By Edward Zelinsky
On a personal level, I enjoyed the news reports that Mitt Romney holds assets worth tens of millions of dollars in his individual retirement account (IRA). These reports confirm a central thesis of The Origins of the Ownership Society, namely, the extent to which defined contribution accounts, such as IRAs and 401(k) accounts, have become central features of American life.
I was also gratified as colleagues, friends and neighbors who are often skeptical of what I do for a living (“You actually teach about pensions?”) sought my opinion about Mitt Romney’s IRA. Since we don’t have all of the details, my answers entailed a certain amount of conjecture. For those too sheepish to ask, here are the questions most frequently posed to me and my answers:Why is Mitt Romney’s IRA so much bigger than mine?
Because he was a better investor than you. It appears that Mitt Romney’s IRA largely consists of investments he made while a partner at Bain Capital and of the proceeds from such Bain investments. Those investments were apparently made in Mitt Romney’s 401(k) account when the investments had relatively little value. When he left Bain, these investments were rolled over, i.e., transferred tax-free, to Mitt Romney’s IRA. While these investments were modest when initially made, they are now quite valuable. That is what successful private equity investors do.
When must Mitt Romney pay taxes on the assets in his IRA?
April 1, 2018. He could start paying taxes before then but what the Code calls his “required beginning date” is April 1, 2018. This date is set by a statutory formula which is quizzical even by the standards of the Internal Revenue Code: Mitt Romney was born on March 12, 1947. He will be 70 years old on March 12, 2017. Six months after this birthday is September 12, 2017. Therefore, Mitt Romney must start to draw down and pay tax on his IRA as of April 1, 2018.
How much tax will Mitt Romney have to pay then?
It will depend on the size of the IRA at that time and the tax rates then in effect. Because Mrs. Romney is only two years younger than her husband, the first distribution from Mitt Romney’s account on or before April 1, 2018 must be at least 3.65% of the account as it then exists. This percentage is based on the Romneys’ joint life expectancies as determined by Treasury actuarial tables. Thus, for example, if Mitt Romney’s IRA is worth $100,000,000 on December 31, 2017, his first distribution from this account on or before April 1, 2018 must be $3,650,000. Assuming that Mitt Romney made only tax deductible contributions to the account, all of this distribution will be taxed as ordinary income, at whatever tax rate then prevails.
What about subsequent years?
Each year, as the IRA holder ages, the required distribution (and thus taxable income) increases as a percentage of the current account balance. For example, when Mitt Romney is 75, his required IRA distribution will be 4.37% of the account as it then exists. When Mitt Romney is 80 years old, he will be required to receive and pay ordinary income taxes on 5.35% of the IRA balance as it then exists.
Wouldn’t Mitt Romney have been better off from a tax perspective keeping these investments as capital assets outside his IRA?
We don’t know. Had these investments been held directly by Mitt Romney as capital assets, they would have been more lightly taxed as capital gains. In contrast, Mitt Romney will pay tax at higher ordinary income rates when these investments are eventually distributed to him from his IRA. However, there are two potentially offsetting factors which Mitt Romney likely considered as part of his tax planning. First, some, perhaps many, of these investments may yield ongoing ordinary income. As to this annual income, it is typically considered desirable to engage in the kind of tax-deferral Mitt Romney has obtained by holding assets in his IRA.
Second, if assets are sold inside the IRA, those sales are tax-deferred. In contrast, if Mitt Romney had kept these assets in his own name and sold them, tax would have been due upfront on each sale. It appears that Mitt Romney concluded that these latter two considerations made it tax efficient to put these investments into his 401(k) account and, from there, into his IRA.
What is a “foreign blocker”?
The term “blocker” is today used to describe a corporation interposed between an investor and an investment. A foreign blocker is a blocker incorporated outside of the United States, typically in a low tax jurisdiction like the Cayman Islands.
Why did Mitt Romney use a foreign blocker for his IRA?
Probably to avoid the Internal Revenue Code’s unrelated business income tax (UBIT).
What is the UBIT?
Otherwise tax-exempt institutions, like pension trusts, university endowments and Mitt Romney’s IRA, trigger federal tax if, instead of investing to obtain dividends, interest and similar forms of passive investment income, they receive active earnings from business operations. The UBIT is the provision of the Code which levies this tax on the active business income received by tax-exempt entities. It is likely that many Bain assets are active businesses and thus would generate UBIT if owned directly by Mitt Romney’s IRA.
So how does the foreign blocker work?
Instead of the exempt institution itself holding active business assets, those assets are held by a foreign corporation which pays little or no corporate tax to its home jurisdiction. This foreign corporation then pays dividends to the exempt institution. These dividends are then tax-deferred to the exempt entity such as Mitt Romney’s IRA.
Without more detail, we don’t know if the foreign blocker corporation actually reduced Mitt Romney’s effective tax obligation. If the foreign blocker corporation owns U.S. business assets, the blocker will pay U.S. tax on its U.S. business income. This typically results in no net tax savings since the U.S. tax obligation is merely shifted from the tax-exempt institution to the blocker corporation.
If, however, the foreign blocker holds foreign business assets, it is possible for the blocker to spare the U.S. exempt institution from U.S. tax while paying little or no foreign tax. In that case, the foreign blocker is a real tax winner.
To evaluate this further, we need to know more about the portfolio of Mitt Romney’s IRA. It is, however, unlikely that a Bain Capital partner would have used a foreign blocker unless some tax savings resulted.
Is this unusual?
Hardly. The use of foreign blockers is quite common. You (here my previously indignant questioner typically becomes quite sheepish) may be covered by a pension plan which uses foreign blockers to defer UBIT on what otherwise would be currently taxed business income. You may also benefit from or contribute to a university endowment which uses foreign blockers.
Can I invest my IRA funds like Mitt Romney?
In theory, yes. In practice, no. There are mutual funds which invest in private equity deals of the sort Mitt Romney holds in his IRA. However, under the best of circumstances, these funds need to be scrutinized carefully as to their management fees and whether they really obtain the kinds of investment opportunities available to a Bain Capital partner. I’m skeptical.
Edward A. Zelinsky is the Morris and Annie Trachman Professor of Law at the Benjamin N. Cardozo School of Law of Yeshiva University. He is the author of The Origins of the Ownership Society: How The Defined Contribution Paradigm Changed America. His monthly column appears here.