IRAs let you invest for retirement in a tax-favored way, and like many tax breaks, IRAs are great vehicles for the wealthy to shelter their income from taxes. In particular, rich taxpayers can use two strategies that will help them build up their IRA balances during their lifetimes and then ensure that anything that goes to the IRS does so as slowly as possible. Below, we'll look at both of these key strategies and how the rich use them with their IRAs to boost their wealth.
Betting on a big payday
The power of compounding can help any saver produce impressive retirement nest eggs even from modest regular contributions. But the windfalls that some rich investors have earned in their IRAs dwarf what most people will ever see in their retirement accounts.
In particular, some of the most successful IRA investments have involved private equity investments and privately held company shares. For instance, PayPal co-founder Max Levchin invested in review service Yelp prior to its IPO by owning shares in his Roth IRA. When Yelp went public in 2012, the Roth IRA enjoyed a huge windfall, with reports at various times suggesting that the value of the retirement account had climbed to between $100 million and $200 million.
Similarly, private equity companies have made it possible for investors to invest in high-risk, high-return investment vehicles within retirement accounts. By creating multiple classes of shares that create opportunities for huge returns when the underlying investments do particularly well, a retirement investor can essentially use the power of leverage to accelerate growth in an IRA dramatically.
Most of the time, ordinary investors don't have access to these opportunities. Most entrepreneurs can't count on being able to enjoy monumental returns from their business activities, and there are limitations on access to private equity investments that require minimum net worth or annual incomes that disqualify the vast majority of Americans. As a consequence, tax-deferred or tax-free growth can sometimes go disproportionately to the rich.
Stretch an IRA as far as it will go
At the other end of the spectrum, the wealthy are also typically in a position in which they don't really need to tap their retirement accounts in order to support themselves after they stop working. With plenty of assets outside tax-favored accounts, rich people have an incentive to leave their IRA money alone as long as possible.
Under current tax law, it's pretty easy to do exactly that. The rules for inheriting IRAs allow a named beneficiary to stretch the annual minimum distributions that they're required to withdraw from their inherited IRAs over the course of their lifetimes. From an estate planning standpoint, the ideal situation for a wealthy family is to leave retirement assets to the youngest available beneficiary. By contrast, even for those families of more modest means who can afford to leave some of their retirement assets untouched, most of them go to older children rather than young grandchildren or great-grandchildren.
The tax impact can be huge. For example, say an 85-year-old dies with a traditional IRA with a $600,000 balance. In a typical family situation, that money might go to a 55-year-old child. That child would have to take out $20,000 from the IRA during the first year, including it in taxable income and paying tax on it. However, a wealthy family might instead leave the IRA to a 3-year-old great-grandchild. Based on the great-grandchild's longer life expectancy, required distributions would be just $7,500 to start out with. The difference of $12,500 would remain in the IRA, continuing to enjoy tax-deferred growth over the course of the great-grandchild's lifetime.
What you can learn from the rich
You might not have access to private equity investments, and you might not be able to afford to leave a huge bequest to your great-grandchildren. But what the strategies that the wealthy use can teach you is that it pays to take maximum advantage of favorable savings opportunities whenever they arise. Even if you won't end up with nine-figure retirement account balances, you can still save enough to enjoy a financially secure retirement.