The Roth IRA Must Die!

It was during a recent email conversation with a prolific LRC blogger that I discovered that my favorite tax haven, Campione d’Italia, is no more. Campione is a delightful chunk of Italy, formerly the property of the bishop of Milan, nestled entirely within the Swiss province of Ticino on the shores of Lake Lugano, what the Italians prefer to call Ceresio; though north of Minneapolis, palm trees grow without protection along the lake due to its effect as a giant solar heat sink. Years back, the only way to get to it from Italy without touching Swiss soil was to take an aerial tram built across Swiss territory. Its currency is Swiss, the franc, and its banks likewise; there used to be no income tax levied on non-Italian residents because a casino in the territory yielded enough revenue that taxes were unnecessary. For foreigners unable to get Swiss residence, it was the closest thing to living in that country of stable money, mandatory gun ownership, and low crime. Sadly, as I learned from my correspondent, casino revenues have dropped, and its status as a tax haven is greatly reduced.

We discussed other locales that avoid taxing the income of foreign residents; as I suggested earlier, places like Dubai might use the lack of personal income taxation to siphon off the most productive citizens from the West, leading to the collapse of the welfare/warfare state without these "Islamists" firing a shot. I learned of a few places I did not know of before, and suggested to him a "country" that also offers income free from taxation.

That "country" is the Roth IRA, which allows a US citizen to put aside money on which he has already paid income tax into an account where all accumulations on the principal are tax free, if withdrawn under certain conditions. Fairmark explains: "when you take money out of a Roth IRA, the first dollars you take out are considered to be a return of your regular contributions. You don’t have to meet any special tests to receive those dollars free of tax. You can take them out any time, for any reason, without paying tax or penalties." To get the earnings out without paying taxes, you must meet two tests: withdrawals must come at least five years after you opened the account, and must be one of the four "qualified" distributions. They are "(d)istributions made on or after the date you reach age 59; (d)istributions made to your beneficiary after your death; (i)f you become disabled, distributions attributable to your disability; u2018(q)ualified first-time homebuyer distributions.’" (As always, check with your attorney for current tax law.)

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So it would seem easy to live the good life: just buy that winning lottery ticket in a Roth IRA and collect your millions tax-free. Unfortunately, conventional IRAs are restricted, usually, to stocks and bonds; self-directed IRAs allow for a wider range of investments, but not lottery tickets or, among others, "investments … includ(ing) artwork, rugs, antiques metals, gems, stamps, coins, alcoholic beverages and other collectibles." However, according to IRAMyWay, things like "Residential Real Estate, Commercial Real Estate, Raw Land, Trust Deeds / Mortgages, and Mortgage Pools, Private Notes and Loans, Private Stock Offerings, Limited Liability Companies (LLC), Limited Partnerships (LPs), Tax Certificates, … and Commercial Paper" can all be held in a self-directed (Roth) IRA.

Imagine two friends, Fred and Joe, each age 60 with a Roth IRA that had been opened ten years previously, with a balance of $200,000. Fred’s self-directed IRA could write a mortgage on Joe’s house, while Joe could write a mortgage on Fred’s house; at 10% interest, each IRA would earn $20,000 in interest annually. The interest, earnings, could be paid out tax free to each man; at the same time, each might deduct (check with your tax advisor!) the $20,000 he paid in interest from his Federal taxes, creating $20,000 in tax-free income. More creative scenarios are left to the reader as an exercise; suffice it to say that the combination of qualified Roth distributions and self-directed investments could easily lead to a situation where the Federal state legally saw many of its citizens avoid taxes entirely.

There are limits; as SmartMoney outlines, "(e)xamples of what the IRS (or the Department of Labor) may consider to be prohibited transactions include the following: (h)aving your IRA buy stock or other assets from you or sell them to you; (h)aving your IRA lease assets from you or to you; (h)aving your IRA buy stock in a corporation in which you have a controlling interest; (h)aving your IRA lend to you or borrow from you; (h)aving your IRA engage in transactions with certain related parties and/or family members." (Some examples of related parties and family members are given here.) Even so, mutually-beneficial friends could take advantage, as well as cousins, uncles/aunts to nieces/nephews, etc. Using the Federal Gift Tax exclusion, a great aunt or uncle could provide the benefits of some tax-free income to a young person otherwise unable to take money out of a Roth IRA directly, or by leaving a qualified Roth to a younger person upon death.

This situation is treacherous for the Federal Government. As Gary North outlined, 2010 is the year that Social Security will take in less net revenue to the government in FICA "taxes" than is paid out in benefits. North proposes a few solutions: "(l)et’s see if Congress will kick the can some more. Let’s see if Congress passes hikes in the FICA tax rates in 2010, or extends the wage base that pays the tax beyond today’s $106,800 limit. My guess: Congress will kick the can. The deficit will grow."

What is certain is that out-of-control spending will continue, and meaningful benefits for those on Social Security will have to be funded from somewhere. My guess for the most likely future source is a wealth tax on the retirement accounts of those who have distrusted the word of the Federal Government to pay benefits, but who have curiously trusted that same government with regard to retirement account security. Remember that Social Security benefits themselves were once tax-free. The promise of tax-free earnings from a Roth IRA must likewise be reneged upon if the Federal State survives.