Tax Bill Includes Changes to Types of Investments You Can Hold in Your IRA

October 22, 2021

The House Ways and Means Committee recently released draft legislation that could significantly impact the types of investments you can own within your individual retirement account (IRA).

Section 13812 of the Ways and Means Amendment to the Budget would “prohibit an IRA from holding any security if the issuer of the security requires the IRA owner to have certain minimum level of assets or income, or have completed a minimum level of education or obtained a specific license or credential.” In other words, IRAs would no longer be able to hold investments that require an “accredited investor.”

What is an accredited investor?

Many private investments, including hedge funds and early-stage startups, are exempt from a range of rules and regulations designed to protect regular investors from the high levels of risk involved. They’re only available to people the Securities and Exchange Commission (SEC) defines as an accredited investor.

To become an accredited investor, you must meet one of the following three requirements:

  • Have an annual income of at least $200,000 ($300,000 if combined with a spouse’s income) and expect to maintain the same level of income this year
  • Be a “knowledgeable employee” of certain investment funds or hold a valid Series 7, 65, or 82 license
  • Have a net worth of $1 million or more, either individually or together with a spouse, excluding the value of your primary residence

Accredited investors can invest in venture capital, angel investments, real estate investment funds, private equity funds, hedge funds, and specialty investment funds (like those focusing on cryptocurrency).

Restricting the types of assets that can be owned within an IRA

The proposal means that owning shares of anything other than publicly traded stock, bonds, or mutual funds within an IRA would be prohibited.

Proponents of the plan believe it reduces IRA’s use as a tax shelter and has investor protection benefits. In contrast, opponents believe it unfairly subjects some high and middle earners to penalties. If passed, the limitation would apply to all retirement savers — not just wealthy taxpayers.

The real concern for our clients isn’t the specific language of the bill but handling IRAs that already hold such investments. While this section would take effect for tax years beginning after December 31, 2021, there is a two-year transition period for IRAs that already hold these investments. Essentially, anyone holding alternative investments in their IRA would need to get them out of the IRA in 2022 or 2023. If an IRA has a prohibited investment after the two-year transition period, the account loses its IRA status on the first day of the tax year. It would be treated as a distribution in an amount equal to the fair market value of its assets to the account owner as of that date.

Owners can sell existing holdings within their IRAs and use the proceeds to buy allowable investments without tax penalties. However, it may be difficult to sell those alternative investments within the required two-year time frame. The proposal currently does not provide any additional transition relief for investments that cannot be sold or transferred during the transition period. Nor does it permit the IRA to sell or transfer prohibited private assets to the IRA owner. This may force some owners to sell at an undesirable price. 

Distributing these assets to the IRA account holder is also a taxable event. Any deductible contributions and earnings (including interest, dividends, and capital gains) will be taxed as ordinary income. You may also be subject to a 10% early withdrawal penalty if you are under age 59½, and a state penalty may also apply. 

The proposed legislation includes other potential changes that will impact how individuals can save for retirement, including additional limitations on IRA investment in an entity in which the owner has a substantial interest. Currently, IRA owners cannot invest their IRA assets in an entity with a 50% or greater interest. The proposal adjusts the 50% threshold down to 10% for investments that are not tradeable on an established securities market. 

Keep in mind that this is just a proposal, and the final rules could be materially different from what is currently proposed. Even if the bill succeeds, investment limitations that require accredited investors could be removed or modified. Lawmakers could also allow existing IRA investors to keep their current investments intact without penalty or provide a longer transition period.

As always, MST will track the key tax proposals and keep you informed of these potential changes. But don’t wait for the proposal to become law to start thinking about how it might impact you and your tax planning. Given the potential significance of these and other tax law changes, now is the time to connect with your MST advisor to discuss how these proposals could affect you and start planning your tax strategies should they become law.

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