,000. It's the government trying
to keep pace. And Congress also realized that
older workers, maybe people who started late,
needed a way to supercharge their savings. Absolutely.
That's the whole purpose of the catch -up contribution.
It was introduced in 2002. It allows anyone over
the age of 50 to contribute an extra amount.
Currently, it's set at $1 ,000, right on top
of that standard limit. It's a key benefit designed
to mitigate the effects of lost time. Now, a
critical point that trips a lot of people up.
This limit is across the board, right? Correct.
That maximum allowable contribution, the $7 ,000
for 2024, that applies to the total you put into
all of your traditional and Roth IRAs combined
for that year. You can split it however you want,
all in a Roth, half and half, but you cannot
go over that total limit. And we have to circle
back. to the complexity around the traditional
IRA deduction, which is tied to whether you have
a plan at work. This is the nuance that makes
the traditional IRA less simple than it sounds.
If you or even your spouse are covered by a retirement
plan at work like a 401k, the tax deduction for
your traditional IRA contribution starts to phase
out once your income crosses certain thresholds.
So a high earner might contribute to a traditional
IRA, but get no tax deduction for it at all.
Exactly. You have to check. the tables in the
IRS publication based on your filing status every
single year. Which brings us to the strictest
rule of all, eligibility. What money can actually
go into this tax advantaged box? The sources
are crystal clear. Only taxable compensation
is allowed. This is a vital gatekeeper rule.
Taxable compensation is income you earn from
working. So wages, salaries, commissions, self
-employment income and even taxable alimony.
If the money didn't come from you working, the
IRS doesn't want it in an IRA. Which means there
is a very specific list of income types that
are strictly excluded. Oh, absolutely. Take unearned
taxable income. If you made, say, $10 ,000 from
stock dividends in your regular brokerage account,
you can't just take that $10 ,000 and stick it
in your IRA. It's investment income. It's not
compensation. And what about tax exempt income?
Most of that is out, too, but there's one big
exception. Correct. Most tax exempt income is
ineligible, but the IRS makes a specific allowance
for military combat pay. Even though that income
is tax -exempt, it is eligible to be contributed
to an IRA. It's a recognition of the unique circumstances
of service members. What about payments that
people really rely on, like Social Security or
child support? Social Security is strictly ineligible.
It doesn't matter if you pay tax on it or not.
It is not considered earned income. Same with
child support payments you receive, explicitly
ineligible. Okay, I get the logic behind excluding
unearned income. But why are the rules so strict
about cash versus assets? The sources make it
clear you can only fund an IRA with cash or cash
equivalents. This rule is essential to maintaining
the integrity of the whole system. The IRS needs
a clear, verifiable value for the contribution.
If you are allowed to contribute assets, say
a stock, or a rare stamp, you'd have to establish
a fair market value for it. And that just opens
the door to abuse where people could intentionally
overvalue assets to get a bigger tax deduction.
So if I have $7 ,000 worth of some crypto in
my personal account. I can't just transfer that
crypto into my new IRA. You absolutely cannot.
You would have to sell the crypto first, realize
the gain or loss on it, deposit the $7 ,000 in
cash into the IRA, and then use that cash to
buy whatever you want inside the IRA. And if
you try to transfer the asset directly? That
is a severe violation. It's called a prohibited
transaction, and it immediately jeopardizes the
entire beneficial tax treatment of the fund.
It's a massive risk for a simple shortcut. Wow.
Okay, so that's why the custodian's role is so
critical. They're the gatekeepers. They are.
They're typically banks. Banks, brokerage firms,
credit unions, they handle the compliance and
hold the assets. But it is so important to remember
what our sources stressed here. The IRS explicitly
states that custodians and administrators cannot
provide investment advice. They facilitate the
structure. They do not guide the decisions. And
that distinction is key, especially as we move
into the more exotic investment options. That
is the perfect segue. For most people, an IRA
is pretty conservative. But once you move into
the self -directed world, the rules of what you
can invest in become fascinating and the potential
pitfalls just multiply. Here's where it gets
really interesting. Because while, you know,
99 % of people use their IRA to hold mutual funds
or ETFs, a dedicated minority uses these specialized
custodians to unlock a huge and often surprising
array of alternative investments. We're talking
about the self -directed IRA. That's where the
custodian is willing to administer assets that
fall way outside the traditional world of stocks
and bonds. So what kind of assets are we talking
about here? What suddenly becomes available?
Almost anything that isn't explicitly prohibited
by the Internal Revenue Code. This includes physical
real estate like actual rental properties or
raw land. It includes private mortgages where
the IRA acts as the lender. The IRA can be the
bank. It can be the bank. It also includes private
company stock, oil and gas limited partnerships,
even intellectual property. Our sources also
note precious metals are allowed as long as they
meet specific fineness standards. It really sounds
like the IRA is acting like its own. independent
investment trust at that point. It is. But, and
this is a big but, most common custodians, your
vanguards, your fidelities, they won't touch
assets like real estate. They limit you to traditional
brokerage assets. If you want to hold an actual
house in your IRA, you need a specialized, self
-directed custodian who is equipped to handle
the unique valuation and compliance issues. Let's
nail down the list of assets that the IRC strictly
prohibits, no matter what the custodian is willing
to do. The law prohibits specific assets known
as collectibles. The list includes things like
art, stamps, antiques, rare coins, with a few
exceptions for government minted coins, baseball
cards and things like that. The other major prohibition
is life insurance. Why those things specifically?
Why collectibles and life insurance? The intention
is to stop people from using tax sheltered retirement
money to buy items they can enjoy or use today.
If you buy a painting with your IRA, you could
hang it on your wall and you're getting an immediate
benefit from the fund. Life insurance is out
because it's fundamentally about providing a
benefit to your family upon your death, which
is different from the core purpose of providing
for your own retirement. So the asset itself
is one hurdle, but the transaction around the
asset, that's the bigger danger. Let's talk about
prohibited transactions, especially the one about
use. This is where the famous leaky toilet story
comes from. This is the most critical and frankly
the least intuitive rule for the self -directed
investor. It's the rule of strict separation.
Once an asset is owned by the IRA trust, let's
say it's a rental house, the IRA owner cannot
receive or provide any immediate benefit from
that investment. Okay, let's walk through that
rental property example because this is where
the risk really hits home. I own a rental property
through my self -directed IRA. First, you can't
live in it. That's an obvious personal benefit.
Second, you can't rent it to any disqualified
person. That means your kids, your spouse, your
parents. That would also be a prohibited benefit.
That all makes sense. But then the unexpected
happens. A pipe bursts. The toilet is flooding
the bathroom. I'm handy. I can fix it myself
in an hour. You absolutely cannot. If you personally
fix that leaky toilet, you are providing labor
and service to the IRA trust. That labor is a
service you would normally pay for. And by providing
it for free, you are essentially making an unrecorded
contribution or receiving a benefit by saving
the IRA money. That is a prohibited transaction.
Wait, I can't even maintain my own asset. The
source material is very clear on this. The IRA
must operate at arm's length. If the toilet needs
fixing, the IRA, through its custodian, has to
hire and pay a third -party plumber. If you,
the IRA owner, fix it yourself, the entire IRA
immediately loses its tax -sheltered status.
The entire IRA, not just the house. The entire
IRA. The whole value is treated as a taxable
distribution in that year, and it's subject to
penalties if you're under 59 and a half. That
is devastating. So you have to maintain absolute
separation between yourself and the asset, even
if it seems inefficient. That's the price you
pay for the tax shelter. The IRS is generous,
but they demand absolute purity in return. OK,
let's move to another complicated layer here.
Yeah. Debt. Can an IRA borrow money to buy an
asset, like getting a mortgage on that rental
property? Yes, an IRA can borrow money, but this
triggers two really severe complications. First,
the loan itself has to be a non -recourse loan.
What does non -recourse mean in practical terms?
It means the lender can only go after the asset
that secures the loan. the real estate itself.
You, the IRA owner, cannot personally guarantee
the loan, and the lender can't have any claim
on the other assets in your IRA. The loan has
to stand completely on the value of the property.
And that makes these loans riskier for lenders,
so they're often harder to get. And the second
complication is that massive tax trap you mentioned
earlier, UBIT. UBIT, unrelated business income
tax. This is the mechanism the IRS uses to look
at debt -financed property inside an IRA. and
say, wait a minute, if you're leveraging this
investment with borrowed money, you're acting
like a business and we are going to tax the profits
that come from that debt. So if I buy a $500
,000 property using $250 ,000 of IRA cash and
a $250 ,000 non -recourse loan, half the income
from that property is debt financed. Exactly.
And the rental income that's attributable to
that debt finance portion will be considered
unrelated business taxable income. The IRA itself
will be liable to pay UBIT on that income. often
at very high trust tax rates. So the takeaway
on UBIT is if I leverage my IRA to buy real estate,
I've basically created a mini business inside
my retirement fund. And the IRS is going to tax
the business income from the debt, which could
defeat the whole purpose of the tax deferral.
That is the perfect summary. It's a severe penalty
designed to discourage competition between tax
exempt funds and regular taxable businesses.
You can do it, but that tax benefit might just
evaporate. We've established the strict rules
for getting money in and making it grow. Now
let's talk about the even stricter rules for
taking money out, which are all about deadlines
and penalties. The entire IRA system is built
on the idea that these funds are locked away
until retirement. The government gives you the
tax break, but it's on the promise that you won't
touch the money early. What is that magic age
when the penalty shield finally drops? The penalty
threshold is age 59 and a half. Unless you meet
one of the specific hardship exceptions, any
funds you pull out before this age are typically
subject to a 10 percent early withdrawal penalty.
And that's on top of being taxed as ordinary
income if it's from a traditional IRA. That's
the when you can take it out rule. Yeah. But
for owners of traditional accounts, there's also
the when you must take it out rule. That is the
infamous required minimum distribution or RMD.
Rule. Owners have to start taking distributions
of at least the calculated minimum amount by
April 1st of the year after the year they turn
age 72. And that age has been slowly creeping
up over time. And if you miss that deadline or
you miscalculate the amount, I really want to
emphasize how severe this penalty is. It is the
most devastating penalty in the entire IRA structure.
If you don't take your RMD, the penalty is a
staggering 50 % of the amount that you should
have distributed. 50%. 50. 5 -0. This isn't a
10 % slap on the wrist. It is the government
taking half of the intended distribution because
you failed to take it. That's almost unbelievable.
The IRS is absolutely determined to get its deferred
tax revenue eventually. Absolutely. And the RMD
amount itself is calculated based on IRS life
expectancy tables, which determine how much you
need to take out each year to empty the account
over your expected lifespan. Although there is
that special exception for older owners to satisfy
their RMD without getting hit with the income
tax. Yes, the Qualified Charitable Distribution,
or QCD. Once you are RMD age, your withdrawals
are paxable unless those funds are paid directly
from the IRA to a qualified charity. It's a crucial
tool for high net worth people to meet their
RMDs while also achieving their philanthropic
goals, all without the RMD counting as taxable
income. OK, now let's talk about those early
withdrawal penalty exceptions. The lifelines,
often called hardship withdrawals. They let you
get money out before 59 and a half without the
penalty, though it might still be taxable. There
are seven major categories. Two are related to
health. The first is for unreimbursed medical
expenses, as long as they exceed 7 .5 % of your
adjusted gross income. The second lets you withdraw
penalty -free to cover medical insurance costs
if you're unemployed. And what about long -term
or permanent inability to work? A verifiable
permanent disability, meaning you can't engage
in any substantial gainful activity that allows
penalty -free access. Also, distributions taken
as a pre -calculated annuity stream called substantially
equal periodic payments, or SCPPs, are exempt.
What about planning for the future? Or getting
on the property ladder? Penalty -free withdrawals
are allowed for qualified higher education expenses
for you, your kids, or even your grandkids. And
there's a limited lifetime exception of up to
$10 ,000 for distributions used to buy, build,
or rebuild a first home. And the last one. Finally,
if the IRS decides to levy the plan to satisfy
your unpaid taxes, that distribution is also
penalty -free. Yeah, it is a surprisingly complex
menu of exceptions. It seems like the government
wants the money locked up, but they do recognize
that life doesn't always go according to plan.
They do. But again, the fine print matters immensely.
You have to meet the exact definition of qualified
and disability to avoid that penalty. Before
we move on, we have to reiterate the huge flexibility
of the Roth IRA when it comes to withdrawals,
specifically regarding the money you put in,
the basis. This is the Roth's killer feature.
Because you already paid tax on the contributed
funds, the IRS lets you withdraw that original
basis, the principal, at any time. Tax -free
and penalty -free. You're just taking back money
you already paid. paid the tax on. So the penalty
only kicks in if you touch the earnings. Right.
The penalty only applies if you start withdrawing
the earnings or growth portion of the account
before 59 and a half, unless a hardship exception
applies. So the Roth acts like a second tier
emergency fund because the principal is so liquid.
It does. But there is a vital complication if
you move money from a traditional IRA to a Roth.
That's a conversion. A five -year rule. Exactly.
If you convert traditional funds into a Roth,
those converted amounts have to stay in the Roth
for a minimum of five years. If you withdraw
the basis of those converted funds before that
five -year clock runs out, you'll face a penalty
on the converted amount. It's a way to stop people
from converting funds just to get immediate liquidity.
So even with the Roth, you've got to respect
the clock. We've established the entry and exit
rules. Now let's discuss the ultimate protection.
The legal shielding of these assets from external
disaster. The tax deferral is the main benefit
of the IRA, but the secondary advantage, the
strong legal framework that shields these assets
from personal financial disaster, is often worth
just as much. We're talking about bankruptcy
protection. And that protection has been substantially
cemented by Supreme Court rulings. The Federal
Foundation was confirmed in 2005, which established
that under federal bankruptcy law, a debtor could
exempt their IRA from the bankruptcy estate as
long as the amount was necessary for retirement.
Trooping necessity sounds like a lawyer's nightmare.
It was messy. But later that same year, Congress
passed a key piece of legislation that dramatically
increased the protection. This act exempted most
IRAs, including Roths and rollovers, up to a
massive inflation -adjusted cap. And the debtor
didn't have to prove necessity. So protection
became automatic up to a really high amount.
Correct. The cap is well into the seven figures
now. But here's the most important legal protection.
Funds that are rolled over from most employer
plans, like 401ks, into an IRA are entirely exempt
from the bankruptcy estate. There's no cap. That
is a huge takeaway. If you leave a job rolling
your 401k directly into an IRA... preserves the
highest possible level of federal bankruptcy
protection. Absolutely. However, as always, there
is a giant loophole and it ties back to our earlier
discussion on prohibited transactions. If an
IRA engages in a prohibited transaction, it immediately
loses its tax status. And if it loses its tax
status, it's no longer considered a legitimate
retirement fund. Precisely. which means it loses
its bankruptcy protection. So if that self -directed
IRA owner uses their IRA -owned house for a two
-week vacation committing a prohibited transaction,
they might not just face a tax bill. They could
lose the entire asset in a subsequent bankruptcy.
Compliance isn't just about taxes. It's about
existential asset protection. Now we get to a
vulnerability that affects estate planning. inherited
IRAs. This is where the Supreme Court carved
out a major hole in the federal shield back in
2014. This is a vital point that so many people
miss. In the 2014 ruling, the Supreme Court stated
that funds in an inherited IRA, specifically
one inherited by a non -spouse, do not qualify
as retirement funds under the federal bankruptcy
exemption statute. That's a huge shift. Why the
difference between a spouse inheriting it and
a non -spouse? The court's reasoning was that
once an IRA is inherited by a non -spouse, the
beneficiary can access the funds relatively easily
and they can't contribute to the account anymore.
So the funds are no longer set aside for the
beneficiary's retirement. They're an investment
asset available for consumption. And as an available
asset, they are fair game for creditors in a
bankruptcy. So the federal shield that protected
the original owner's million -dollar IRA just
evaporates the moment it passes to a non -spouse
child, leaving the assets totally exposed. That
is the grim reality at the federal level. At
that point, you just have to hope that your state
law provides some protection. Which brings us
to general creditor protection outside of bankruptcy.
We saw that many states have laws prohibiting
the seizure of IRA assets in standard lawsuits.
Many do, but the level of protection is all over
the place. Nevada, for example, is very protective.
It exempts IRA assets up to half a million dollars.
But other states, like California, have these
highly subjective statutes. How does California
determine protection? The California statute
only protects the amount necessary to provide
for the support of the judgment debtor when the
judgment debtor retires. So a court has to look
at the debtor's age, career, other savings, future
earning potential. So a 35 -year -old high -earning
engineer facing a lawsuit might get very little
protection because the court assumes they can
just rebuild their savings later. Exactly. It's
judged case by case and it often provides less
defense to younger, more highly skilled debtors.
And even where state protection exists. It's
not absolute. No, it typically collapses in cases
of divorce, failure to pay taxes or judgments
related to fraud. Finally, let's touch on that
temporary borrowing mechanism, the 60 day indirect
rollover. This is a very niche tool for short
term liquidity. It's the one exception to the
no borrowing rule. An IRA owner is allowed to
take a distribution from their account and it's
tax and penalty free at that moment as long as
the owner redeposits the entire amount into another
IRA within 60 calendar days. So I can use the
IRA money for two months? interest free if I
return it perfectly on time. That's the idea.
It's an indirect rollover. But you can only do
this once in a calendar year. And if you go past
that 60 day window or if you don't deposit the
full amount, the whole transaction is retroactively
treated as a permanent early withdrawal. Which
means taxes and potentially the 10 percent early
withdrawal penalty. That's a massive risk. It's
a high wire act. It's mostly used when switching
custodians or solving a very short term cash
crunch. It really just reinforces the idea that
the IRA is a permanent savings vehicle, not a
personal bank account. We've covered the entry,
growth, exit, and legal protection of the IRA.
Now let's discuss what happens at the end of
the owner's journey, inheritance. The inheritance
rules are arguably the most confusing part of
the entire structure, especially with the recent
legislative changes. The treatment of the assets
depends entirely on whether the beneficiary is
a spouse or a non -spouse. Let's start with the
spouse. Who gives the most flexibility and the
biggest advantage? A surviving spouse has several
great options. The most common choice is to treat
the IRA as their own. This is basically a continuation
of the tax deferral. The spouse can keep making
contributions, they can name new beneficiaries,
and crucially, they don't have to start required
minimum distributions until they reach the RMD
age. They can also just roll the funds over into
another plan. Yes, they can roll the funds into
another plan and take distributions as a beneficiary
based on their own life expectancy. This gives
them a much slower distribution schedule than
the rules for non -spouse heirs. Or, you know,
they can take a lump sum, but that comes with
a high immediate tax cost if it's a traditional
IRA. And what about the option to disclaim? They
can disclaim up to 100 % of the assets. This
is usually done for sophisticated estate planning.
It lets the next beneficiaries, like adult children,
inherit the funds right away. It's useful if
the surviving spouse has plenty of other resources
and wants to bypass their own estate. Okay, now
the situation changes dramatically for a non
-spouse beneficiary, like a child or a friend.
They are explicitly prohibited from treating
the IRA as their own. Correct. For non -spouse
beneficiaries, the standard rule is now the 10
-year rule. This says the beneficiary has to
empty the entire IRA account within 10 years
of the original owner's death. It's designed
to accelerate taxation and stop multigenerational
stretching of the tax deferral. The 10 -year
rule is a major shift from how things used to
be. The old stretch option, where they could
take distributions over their own life expectancy,
that's largely on now. It's been severely curtailed.
It forces distribution and taxation much, much
sooner. However, there are some important exceptions
for certain eligible designated beneficiaries
who can still use a longer schedule. Who qualifies
for that? First, minor children of the decedent.
They can take distributions based on their own
life expectancy, which is a very slow schedule,
but only until they reach the age majority, usually
21. Once they hit 21, the 10 -year rule kicks
in, and they have to get everything out by the
10th year after that 21st birthday. And what
about beneficiaries who were dependent on the
deceased? Beneficiaries who are chronically ill
or permanently disabled, no matter their age,
can use their own life expectancy to stretch
out the distributions. This is critical for providing
long -term support. The final exception allows
the life expectancy schedule for beneficiaries
who are not more than 10 years younger than the
decedent. If an inherited IRA has multiple non
-spouse beneficiaries, how do the RMDs work then?
If the inherited IRA is kept as one undivided
account, yes, the distributions are based on
the age of the oldest beneficiary, which forces
everyone onto the shortest timeline. But beneficiaries
are usually allowed to split the inherited IRA
into separate accounts. If they do that, then
the RMD rules apply separately to each account
based on that individual heir status. Before
we wrap this up, let's briefly touch on the frustration
of double - taxation that can happen when IRAs
hold certain international assets. This is a
really frustrating loophole that affects sophisticated
investors. Double taxation happens when an IRA
holds foreign stocks that pay dividends. Those
dividends get taxed by the foreign country, say
Canada, at the source. But because the IRA is
a tax -advantaged trust, the IRS generally doesn't
recognize this foreign tax as a creditable deduction
for the IRA. So the money gets taxed abroad,
and then it gets taxed again by the U .S. when
it's eventually pulled out of a traditional IRA.
Exactly. It creates the situation where the foreign
tax credit that a normal brokerage account would
get just isn't available. And it leads to all
these arguments about whether this violates international
tax treaties. And finally, for some global context,
this elaborate U .S. system isn't unique, is
it? Many developed countries have similar mechanisms.
They do. It reflects a global policy goal to
encourage private retirement saving. Canada has
the RRSP, which is like the traditional IRA,
and the TFSA, which mirrors the Roth. The UK
has the Individual Savings Account, or ISA. Even
Australia's compulsory superannuation system,
which is a very different structure, is aiming
at the same goal. It's clear the US IRA is part
of a global movement, but the specifics of its
strict separation rules and self -directed flexibility
seem uniquely American. Now, let's ground this
whole conversation in reality by looking at the
hard data, which paints a picture of extreme
disparity. The statistics are, I think, the most
jarring part of this whole deep dive. They show
that the IRA system is effectively serving two
vastly different populations, one that uses it
for massive tax -free wealth accumulation and
the other, the majority that is struggling just
to meet basic retirement goals. Let's start with
that classic split between the average and the
median balance. We're using 2008 data from the
Employee Benefit Research Institute here. The
data showed the average individual IRA balance
was nearly $70 ,000, but the median individual
IRA balance was just over $20 ,000. An almost
$50 ,000 gap. That is a huge difference. It's
a perfect illustration of positive skew. The
average is pulled way, way higher than the median,
the true midpoint, by a very small number of
people who hold accounts worth hundreds of thousands
or even millions of dollars. The median is a
much more accurate reflection of the typical
saver's reality. But what really changes the
perception of the IRA is how the money gets in.
The data on rollovers versus contributions is
stunning. This is probably the most defining
statistical characteristic of the system. The
IRA, statistically, is overwhelmingly a wealth
preservation mechanism. The vast majority of
dollars that enter IRAs come from rollovers,
transfers from old 401ks when people change jobs,
not from new annual contributions of earned income.
And the data quantifies this staggering difference.
Rollovers add over 10 times as much money to
IRAs every year than new contributions do. This
suggests the IRA's primary function isn't necessarily
encouraging the average worker to save $7 ,000
from scratch each year, but rather serving as
a holding tank for large, accumulated sums that
are transferred from workplace plans. So it's
more of an administrative vessel for job changers,
not a primary savings vehicle for a worker just
starting out. Exactly. And while many rollovers
are small, A significant portion are massive.
Over 20 % of them exceed $100 ,000, injecting
these huge pre -tax sums into the system. And
when we look at who does contribute new money,
the effort is really concentrated. Of those who
actively contribute to their IRA in a given year,
something like 40 % contributed the maximum allowable
amount. This shows that the people engaging with
the system are highly disciplined and focused
on maximizing that tax benefit, but they are
a distinct minority of the total account holders.
Let's look at the sheer scale of the system now,
using that 2011 GAO data. The total value is
just enormous. In 2011, 43 million taxpayers
held IRAs, totaling a fair market value of $5
.2 trillion. And the cost to the federal government
in foregone tax revenue is estimated at over
$17 billion a year. That's the price of the incentive
to shelter those assets. Within that $5 .2 trillion,
the vast majority, 98 .5%, have balances of a
million dollars or less. But let's zero in on
that tiny sliver that drives the skew, the mega
IRA phenomenon. This is where that self -directed
IRA discussion from earlier comes back to life.
The data shows incredible wealth concentration
at the very top. Very few taxpayers have balances
over $5 million. In 2011, there were only about
7 ,900 taxpayers in that $5 to $10 million range.
And at the absolute extreme end, the numbers
are just shocking. There were only 314 taxpayers
who held aggregated balances over $25 million.
And the source material highlights the most famous
example of this. Peter Thiel, who reportedly
leveraged the self -directed Roth IRA to amass
a value of $5 billion by investing in startups
like PayPal and Palantir very early on. So he
used the Roth structure to invest in private
company stock. those alternative investments
we talked about. And when those companies went
public, the exponential growth was entirely tax
-free. That is the mechanism. It illustrates
that for a tiny fraction of the ultra -wealthy,
the IRA transforms from a middle -class retirement
vehicle into an engine for generational tax -free
wealth accumulation. And that has led policy
critics to argue that the tax benefits should
be capped or limited to prevent such extreme
outcomes. But that concentration of wealth is
only half the story. Let's pivot sharply to the
counterpoint. The American retirement crisis.
The reality for the typical worker is just stark.
According to the research, 45 percent of working
Americans do not own any retirement account assets
at all. No IRA, no 401k, nothing. 45 percent.
That is nearly half of the workforce completely
uncovered. And for those who do save, the balances
are just perilously low. Median retirement account
balance, and that's combining IRAs and employer
plans, is only $2 ,500 for all working age households.
Even for households that are nearing retirement,
that median balance only crawls up to $14 ,500.
And looking at 2020 data, half of American adults
combined had less than $6 ,500 in their IRAs
and defined contribution plans. That is the overwhelming
context against which those multi -million dollar
mega IRAs are built. It creates a huge ethical
and policy question about the effectiveness and
fairness of the system. It was designed to promote
savings but it appears to be heavily utilized
as a wealth preservation tool for those who already
have high capital and access to these complex
self -directed strategies. Hashtag outro. If
we summarize the key insights from this deep
dive, I think it's that navigating the IRA requires
precision. The primary choice is the tax structure,
right? Traditional for the upfront break, Roth
for the tax -free exit, and that flexible principle.
The second necessity is understanding the strict
rules, particularly that severe risk of prohibited
transactions and self -directed accounts, where
even a minor involvement by the owner can completely
void the entire tax shelter. And finally, the
legal landscape is just full of these potential
pitfalls. While federal bankruptcy protection
is robust, the moment an IRA is inherited by
a non -spouse, that protection is largely stripped
away. And that creates a crucial vulnerability
for estate planning. It really feels like this
system has evolved from a simple savings tool
into this complex financial structure with highly
divergent outcomes, heavily favoring those who
already have significant wealth to roll over.
Knowing these nuances, from the 50 % RMD penalty
to the UBIT trap, it's essential if you want
to use the IRA effectively and just avoid the
costly surprises that are hidden in the fine
print. Let's leave you with this final provocative
thought, connecting that statistical reality
with the purpose of the IRA. If rollovers overwhelm
new contributions by a factor of 10, does the
IRA function more effectively as a wealth preservation
mechanism for those changing jobs than as a primary
savings vehicle for the average worker who's
starting from scratch and who desperately needs
that median balance to climb? So what does this
all mean? We'll let you decide on this deep dive.