Grow Your Own "Stealth" Retirement Account
Do you have any money saved in an IRA? How about a Roth IRA? Or a 401(k)? Or maybe a Simplified Employee Pension Plan?
Chances are you do.
That means you need to get out a pen and paper, read this entire essay and take notes. Because I’m going to show you how to protect yourself against a very possible threat to the retirement you have planned.
Remember all the way back to this past January? To President Obama’s State of the Union address? He called on Congress to “fix an upside-down tax code that gives big tax breaks to help the wealthy save.”
A special “fact sheet” from the president’s office after the speech specified exactly what he meant: “Removing retirement tax breaks for the wealthiest while improving them for the middle class.”
Frankly, it doesn’t matter if he gets his wish. The government will sooner or later take a closer look at the most popular types of retirement accounts, figuring out the best ways to make them less effective. Who knows what schemes they’ll come up with?
Not only to limit contributions… but maybe someday soon to tax what’s in there. Believe me, it’s not that far of a leap.
Frankly, if you have one or more of these retirement accounts, your money is at risk. But there is an easy way to avoid the extra scrutiny and to protect yourself from any extra taxes that Washington may dream up for these accounts…
Just avoid the common retirement accounts altogether.
In today’s reckoning, I’ll show you how to set up a retirement investment account that will help shield you from the Internal Revenue Service’s (IRS) radar. This information is very valuable.
First, just to make sure you fully understand why I’m recommending you open a “stealth” retirement account, let’s take a look at how the various types of traditional retirement investment accounts work.
When the president talked about retirement accounts, he was referring to individual retirement accounts (IRAs) — a special class of investment accounts created by the Employee Retirement Income Security Act of 1974.
Frankly, if you have one or more of these retirement accounts, your money is at risk.
They were designed to encourage more people to save money for retirement. Instead of merely collecting interest, these accounts often allow investments in stocks, bonds and other instruments. They also offer some tax-deferred benefits.
The specific benefits vary by the type of account.
There’s the traditional IRA. Your contributions to this account can be tax deductible, assuming you meet certain conditions. More importantly, the account’s transactions aren’t taxed until you withdraw the funds. So none of the interest, dividends or capital gains you collect goes to the IRS.
Instead, six months after your 59th birthday, you can start withdrawing money from the account. At that point, the money you withdraw will be considered income and taxed appropriately.
There are strict limits to who can deduct their contributions to an IRA, and limits on the amount you can deduct. If you’re not eligible for a traditional IRA, you can look into a nondeductible IRA. As the name implies, you can’t deduct any of the money you put into this IRA. On the bright side, you still aren’t charged any taxes on any gains in the account, and at retirement age the withdrawals are treated like income.
There’s also a Roth IRA. You don’t get to deduct contributions to the IRA, but once you’re 59.5 years old, certain withdrawals will be tax free.
You can choose to have a portion of your paycheck paid directly into your IRA or Roth IRA. Or your employer can set up a plan where he or she chooses how much to contribute to your IRA.
That’s called a simplified employee pension (SEP) plan. You have no control over how much money goes into the account, nor can you choose to bolster your employer’s contribution. But you can choose and manage what’s inside your IRA account.
And there’s another off-shoot of the SEP that you may have heard of — 401(k) and 403 (b) accounts. The names refer to the sections of the IRS tax code that created them.
The 401(k) account is set up by companies for their employees to deduct pre-tax earnings into an account that’s like an IRA. The additional benefit is that your employer can also make contributions on your behalf on a pre-tax basis.
But while all of these retirement accounts offer different investing options and different tax benefits, there’s one thing they all have in common — they are all closely monitored by the IRS.
By law, the brokerage and bank trustees where your accounts are held must report to the IRS the cash and assets you put into the account. Distributions must be noted too and need to be rectified against your income tax filings.
So there’s a great deal of reporting attached to these traditional retirement accounts. The IRS knows exactly how much money you’re putting in and taking out of them. And they’ll be ready to pounce on any changes to the tax codes that affect these accounts.
But there is a way you can set up a personal retirement account that can dramatically reduce tracking and monitoring by the IRS without giving up all of the tax advantages that traditional accounts offer you.
And the great thing is that setting up this kind of account involves a lot less paperwork than setting up IRA, SEP, 401(K) or 403(B) accounts.
The way you can set up a retirement account that shields current income from taxes while also reducing or even eliminating reporting to the IRS is very straightforward.
It’s so straight-forward that it might surprise you.
Just set up a simple account with any bank or brokerage account that enables you to buy or own investment securities.
It must be as plain vanilla as possible. Don’t open an account that qualifies as an IRA or 401(k). That way the bank or brokerage won’t have to file forms to the IRS.
Also, makes sure the account doesn’t pay any interest. It shouldn’t have a money market, sweep or any other type of interest-bearing portion. It must simply hold cash with no interest paid. That will enable the brokerage to not file forms on the cash to the IRS.
Almost any brokerage will do, and many banks offer simple investment accounts, too. Just go to your bank’s homepage and look for information on investing. Some allow you to write checks against the cash in your account, but that’s not a necessity.
(Not every bank offers an investment option, so you may need to find a bank that does, or sign up with a brokerage firm.)
By following these rules you’ve set up an account that will largely stay off the IRS radar.
Set it up correctly, and the only taxes you’ll have to worry about are from dividend income and any capital gains you get from selling stock.
Now I know what you’re probably thinking — you’ve giving up a lot of tax advantages by opening a basic account. And if you still have to pay taxes on dividends and capital gains, what’s the point?
Well, here’s where it gets really interesting… because I’m going to tell you how to collect dividends with almost zero tax liability, and even avoid capital gains!
It all comes down to buying the right assets.
You can replicate some of the tax advantages that retirement accounts offer by filling your stealth account with instruments that pay dividends that are shielded from current ordinary income tax liability. Better still, these dividends are often higher than typical dividends, so you won’t be collecting measly payouts for giving up the tax benefits.
This special investment class was codified by the Tax Reform Act of 1986 and signed into law by then President Ronald Reagan. They come in various types of partnerships going by names like General Partnerships (GP), Limited Partnerships (LP), Master Limited Partnerships (MLP) and Limited Liability Corporation (LLCs).
Collectively they are known as publicly traded partnerships (PTPs)… but I like to call them “passthroughs.”
That’s because they pass through their profits to shareholders in the form of dividends. And they also pass through their corporate tax shielding on things like depreciation, depletion and countless other deductions. So when tax time comes, a portion — if not all — of your dividend is protected.
Passthroughs may sound fancy, but they trade right along stocks on the major exchanges. It’s just a matter of telling your broker the company’s symbol and number of shares you want.
Thanks to their unique structure, most — if not all — of the money passthroughs pay out to investors is not considered dividend income. Instead, it’s considered return of capital. So instead of a 1099 form from your bank or broker, you’ll get a K-1 from the companies themselves.
Even better, the return of capital is subject to depreciation allowances, which means you pay less tax on that income. In some cases, you won’t have to pay any taxes at all. (Don’t worry — the company’s K-1 form will let you know exactly what your tax liability is.)
The downside is that each “return of capital” check reduces your cost basis in the PTP. The cost basis is the value used to calculate your capital gains when you sell the PTP. A lower cost basis often means greater capital gains, and thus more taxes.
When you sell the shares, you’ll be taxed on the difference from the sale proceeds and your reduced cost basis at capital gains rates.
Think of it this way… let’s say you buy one share of a PTP for $27. It sends you a dividend check for $2. First, assuming the company’s depreciation allowances exceeded $2 a share, you won’t have to pay any taxes on that $2.
But now your cost basis has shrunk to $25. If you sell the PTP share at $27, the IRS will actually say you profited $2 on the sale, and will tax your capital gains appropriately. So it’s better to hold on to your passthrough shares as long as possible.
And if you die, the cost basis of a PTP is reset to the initial cost basis. So, using the example above, no matter how many dividend checks you collected from the PTP, upon your death, the IRS will make the cost basis $27 again. Thus, PTPs can allow investors to leave beneficiaries an income-paying asset without owing tax on shielded income.
In short, by adding passthroughs to your stealth retirement account, you’ll collect big dividend checks that are mostly — if not entirely — shielded from current income taxes. You’ll only need to worry about capital gains taxes… and if you pass on, you won’t pass on the capital gains taxes to your heirs.
Of course, since PTPs look and trade exactly like stocks, it can be tough to tell the difference. You want to make sure you’re buying a passthrough and not an ordinary stock.