Individual Retirement Accounts: IRS Could Bolster Enforcement on Multimillion Dollar Accounts, but More Direction from Congress Is Needed
Released: 2014-11-19T00:00:00


Highlights: section_title: Why GAO Did This Study
paragraphs: In 2014, the federal government will forgo an estimated $17.45 billion in tax revenue from IRAs, which Congress created to ensure equitable tax treatment for those not covered by employer-sponsored retirement plans. Congress limited annual contributions to IRAs to prevent the tax-favored accumulation of unduly large balances. But concerns have been raised about whether the tax incentives encourage new or additional saving. Congress is reexamining retirement tax incentives as part of tax reform.GAO was asked to measure IRA balances and assess IRS enforcement of IRA laws.

This report (1) describes IRA balances in terms of reported FMV aggregated by taxpayers; (2) examines how IRA balances can become large; and (3) assesses how IRS ensures that taxpayers comply with IRA tax laws. To address these objectives, GAO analyzed 2011 IRS statistical data, reviewed IRS documentation and relevant literature, and interviewed government officials, financial industry stakeholders, and academics. GAO compared IRS enforcement plans and procedures with law and criteria for evaluating an enforcement program.

section_title: What GAO Found
paragraphs: For tax year 2011 (the most recent year available), an estimated 43 million taxpayers had individual retirement accounts (IRA) with a total reported fair market value (FMV) of $5.2 trillion. As shown in the table below, few taxpayers had aggregated balances exceeding $5 million as of 2011. Generally, taxpayers with IRA balances greater than $5 million tend to have adjusted gross incomes greater than $200,000, be joint filers, and are age 65 or older. Large individual and employer contributions sustained over decades and rolled over from an employer plan would be necessary to accumulate an IRA balance of more than $5 million. There is no total statutory limit on IRA accumulations or rollovers from employer defined contribution plans.

A small number of taxpayers has accumulated larger IRA balances, likely by investing in assets unavailable to most investors—initially valued very low and offering disproportionately high potential investment returns if successful. Individuals who invest in these assets using certain types of IRAs can escape taxation on investment gains. For example, founders of companies who use IRAs to invest in nonpublicly traded shares of their newly formed companies can realize many millions of dollars in tax-favored gains on their investment if the company is successful. With no total limit on IRA accumulations, the government forgoes millions in tax revenue. The accumulation of these large IRA balances by a small number of investors stands in contrast to Congress's aim to prevent the tax-favored accumulation of balances exceeding what is needed for retirement.

The Internal Revenue Service (IRS) has enforcement programs covering specific aspects of IRA noncompliance, such as excess contributions and undervalued assets. As recommended by an internal task team, IRS plans to collect data identifying nonpublicly traded assets comprising IRA investments. IRS expects the data will help it identify potential IRA noncompliance. However, research on those taxpayers and IRA assets at risk will hinge on getting resources to effectively compile and analyze the additional data. IRS officials said IRA valuation cases are audit-intensive and difficult to litigate because of the subjective nature of valuation. Additionally, the 3-year statute of limitations for assessing taxes owed can pose an obstacle for IRS pursuing noncompliant activity that spans years of IRA investment.

section_title: What GAO Recommends
paragraphs: Congress should consider revisiting its legislative vision for the use of IRAs. GAO makes five recommendations to IRS, including approving plans to fully compile and digitize new data on nonpublicly traded IRA assets and seeking to extend the statute of limitations for IRA noncompliance. IRS generally agreed with GAO's recommendations.

section_title: Letter
paragraphs: Enacted as part of the Employee Retirement Income Security Act of 1974  (ERISA), individual retirement accounts (IRA) are a key vehicle for  individuals to save for retirement. IRAs hold about 26 percent of all  retirement assets, and more than 54 million taxpayers held an estimated  $5 trillion in IRAs in 2010, according to the latest published analysis by  the Internal Revenue Service (IRS). IRAs also are increasingly important  as a way for individuals to roll over savings from pension plans. Most  eligible taxpayers do not take advantage of IRAs as an opportunity to  save for retirement. For example, the IRS estimated that of 145.6 million  taxpayers eligible to contribute to an IRA in 2010, less than 8 percent  contributed.

In 2014, tax-preferred treatment for IRAs will result in the federal  government forgoing an estimated $17.45 billion in net income tax  revenue, according to estimates by the Department of the Treasury  (Treasury). To limit the amount of federal revenue forgone and their use  by higher-income individuals, IRAs are subject to a total annual  contribution limit, as well as some income and other limits on eligibility. In  addition, some IRA types require minimum distributions starting at age  70½. The tax code also imposes an additional tax on excess contributions  and early withdrawals. However, the tax code does not place any total  limit on how much can be accumulated in an IRA.

GAO, Individual Retirement Accounts: Government Actions Could Encourage More  Employers to Offer IRAs to Employees, GAO-08-590 (Washington, D.C.: June 4, 2008)  and Private Pensions: Some Key Features Lead to an Uneven Distribution of Benefits,  GAO-11-333 (Washington, D.C.: Mar. 30, 2011). such as the beneficial tax treatment of IRAs under an income tax  system.

To better understand how balances accumulate in some IRAs, you asked  us to review IRA account balances and IRS enforcement of IRA rules.  This report (1) describes the number and types of taxpayers with IRAs  and the size of IRA balances in terms of aggregate fair market value  (FMV), adjusted gross income (AGI), filing status, and age; (2) examines  how IRA balances can become large; and (3) assesses how IRS ensures  that taxpayers comply with IRA tax laws.

To describe the number and types of taxpayers with IRAs and the size of  IRA balances in terms of FMV, we analyzed individual tax data for tax  year 2011 (the most recent year available) from IRS’s Statistics of Income  (SOI). We analyzed these data by size of IRA FMV—as reported by IRA  custodians to IRS—as well as other factors, including the type of IRA,  taxpayers’ adjusted gross income, age, and filing status. Because SOI  samples tax returns, and taxpayers may have multiple IRAs, we  aggregated IRA data (including inherited IRAs as IRS data do not readily  identify inherited IRAs) by tax return. Our unit of analysis was the  taxpaying unit, and a tax return, such as for a married couple filing jointly,  may include more than one IRA owner. Our analysis of SOI statistical  data is subject to sampling errors because the SOI data set is based on a  sample of tax returns as filed.audit results. To assess the reliability of the statistical data we analyzed,  we reviewed IRS documentation and interviewed agency officials familiar  with the data. We determined that these data were sufficiently reliable for  the purposes of this report. However, the IRS SOI sample may not   In addition, the data do not reflect IRS  provide a precise estimate of the number of taxpayers or other quantities  when the number of taxpayers in a particular reporting group is very  small. To give perspective on what might be considered a large IRA, we  developed two contribution scenarios to illustrate how much a person and  an employer could have contributed given statutory limits on contributions  from 1975 to 2011. We calculated hypothetical accumulations using  historical stock and bond market returns and interest rates as well as  what return rates would be necessary to accumulate balances of $1  million or $5 million under each contribution scenario.

To examine how IRA balances can become large, we conducted literature  reviews on IRA investment strategies and held semistructured interviews  with finance industry stakeholders, government officials, and academics.  We selected interviewees through our literature reviews and through  referrals from internal and external stakeholders for individuals with  relevant legal, tax, and financial expertise. We also searched for  documentary evidence of IRA investment strategies in publicly available  filings with the Department of Labor (DOL) and the Securities and  Exchange Commission (SEC). We could not determine how many IRAs  used the strategies identified because IRS does not collect data on asset  types held in IRAs. We then compared our findings from the literature  reviews, interviews, and filing searches with our criteria on tax  expenditures and tax policy, focusing primarily on whether the tax  treatment is fair and equitable.

We also shared our criteria with IRS officials. The criteria we

Enforcement programs should cover key IRA laws.

Enforcement procedures should take into account the cumulative tax- revenue effect of an improperly valued asset that the taxpayer  contributed to a plan.

Enforcement management should collect and use data that will enable  examiners to accurately weigh the noncompliance risk of potentially  misreported IRA values.  IRAs should be considered in making enforcement plans.

Examiners should be trained to identify potential IRA noncompliance.

IRS should collaborate with the appropriate agency on enforcing  certain prohibited transactions that could lead to large, noncompliant  IRAs.

Examination management should collaborate with staff in its own  service and outreach functions to help the public better understand  laws related to potential IRA investment.

We then compared the criteria to documentation on IRS enforcement  plans and procedures. We also collected information for the comparison  from interviews with relevant IRS, Treasury, and DOL officials.

For more detail on our methodology, see appendix I.

We conducted this performance audit from June 2013 through October  2014 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: IRAs serve dual roles by (1) providing a way for individuals not covered  by a pension plan to save for retirement and (2) providing a place for  retiring workers or individuals changing jobs to roll over, or transfer, their  employer-sponsored pension plan balances.
subsections: section_title: IRA Types
paragraphs: During the past 40 years, several types of IRAs with different features for  individuals and small businesses have been authorized. Two types of  IRAs are geared toward individuals—each with its own federal income tax  benefits:

Traditional IRA: Eligible individuals may make tax-deductible  contributions of earned income with taxes deferred on investment  earnings until distribution at retirement. If either the taxpayer or his or  her spouse is covered by an employer retirement plan, the individual  may be eligible for only a partial deduction or no deduction at all,  depending on the taxpayer’s income and filing status. Individuals may  make nondeductible contributions to receive the tax deferral on  investment earnings. Individuals older than 70½ cannot contribute and  must begin receiving required minimum distributions from these  accounts. Generally, distributions are taxed as ordinary income. Individuals who made nondeductible contributions to their IRAs may  receive a tax-free return of those amounts. Early withdrawals before  age 59½, other than for specific exceptions, are subject to a 10  percent additional income tax.

Roth IRA: Enacted as part of the Taxpayer Relief Act of 1997, this  type of IRA allows eligible individuals to make nondeductible  contributions to these accounts but generally receive tax-free  distributions. Annual Roth IRA contributions are limited based on a  taxpayer’s income and filing status. Since January 1, 2010,  conversions—where a taxpayer pays taxes deferred on balances in a  traditional IRA to transfer those amounts to a Roth IRA—are no longer  subject to income eligibility rules.contributing, and no distributions are required during the individual’s  lifetime. Withdrawals are generally tax-free after age 59½, as long as  the individual held the account for 5 years; early distributions other  than for specific exceptions are subject to an additional 10 percent  income tax on earnings.

There are no age limits on  The dollar limit on all IRA contributions is adjusted annually for cost-of- living increases. For 2014, the maximum contribution for all traditional  and Roth IRAs in total is $5,500. Individuals age 50 and older are eligible  to make additional catch-up contributions of $1,000. Taxpayers age 70½  and older can contribute to a Roth IRA only. Any contribution exceeding  the annual limit or made by an ineligible taxpayer is subject to a 6 percent  excise tax on the amount of excess contributions.

Two other types of IRAs are intended to encourage savings sponsored  through small employers:

Simplified Employee Pension Plan (SEP) IRA: Enacted under the  Revenue Act of 1978, this type of IRA was designed with fewer  regulatory requirements than traditional employer pension plans to  encourage small employers to offer pension plans to their workers.  SEP IRAs allow employers to make tax-deductible contributions to  their own and each eligible employee’s accounts. SEP IRAs have  higher contribution limits than other IRAs: $52,000 in 2014. Annual  contributions are not mandatory, but as with pension plans, they must  be based on a written allocation formula and cannot discriminate in  favor of highly-compensated employees.

Savings Incentive Match Plan for Employees (SIMPLE) IRA:  Enacted under the Small Business Job Protection Act of 1996,  SIMPLE IRAs help employers with 100 or fewer employees more  easily provide a retirement savings plan to their employees. In this  plan, eligible employees can direct a portion of their salary, within  limits, to a SIMPLE IRA and employers must either (1) match the  employees’ contribution up to 3 percent of the employee’s  compensation, or (2) make nonelective, 2 percent contributions of  each employee’s salary for all employees making at least $5,000 for  the year. The employee salary reduction contribution limit for 2014 is  $12,000.which in 2014 are limited to $2,500.

section_title: Rollovers from Employer Plans
paragraphs: Individuals can roll over assets from employer retirement plans into  traditional or Roth IRAs.retirement plans: (1) defined benefit (DB) plans, which promise to provide  benefits generally based on an employee’s years of service and  frequently are based on salary, regardless of the performance of the  plans’ investments, and (2) defined contribution (DC) plans, in which  benefits are based on contributions and the performance of the  investments in participants’ individual accounts. Over the last three  decades, employers have shifted from sponsoring DB plans to DC plans.  The 401(k) plan is the predominant type of DC plan in the United States.  Typically, 401(k) plans allow participants to specify the size of their  contributions and direct those contributions to one or more investments  among the options offered within the plan.

Employers may sponsor two broad types of  In passing ERISA, Congress intended to harmonize the regulation of all  tax-advantaged retirement plans, including IRAs, to prevent, among other  things, “njustifiable differences in tax treatment of corporate owner- employees and self-employed individuals under qualified plans.” At the  time, while DB plans were the dominant type of employer-sponsored  retirement plan, Congress placed various limits on both DB and DC plans.  For DB plans, benefits are limited to amounts needed to provide an  annual benefit no larger than the lesser of a specific dollar amount or 100  percent of the participant’s average compensation for the highest 3  consecutive calendar years.maximum annual benefit under a DB plan is $210,000. An individual  receiving a lump sum distribution from a qualified plan may defer taxes by  rolling the lump sum into a traditional IRA.

For tax year 2014, the limit on the  Whereas DB plans have a limit on total benefits, DC plans (like IRAs)  have annual contribution limits but no total limit on how much an account  can accumulate. For DC plans, annual contributions are limited to the  lesser of a specific dollar amount or 100 percent of the participant’s  compensation. For tax year 2014, the contribution limit on an  employee’s elective deferral is $17,500, and the overall contribution limit,  which includes the total of all employer contributions and employee  elective deferrals, is $52,000. Employees age 50 and older are eligible  to make additional catch-up contributions of $5,500. Employees older  than age 70½ generally can continue contributing and, if their employer  plan allows, delay required minimum distributions until retirement.  Rollovers from employer plans such as 401(k) plans have become the  predominant source of funds into IRAs. Tax-deferred balances may roll  into a traditional IRA, and balances from a designated Roth account can  roll directly into a Roth IRA.

For employer plans, tax incentives are structured to strike a balance  between encouraging employers to start and maintain voluntary, tax- qualified pension plans and ensuring that lower-income employees  receive an equitable share of the tax-subsidized benefits. In addition to  the annual limit on employee contributions, other statutory limits include,  for example, a limit on the amount of compensation ($260,000 for 2014)  that can be taken into account in determining qualified pension plan  contributions or benefits. One important requirement for tax-qualified  pension plans of private employers is that contributions or benefits be  apportioned in a nondiscriminatory manner between highly compensated  employees or other workers.

section_title: IRA Investments
paragraphs: IRA owners have wide latitude in the types of assets in which they can  invest. IRA owners can choose to invest in publicly traded securities or  assets in custody of a financial institution or custodian. As a way to invest  in a wider range of assets, albeit with higher risk, some IRA owners  choose to invest in nonpublicly traded alternative assets, such as real  estate and private placement stock. Alternative assets may involve  more direction of investment and activities by the IRA owner, limiting the  typical role of the custodian.

An IRA owner choosing to directly control IRA assets or invest in  alternative investments must navigate the IRA tax laws and can face  additional taxes for noncompliance. An IRA owner is not permitted to  engage in certain prohibited transactions with the IRA. These transactions  are prohibited to prevent misuse of an IRA to benefit the owner or other  disqualified persons in a way other than as a vehicle to save for  retirement. Such prohibited transactions specifically include, for  example, borrowing money from an IRA, selling property to an IRA, using  an IRA account as security for a loan, and buying property for personal  use with IRA funds. If the IRA owner or beneficiary engages in a  prohibited transaction, the IRA loses its status as an IRA. As a result, the  account is treated as distributing all of its assets to the IRA owner at the  FMV on the first day of the year in which the transaction occurred. The  distribution may be subject to any additional income taxes associated with  an early distribution and additional excise taxes.

IRA custodians are responsible for ensuring that all IRA assets (including  those not publicly traded) are valued annually at their FMV and are  required to report the account’s FMV at year-end to IRS. The FMV is the value reflecting contributions and rollovers into the IRA, distributions from  the IRA, investment earnings (such as interest and dividends), and any  change in the market value of assets held in the IRA. Nonpublicly traded  assets do not have easily determined FMV.

section_title: IRS Enforcement and Taxpayer Service
paragraphs: Multiple IRS units are responsible for enforcing IRA tax laws and  conducting outreach activities to increase taxpayer understanding of the  laws. Also, IRS and DOL share responsibility for overseeing prohibited  transactions relating to IRAs. DOL defines the prohibited transactions and  may grant exemptions. IRS assesses additional taxes for IRAs found to  engage in prohibited transactions.

Third-party reporting by IRA custodians provides information that  taxpayers can use in preparing their tax returns and that IRS can use to  identify noncompliant taxpayers. For every IRA, the custodian is  required to submit a Form 5498 IRA Contribution Information to IRS. The  form details the IRA type (traditional, SEP, SIMPLE, or Roth), total  contributions, Roth conversions, rollovers, and FMV of the account. In  IRA examinations, FMV may be essential in determining a plan or an  IRA’s compliance with the law, such as whether the contribution value  causes a taxpayer to violate contribution limits. Custodians are also to  report on Form 5498 whether a taxpayer is subject to required minimum  distributions for the coming year; custodians are not required to report the  minimum amount calculated for each account. The custodian is also  required to submit a Form 1099-R Distributions From Pensions,  Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts,  etc., each year that indicates an IRA withdrawal took place and details the  total distributions from the account during the calendar year. Form 1099- R also provides information about the IRA distributions, such as whether  the distributions were taken before age 59½.

The IRS Wage and Investment division operates automated enforcement  programs that check taxpayer reporting of IRA transactions. The math  error program checks tax returns for conspicuous taxpayer errors as tax  returns are processed. The automated underreporter program (AUR)  identifies noncompliance with certain IRA deduction and distribution rules  by matching custodians’ Form 5498 and Form 1099-R information returns  with taxpayers’ income tax returns. AUR may ask taxpayers for additional  information to reconcile discrepancies. Some AUR cases may be handled  as correspondence examinations, while other IRA compliance issues,  such as those with large asset values, may be referred for field  examination.

The IRS Small Business/Self-Employed (SB/SE) division conducts field  examinations targeting more complex individual tax returns. Field  examinations are IRS’s most costly form of examination. Figure 1 shows  SB/SE’s process for examining returns.

Whereas SB/SE examines individual tax returns, the IRS Tax  Exempt/Government Entities division (TE/GE) has jurisdiction over  employee plans (including employer-sponsored SEP and SIMPLE IRA  plans) and requirements for rollovers from qualified employer plans into  IRAs. If TE/GE examiners discover an individual tax issue, they may refer  it to other examination offices, including SB/SE.

IRS service activities aim to increase taxpayer understanding of and  improve compliance with tax obligations, including IRA requirements, as  well as deliver clear and focused outreach communications and education  programs to assist taxpayer understanding of tax responsibilities and  awareness of changing tax laws. IRS Publication 590 Individual  Retirement Arrangements (IRAs) (Publication 590) explains the  requirements that taxpayers are to follow in contributing to, and receiving  distributions from, traditional, Roth, and SIMPLE IRAs.

section_title: Few Taxpayers Had Reported IRA Balances Greater Than $5 Million
subsections: section_title: Most Taxpayers with IRAs Have IRA Balances of $1 Million or Less
paragraphs: Of the 145 million married couples and individuals who filed individual  income tax returns for tax year 2011, an estimated 43 million, or 30  percent, had IRAs with an estimated total balance—in terms of FMV  reported by custodians—of $5.2 trillion at the end of 2011.percent of those taxpayers had aggregate IRA balances of $1 million or  less and accounted for around 78 percent of the total balance. The  median accumulated IRA balance for this group was around $34,000.  Taxpayers with aggregated IRA balances exceeding $1 million, around  600,000 taxpayers, accounted for about 22 percent of total balance and  had a median of around $1.4 million.

As seen in tables 1 and 2, less than 0.1 percent of taxpayers (about 6,000  to 10,000 taxpayers) had aggregated IRA balances greater than $5  million to $10 million but accounted for about 1 percent of the total  balance. From around 700 to more than 1,000 taxpayers with IRA  balances more than $10 million accounted for about 2 percent of the total  balance. A number of taxpayers had IRA balances exceeding $25  million though our estimates varied widely from around 115 to more than  600 taxpayers. Some of these taxpayers had very large aggregated  balances (see appendix III, table 10 for estimated median IRA balances  by size of IRA balance and their associated ranges).

To characterize taxpayers with IRAs by IRA type, adjusted gross income  (AGI), filing status, and age, we compare two subgroups of taxpayers— those with IRA balances of $1 million or less, which comprised 99 percent  of all taxpayers with IRAs, and those with IRA balances of more than $5  million. We do not report on taxpayers with IRA balances greater than $1  million to $5 million to avoid disclosure of taxpayer information.

Taxpayers held about 87 percent of the total balance in traditional IRAs,  around $4.4 trillion to $4.7 trillion, while the proportion of total balance  held in Roth IRAs was 7 percent, around $359 billion to $378 billion.  Those held in other employer-sponsored SEP and SIMPLE IRAs, around  6 percent, accounted for the remaining value. Figure 2 shows a  breakdown of IRA types by taxpayers with IRA balances of $1 million or  less and those with balances of more than $5 million.

section_title: Taxpayers with IRA Balances Exceeding $5 Million Have Higher AGI
paragraphs: For those taxpayers with IRA balances of $1 million or less, most (around  90 percent) have AGI of $200,000 or less. For those with IRA balances  of more than $5 million, most (about 90 percent) have AGI greater than  $200,000. However our estimates for this subgroup are imprecise as  seen in the wide confidence intervals in figure 3.

section_title: Taxpayers with IRA Balances Greater than $5 Million Tend to be Joint Filers and Age 65 or Older
paragraphs: Joint filers comprised a larger proportion of taxpayers with IRA balances  greater than $5 million in comparison to those with IRA balances of $1  million or less. Joint filers also accounted for a larger share of the IRA  balance with about 90 percent of the IRA balance for those with balances  more than $5 million, as shown in figure 4.

Those who are age 65 and older—and have had more years to  accumulate funds in IRAs—comprised at least 86 percent of taxpayers  with balances greater than $5 million and about 90 percent of the total  IRA balance for the group. This age group comprised a smaller percent,  about 27, of taxpayers with balances of $1 million or less, but has a  disproportionate share of the total IRA balance for the group, as shown in  figure 5.

section_title: IRA Balances Greater Than $5 Million Could Be Considered Large Based on What Individuals Typically Contribute
paragraphs: While there is no total limit on IRA or DC plan accumulations, scenarios  illustrating the maximum annual contributions by an individual and  employer over time can shed light on what could be considered a large  IRA (see appendix I for the statutory annual contributions limits and more  detailed scenario descriptions). Table 3 illustrates total contributions by  an individual assuming (1) maximum contributions every year since IRAs  were created under ERISA, and (2) maximum employer and employee  contributions since 401(k) plans were created. These scenarios  represent the upper bounds on allowable contributions and do not  represent how much individuals and employers typically contribute. Some  may not have sufficient income to even approach the employee limit or  might not have an employer able or willing to provide additional  contributions up to the maximum combined employee plus employer limit.  For 2011, the limit for combined employer-employee contributions,  (including catch-up contributions for those who are age 50 and older)  totaled $54,500, with the employee contribution limit (also including catch- up contributions) being $22,000. Few, if any, individuals would sustain  maximum contributions for more than three decades, given that in  practice, few individuals contribute the maximum to an IRA or employer  DC plan in any given year. Further, few, if any, individuals would be  employed by employers who made matching and additional contributions  for more than three decades at a level high enough to reach the  combined employee plus employer limit. Our previous work estimated  that only one-tenth of 1 percent of plan participants had contributions at or  above the combined employer-employee contribution limit for 2010.  Nonetheless, to illustrate possible accumulations under these upper  bounds for contributions, the scenarios shown in table 3 assume all  contributions are invested in a broad stock market index—specifically, the  Standard & Poor’s (S&P) 500—and are not intended to represent how  individuals typically invest. We also looked at other illustrative investment  allocations, shown in appendix I. The scenarios do not reflect any  withdrawals or investment fees.

As shown in table 3 above, it would take double-digit rates of return—in  excess of the S&P 500 return over the period—to achieve a balance of $1  million or more assuming an individual made only IRA contributions.

Accounting for the maximum possible combined employer-employee  contributions and no withdrawals, the DC plan scenario with investment  sustained over more than three decades could accumulate an individual  account balance of more than $5 million; however, as already noted, such  a level of contributions is rare, and such a sustained level is improbable.  Moreover, an accumulation of more than $5 million looks large in  comparison to what can be substantial rollovers of lump sum payouts  from an employer DB plan. For 2011, the maximum lump sum payable  to a 65-year-old DB participant would have ranged from $2.3 million to  $2.6 million, depending on the interest rate factors used in the lump sum  calculations. Finally, as discussed above, we found few taxpayers  (including married couples filing jointly) with IRA balances greater than $5  million. For all of these reasons, one could consider an IRA balance  accumulated by one individual greater than $5 million to be large.

Historically, IRS has collected annual FMV as reported by custodians for  each IRA annually but no data on what type of assets are held in IRAs.   As a result, we could not describe the composition of assets held in IRAs  using the available IRS SOI data. IRS officials pointed out that an  individual may have a larger IRA balance by inheriting a large IRA. The  IRS IRA data do not readily identify inherited IRAs, so we could not  describe how many taxpayers had inherited IRA balances as of 2011.

section_title: Alternate Strategies Are Likely the Cause of Large IRA Balances That Congress May Not Have Intended
subsections: section_title: Investments with Low Initial Values Not Available to Most Investors Help a Small Number of Individuals Accumulate Large IRA Balances
paragraphs: Our interviews with industry stakeholders and review of publicly available  filings with the SEC and DOL indicate that a small number of individuals  with access to certain types of nonpublicly traded shares in companies or  a particular type of partnership interest, as shown in table 4, can generate  IRA balances far exceeding $10 million. This is in contrast to the vast  majority of IRA owners with balances well under $1 million. Although IRS  data at present do not provide information on the investment strategies of  IRA owners or the assets in their accounts, we found that an IRA owner  would need to participate in a DC plan and sustain large contributions  over decades to generate an IRA greater than $5 million. As we have  previously found, IRA owners face many challenges in trying to  accumulate even modest retirement savings, such as the pressure to  draw down their savings for nonretirement expenses like purchasing a  home or paying college tuition for their children or medical bills. This is a  strong indicator that the individuals able to accumulate such large  balances have not done so through steady contributions and investments  in publicly traded stocks, bonds, and mutual funds. Instead, these  individuals likely use alternate strategies involving investments not  available to most taxpayers. In addition to access, to generate a large  IRA, investments must have a low initial value and the potential for  unusually high investment returns. The low initial value of these  investments: (1) allows the individual to purchase a quantity within IRA  contribution limits sufficient to generate tens of millions of dollars if the  investments are successful; and (2) protects the individual against  financial loss, given the increased likelihood that these investments end  up worthless. For example, according to SEC documents, the founders of  one prominent technology company issued nonpublicly traded shares in  the newly created company for an initial value, or par value, of $0.000001  per share.

Nonpublicly traded shares and partnership interests can generally be  accessed directly by only a small number of individuals, in part because  all offers and sales of securities must be registered under the Securities  Act of 1933, unless an exemption from registration is available. The most  commonly used exemption limits the investors who can purchase  securities in the offering to accredited investors and “sophisticated”  investors who are able to evaluate the risks and merits of the investment  and bear its economic risk. Even among this select group, only a small  number of individuals can use nonpublicly traded shares and partnership  interests to generate a large IRA. For example, only the founders of  successful companies and some of their initial employees and investors  have access to nonpublicly traded shares issued at the creation of the  company, at which time these shares can be valued at less than $0.01  apiece. Given the risks associated with starting new companies, most  founders are unlikely to see their initial investment grow to a balance of  tens of millions. However, founders of successful companies may  accumulate large returns disproportionate to the amount they initially paid  for shares in their own company.

Most investors are unlikely to have access to these investments when  their value is low enough to accumulate such disproportionate investment  returns. This is because few investors are likely to be founders of  companies or key employees in private equity firms and hedge funds.  However, some individuals who do not meet the requirements to invest  directly in private equity funds and hedge funds may still be able to invest  in them indirectly if they are participants in large public or private sector  DB plans. We found in 2012 that an increasing percentage of large DB  plans have invested in private equity funds and hedge funds in recent  years. Still, because pension benefits from such plans are generally set  based on a participant’s salary and years of service, unusually high  returns from such investments are unlikely to result in greater pension  plan benefits.
subsections: section_title: Accumulating Nonpublicly Traded Shares in an IRA
paragraphs: According to a number of industry stakeholders, individuals may in some  cases purchase nonpublicly traded shares using funds they accumulated  in an IRA through contributions and rollovers from employer-sponsored  plans. Figure 6 demonstrates an instance in which, according to SEC  documents, one of the founders of a successful technology company  used a Roth IRA to purchase at least 4 million nonpublicly traded shares   For an example of how nonpublicly  of his newly created company. traded shares can generate a large IRA balance for the founder of a  successful company based on this instance, see appendix IV.

SEC documents indicate that the initial value, or par value, of these nonpublicly traded  shares was $0.000001 per share. As a result, the founder could have paid as little as $4  from after-tax contributions to purchase almost 4 million shares. In contrast, from 2000  through June of 2014, companies charged an average of $14.50 per share through initial  public offerings, when companies first offer shares to the general public, often primarily to  institutional and high net-worth investors. At this price, four million shares would cost an  investor about $58 million before commissions or fees, well in excess of annual IRA  contribution limits.

According to two industry stakeholders, private equity firms currently use a ratio of about  4:1 to split the value of a portfolio company between preferred and common share  classes, respectively. This means about 80 percent of the company’s value would be  assigned to the preferred share class and the remainder to the common share class. In  some instances in the 1990’s, private equity funds used ratios as high as 9:1, which one  industry stakeholder said would have been seen as “pushing the envelope” at the time.  Another industry stakeholder said that today, a ratio this high would likely be challenged  as aggressively devaluing the riskier common share class. it would be difficult for IRS to prove these shares were inappropriately  valued, because, for each risky share the employees purchased, they  also purchased a share from a less risky higher-priced share class. Taken  together, these shares may more accurately reflect the portfolio  company’s value.

section_title: Generating Large IRAs through a Profits Interest (Carried Interest)
paragraphs: Carried interest is another means by which key employees of private  equity firms and hedge funds can generate large IRA balances.  According to one industry stakeholder who advises wealthy clients,  including key employees of private equity firms, access to profits interests  was likely the chief determinant of an individual’s ability to accumulate a  large IRA balance. He added that the rest of his clients, even those  whose wealth surpasses $100 million, were unlikely to have an IRA  exceeding $5 million because of the IRA contribution limits. The share of  profits paid by outside investors, known as limited partners, to the general  partner as a performance fee is referred to as the general partner’s  carried interest in a fund. The general partner typically distributes a  portion of this fee, referred to as an investment fund’s “carry,” to a few key  employees by first granting them a profits interest in the fund (see fig. 7).  A profits interest has the potential to provide a key employee investment  returns that are disproportionate to his or her invested capital if the fund is  a success, according to six industry stakeholders who represent private  equity firms and hedge funds or advise private equity professionals. If, on  the other hand, a fund does not generate a minimum rate of return for its  outside investors, profits interests may expire without generating any  money for the key employee. For an example of how carried interest can  generate a large IRA balance, see appendix IV.

Profits interests in a private equity fund or hedge fund can have a low  initial value because they do not necessarily represent a cash investment  to the fund by key employees. Instead, they represent an agreement that  key employees will provide expertise, ideas, and work to make the fund a  success in exchange for a share of the profits from the fund. IRS provided  guidance on treatment for the receipt of a profits interest for services,  saying that the grant of a profits interest is generally not a taxable event.Some industry stakeholders may have taken this to mean that profits  interests can have an initial value of as low as $0.00, referred to as a  liquidation value.

As with nonpublicly traded shares, key employees at private equity firms  and hedge funds may use IRAs to purchase profits interests from the  general partner. According to an industry stakeholder who advises private  equity professionals in estate planning, key employees may first  accumulate profits interests in a DC plan, such as a 401(k) or profit  sharing plan, then subsequently roll over the assets of their employer- based account into an IRA (see fig. 8). A rollover to an IRA can include  both cash and noncash assets, such as a profits interest that is not done  yielding distributions of carried interest. According to DOL officials, ERISA  does not necessarily prohibit an employer from contributing a profits  interest to the DC plan of its employees, although Internal Revenue Code  requirements administered by IRS may restrict or regulate these types of  transactions.

A number of industry stakeholders we interviewed expressed concerns  that individuals who invest in nonpublicly traded shares or profits interests  using IRAs and DC plans may undervalue these assets, thus substantially  increasing their tax benefits. According to one industry stakeholder who  advises clients on using IRAs to invest in alternative assets, individuals  can manipulate contribution limits by grossly undervaluing investments at  the time the individual uses an IRA to purchase them. Two industry  stakeholders who advise wealthy clients or who research carried interest  arrangements told us that IRA balances exceeding $10 million are a  strong indication that assets may have been inappropriately valued. For  example, company founders may have extensive knowledge of a  company’s value based on its future assets and liabilities.

It is often difficult for IRS to pursue cases of potential abuse based on  inappropriately valued assets. First, in response to a congressional  inquiry, IRS said it generally requires individuals to assess the FMV of  assets in IRAs rather than use a liquidation value or other valuation  method. However, IRS guidance implies that individuals can use the  liquidation value of a profits interest for certain tax purposes. One industry  stakeholder also noted that individuals can use case law to support very  low valuations of nonpublicly traded shares and profits interests.  Second, according to IRS officials, valuation can be subjective and IRS  may expend resources and ultimately conclude that the taxpayer’s  valuation is reasonable. Third, the statute of limitations for IRS to pursue  cases is generally only 3 years, which poses certain obstacles to pursuing  noncompliant activity that spans years of IRA investment. For example,  as we have previously found, the long-term nature of private equity  investment requires lengthy financial commitments and delayed financial  returns. A private equity fund may not begin making profits for 4 or more   For examples of the time that may in some cases be needed to  years.realize disproportionately large investment returns from such investments,  see appendix IV.

section_title: Identifying Carried Interest in DC Plans and IRAs Is Difficult
paragraphs: Due to a lack of information in publicly available filings by private equity  firms and hedge funds, we could not determine the extent to which key  employees use DC plans or IRAs to invest in profits interests and thus  shelter their portion of the general partner’s carried interest from taxation.  However, one industry stakeholder who values carried interest  arrangements told us that he has been asked in one or two cases to  value carried interest held in a profit sharing plan. We could not determine  from publicly available filings with SEC and DOL if private equity firms  and hedge funds enable key employees to invest in profits interests using  DC plans. Of the 60 private equity firms and hedge funds we reviewed,  about half did not include in their filings with DOL a description of the  assets held in their employer-sponsored plans.

Of the filings that did include a description of assets held in the employer- sponsored plan, we found four hedge funds and one private equity firm  whose employees were substantially invested in their employer’s  investment funds (see sidebar). However, we could not determine if these  were investments in profits interests that would yield disproportionately  large investment returns in the form of carried interest, or if they were  investments in capital interests on terms similar to those of outside  investors. In 2014, we found that there were challenges regarding the  usefulness, reliability, and comparability of plan asset information on  Form 5500s—the annual report that employee benefit plans file with  DOL. These challenges, identified by Form 5500 stakeholders, included  a lack of detailed information on plan assets for filers with fewer than 100  participants that are not required to file a Schedule H, which is a part of  Form 5500 detailing a plan’s assets. We recommended, among other  things, that DOL and other agencies responsible for administering Form  5500 revise Schedule H to provide more transparency into plan  investments.

Drawing on public filings with the SEC we determined that the private  equity firm and hedge funds enabling employees to invest in their own  funds charge their outside investors a performance fee that amounts to a  carried interest in these funds. But, despite recently expanded reporting  requirements by SEC on private equity firms and hedge funds, we could  not determine how general partners distribute carried interest among  various partnership interests, such as those held by employees investing  in employer-sponsored plans. Although the private equity firm and  hedge funds disclosed that they held a carried interest in their funds, they  did not disclose the general partner’s internal distribution of this carried  interest among key employees (see appendix IV for an example of how a  key employee can invest in a portion of the general partner’s carried  interest through a profits interest). Absent increased transparency in  filings with DOL documenting the assets held in employer plans and  information about how the profits of private equity firms and hedge funds  are distributed among various types of partnership interests, IRS will have  difficulty assessing the kinds of assets being rolled into IRAs.

Given the difficultly and uncertainty IRS faces in selecting and pursuing  potential instances of noncompliance based on valuation, a few  individuals can realize tax advantages from IRAs that substantially  exceed those available to the vast majority of investors. According to IRS  officials, any additional information about assets that have been rolled  over into IRAs would be helpful. IRS officials told us that expanded  information could reduce the considerable time and cost of pursuing  cases of potential noncompliance based on the valuation of assets in  IRAs. DOL filings for employer-sponsored plans in some instances do not  contain any detail on the assets held by a plan. However, even when a  description of assets is included, neither DOL nor SEC filings include  information on whether the general partner distributes carried interest to  profits interests held by key employees in a DC plan. This information  could help IRS understand the potential investment returns that could  have been expected to accrue to a profits interest rolled into an IRA and  thus determine if the initial valuation of the profits interest was  appropriate. Without this additional detail it will continue to be hard for  IRS to determine the magnitude of investment returns a profits interest  held in an IRA could reasonably be expected to generate. Such  information could be used to determine how assets in IRAs might  appropriately have been initially valued. Our prior work has shown that an  important feature that helped DB plan sponsors successfully address the  challenges of investing in private equity funds and hedge funds includes  the transparent disclosure of fees such as carried interest.

section_title: Congress Likely Did Not Intend IRAs to Result in Tax-Favored Accumulations of Funds beyond Those Reasonably Necessary to Support Individuals in Retirement
paragraphs: Congress enacted ERISA to promote opportunities for individuals to  accumulate resources for their retirement and IRAs were originally  authorized largely to ensure equitable tax treatment for individuals without  access to an employer-sponsored plan. Congress envisioned that these  individuals would be the most likely to establish and rely on IRAs. IRAs  provide a way for individuals not covered by employer-sponsored plans to  save for retirement and give retiring workers or individuals changing jobs  a way to preserve assets from employer-sponsored DC plans by allowing  them to roll over, or transfer plan assets into IRAs. Prior to this,  individuals not covered by an employer-sponsored plan could not save for  retirement under the favorable tax treatment afforded to participants of  employer-sponsored plans. This resulted in inequitable tax treatment of  individuals not covered by employer-sponsored plans. Congress cited the  need, on the basis of equitable tax treatment, to create IRAs and grant  these individuals a limited tax deduction on their retirement savings.Similarly, the Taxpayer Relief Act of 1997 created Roth IRAs, which  extended tax incentives to individuals who, based on their income, were  ineligible to make tax deductible contributions to traditional IRAs. It  extended retirement tax incentives to individuals who made just enough  that they could not benefit from the deductibility of contributions to  traditional IRAs.

Since Congress created traditional and Roth IRAs, they have become the  key retirement savings vehicles for many individuals not covered by  employer-sponsored plans, including small business owners and  independent contractors. But a small number of individuals have found  IRAs, and in particular Roth IRAs, to be an advantageous investment  vehicle for purchasing disproportionately profitable assets at a low initial  value, or transferring such assets from employer-sponsored plans,  without paying more than a nominal amount of tax on their gains. The use  of IRAs permits these individuals to accumulate far more in resources,  under favorable tax treatment, than may be reasonably necessary to  support them in retirement.

Through ERISA, Congress also amended the Internal Revenue Code to  impose certain limits on employer-sponsored plans seeking preferential  tax treatment. Specifically, Congress established a limit on benefit  payments from employer-sponsored DB plans and contribution limits on  DC plans. Congress established similar contribution limits on IRAs.  Congress imposed these limits to prevent the tax-favored accumulation of  balances “completely out of proportion to the reasonable needs of  individuals for a dignified level of retirement income.”

Forty years after the enactment of ERISA, some in Congress continue to  be concerned with the fairness of tax-favored retirement balances. In a  2012 letter to IRS, some members of Congress expressed concern that  strategies for accumulating large IRAs by using very low valuations might  be widespread among certain higher-income individuals. Members of  Congress also noted the opportunity to address inequities stemming from  the inappropriate use of retirement tax benefits presented by Congress’s  current efforts to reform the broader tax code. In a 2012 hearing on tax  reform and tax-favored retirement accounts, the Chairman of the House  Ways and Means Committee stressed the importance of increasing  participation in retirement accounts by low- and middle-income taxpayers,  and ensuring that retirement tax benefits are effectively and appropriately  targeted.

We have long recommended greater scrutiny of tax expenditures, such as  the deferral of taxation on retirement savings in traditional DC plans and  IRAs and the ability to essentially pay taxes up front on contributions to  designated Roth accounts in DC plans and to Roth IRAs, in exchange for  tax-free investment earnings and distributions. We developed criteria to  assist policymakers in assessing tax expenditures. These criteria  include the following.

Identifying the tax expenditure’s purpose, a necessary first step in  assessing its performance.

Considering the fairness and equity of the tax expenditure. For  example the criteria include determining who benefits from the tax  expenditure, and whether taxpayers with different abilities to pay  receive different benefits from the tax expenditure.

Determining the budget consequences of the tax expenditure, or, how  much the tax expenditure costs the government in forgone tax  revenue. Specifically, the criteria suggest policymakers consider  options for limiting revenue losses from the tax expenditure, for  example, by capping the aggregate amount taxpayers can claim.

In the absence of changes by Congress to current tax incentives for  retirement savings, certain individuals with the resources to do so will  likely continue to engage in sophisticated investment strategies that  effectively change their DC plan or IRA from an account for modest  retirement savings into a tax-advantaged investment vehicle for  accumulating significant wealth. This will be done through investments  unavailable to most taxpayers. IRS officials reported in 2012 that long- term revenue losses to the federal government from IRA abuses had  increased significantly since 2004, when IRS first created an Issue  Management Team (IMT) to address this issue. IRS officials warned that,  without legislative change, certain IRA strategies could conceivably result  in thousands of families living for generations without the need to  contribute to retirement accounts or pay federal income tax. In  discussions with industry stakeholders and government officials, a  number of proposals have been raised to address the accumulation of  large IRAs. Two approaches are restricting the types of assets that can  be held in IRAs or imposing a minimum valuation requirement on assets  in IRAs. For example, a minimum required purchase price of one dollar  per share could prevent the founders of companies from purchasing  millions of nonpublicly traded shares within IRA contribution limits.  Additionally, a limit on the amount of accumulations allowed in DC plans  and IRAs is another approach. Similarly, Treasury officials have proposed  limiting contributions to IRAs once a certain level of savings has been  achieved.

section_title: IRS Has Dedicated Resources to IRA Compliance but Faces Challenges with Nonpublicly Traded IRA Investments
subsections: section_title: IRS Relies on the Automated Underreporter Program and Field Examinations to Enforce IRA Tax Laws and Has Targeted Abusive IRA Transactions
paragraphs: Within the Wage and Investment (W&I) division, the Automated  Underreporter Program (AUR) covers a broad range of taxpayers with  IRAs and is IRS’s primary means of detecting noncompliance with  contribution and distribution requirements. In tax year 2010 (the last full  available year), AUR assessed additional taxes of $88 million for about  226,000 tax returns with IRA discrepancies. IRS continues to take action  aimed at noncompliance by taxpayers who fail to take required minimum  distributions or contribute more than the allowable limits. In addition to  outreach efforts targeting these rules, W&I held two tests sending  taxpayers soft notices—letters that require no action on the taxpayer’s  part but encourage the taxpayer to check his or her return for errors.  These tests were intended to improve IRA compliance without IRS having  to invest audit resources. The December 2013 test reminded taxpayers  that they need to take a required distribution, and the February 2014 test  targeted taxpayers who made excess contributions. As of October 2014,  IRS was collecting test data, such as whether taxpayers plan to correct  the errors, for use in evaluating future soft notice efforts or whether other  compliance activities are needed.

IRS’s Small Business/Self-Employed (SB/SE) division uses field  examinations to pursue more complex tax return cases, including those  that could involve the multimillion dollar IRA strategies described above.  In fiscal year 2013, field examiners audited IRA issues on 1,588 returns  and recommended $3.3 million in additional taxes, representing 0.3  percent of SB/SE examinations and 1.1 percent of total tax adjustments  for that year. SB/SE training for new revenue agents and tax compliance  officers covers specifics on enforcing IRA tax laws. Examiner job aides,  also called lead sheets, emphasize investigating all of the taxpayers’  contributions over time to determine if the taxpayers are noncompliant  with their reporting. IRS’s Engineering Department, which is part of the  Large Business and International (LB&I) division, also provides in-house  expertise on valuation issues and can be called upon when IRS discovers  a valuation issue during an examination. SB/SE examination officials  have developed additional guidance on IRAs for examiners’ continuing  professional education.

SB/SE also has conducted special compliance initiative projects (CIP) to  identify patterns of IRA noncompliance and better allocate examination  resources and education efforts. Since 2007, CIPs have targeted excess  contributions, early distributions, and taxes owed on Roth IRA  conversions.

Also led by SB/SE examiners, the Abusive Transactions and Technical  Issues (ATTI) Program has targeted abusive schemes using IRAs. ATTI  generally gets leads for investigating individuals involved in IRA schemes  from investigations and monitoring of promoters who market tax shelters.  In 2012 (the last full year of available data), ATTI examined 95 taxpayers  and assessed additional taxes totaling $15 million in IRA-related cases.  Two types of abusive IRA transactions that IRS examination officials said  they have focused on include:

Roth IRA “stuffing”: This scheme involves shifting value through  transactions that disguise Roth IRA contributions exceeding annual  IRA limits, such as selling receivables at less than fair market value to  a Roth IRA. In 2004, IRS determined that this abusive tax avoidance  shelter is a listed transaction that taxpayers must report to IRS.  Because IRA stuffing can involve improper valuation, IRS’s efforts in  this area have the potential to detect abuse in asset valuation in the  strategies that stakeholders told us could lead to multimillion dollar  IRAs. In a 2012 briefing document, IRS examination officials said that  noncompliance using this approach “could conceivably result in  thousands of families living for generations without the need to  contribute or pay federal income tax. IRS continues to monitor  taxpayer attempts at Roth IRA stuffing.

Self-dealing within an IRA: These are prohibited transactions in  which a taxpayer in control of the IRA’s asset management ultimately  benefits from the asset before retirement in violation of tax laws.  Examples are having the IRA purchase a beachfront home as a  rental, but the taxpayer uses it for herself, or an IRA owner drawing a  salary from an IRA-invested business.

Other IRS enforcement programs do not target IRA noncompliance but  may refer IRA-related cases for field examination. Within LB&I, the Global  High Wealth industry unit targets individual taxpayers with assets or  earnings of tens of millions of dollars and, in looking at their complete  financial picture and the enterprises they control, may notice possible  noncompliance with a taxpayer’s IRA. Similarly, IRS Estate and Gift tax  examiners may detect possible IRA noncompliance in reviewing a  decedent’s estate tax return. IRS enforcement officials from SB/SE and  TE/GE said that reliance on referrals from one division to another requires  coordination, without which IRS may be vulnerable to noncompliance that  spans division expertise. For example, asset valuation issues may  originate in an employer DC plan before being rolled over to an IRA.  TE/GE examiners would be responsible for valuation issues within a DC  plan, and it may be many years before the noncompliance is discovered  by an examiner auditing an individual tax return.

In 2008, IRS chartered an IMT—including representatives from SB/SE  and TE/GE—to develop IRS-wide strategies and solutions to curb the  proliferation of IRA abuse and potentially clarify and strengthen IRA tax  laws. In 2009, the IMT suggested collecting additional data from  custodians holding IRAs with hard-to-value nonpublic assets as an  immediate step supporting a longer term strategy recommending  legislative changes, among other things, to limit the types of IRA  investments. By 2012, without progress on having IRS’s legislative  proposals considered by Treasury, the IMT developed an interim strategy  for IRS to move forward with increased data collection and draw more  attention to IRA noncompliance.

section_title: IRS Plans to Collect Data to Identify IRAs with Riskier Nonpublic Assets, and Examiner Use Depends on Digitizing the Data
paragraphs: IRS plans to evaluate more data on hard-to-value IRA assets that would  help to refine its enforcement efforts. For tax year 2014 (to be filed in  2015), IRS Form 5498 has new boxes for custodians to report the portion  of the IRA FMV attributable to nonmarket assets as well as a box with  codes describing the type of nonmarket assets, as shown in figure 9. Also  for tax year 2014, custodians are to report similar information on Form  1099-R identifying distributions of IRA assets that do not have a readily  available FMV. The new reporting is optional for 2014, and IRS plans to  require custodians to provide the information for tax year 2015 (to be filed  in 2016). As of September 2014, IRS officials said that they will continue  to assess comments from stakeholders about the form changes, but IRS  does not anticipate changes to the timeline.

SB/SE examination officials said that the new Form 5498 data will help  them better identify taxpayers with IRAs invested in nonpublicly traded  assets. They said the data also will help them review the history of FMV  reported.

Efficient use of the new Form 5498 and 1099-R data for examination case  selection hinges on IRS’s ability to compile and analyze the new  information on nonpublicly traded assets types and FMV. Custodians, like  other third-party reporters, must file electronically if they submit 250 or  more of one kind of information return. A specialty custodian submitting  fewer than 250 forms currently may file on paper. An IRS Submissions  Processing official told us about 1,400 custodians submitted only paper  forms in tax year 2012. As previously reported, IRS historically has limited  the use of electronically filed data for classification to only the types of  data that are transcribed from paper-filed returns to assure that paper- filed returns are treated the same as electronic returns Unless the new  information is available electronically—most commonly achieved through  data transcription—IRS classifiers will not be able to fully use the new  information, undercutting IRS’s intention to more systematically identify  IRAs with greater risk of noncompliance.

W&I’s Submission Processing office has requested transcription of the  new IRA asset-type reporting that will be mandatory for 2015 forms to be  filed in 2016. IRS prioritizes transcribing data based on a number of  factors, such as physical capacity, as well as resources and funding. In  June 2014, we reported that IRS faces budget uncertainty and indications   As of  are that its funding will be constrained for the foreseeable future.October 2014, IRS has not finalized plans for making the data available  electronically. The cost of transcribing the new data would be relatively  small, as IRS estimated that about 9,000 Form 5498 submissions were  filed on paper in 2013 out of more than 118 million filings. A similarly  small percentage of Form 1099-R filings go to IRS on paper. IRS  estimated for us that the annual labor cost for transcribing the forms  would be $2,322 to $12,210. However, noncompliance with IRA rules  can result in sizable revenue losses if IRA transactions are misreported  continuously over many years.

Custodian and taxpayer behavior could change because of heightened  attention on nonpublic IRA assets with the new reporting and the potential  for greater IRS scrutiny. Some custodians already restrict IRAs to holding  only publicly traded investments, and the additional reporting for  alternative assets may dissuade other custodians from holding IRAs with  such assets. Furthermore, taxpayers who want to manipulate valuations  will have less room to do so, since custodians will still report on the type  of asset in the account. Increased reporting on alternative assets by  custodians to IRS may encourage better compliance by some taxpayers.  According to IRS examination and Chief Counsel officials, however,  custodians may not always be able to get accurate asset information  about IRAs if the IRA owner has day-to-day investment control, which  could lead to unreliable Form 5498 reporting of asset types and FMV. It  may be difficult to apply general penalties to custodians for third-party  misreporting if the IRA owner is the source of the inaccurate FMV data.

section_title: IRS Has Tried to Address Challenges in Auditing the Valuation of Nonpublic IRA Assets and Detecting Prohibited Transactions
paragraphs: SB/SE examination officials said IRA noncompliance is difficult to pursue  for a variety of reasons. First, some IRA cases—including the large-dollar  IRA accumulation strategies cited by financial industry stakeholders—are  about valuation issues. IRS officials said these issues are expensive to  audit and often must be pursued through litigation in court. For example,  IRS examination officials said that determining that an asset was  undervalued cannot be made without expensive auditing and litigation.  Each case requires extensive resources, including significant time of  examiners, engineers, appraisers, appeals officers, and attorneys and  fees to obtain appraisals from external contractors, according to  examination officials. Examination and Chief Counsel officials said that  valuation cases are a matter of opinion, and typically involve taxpayers  with lots of resources. Taxpayers can find appraisers who will value  assets in an IRA the way they want, and IRS faces difficulty in that it has  to procure and present its expert testimony about the valuation. An  improper valuation made many years prior to its discovery by SB/SE also  may fall outside the 3-year examination statute of limitations discussed  above.

For example, IRS Chief Counsel officials said IRS has not completed an audit in which  the founder stock purchase facts were present. DOL retains the ultimate authority to  interpret whether such a transaction would constitute a prohibited transaction. prohibited transactions. According to IRS, abuses frequently are not  reflected on any filed tax return and are difficult to detect within the  general 3-year statute of limitation period. When certain prohibited  transactions occur, the IRA loses its tax-favored status and is treated as  distributing all of its assets at the FMV on the first day of the year when  the prohibited transaction occurred. Once IRS examiners detect a  prohibited transaction, the taxpayer can dispute when the income should  have been reported.

There are few judicial opinions regarding prohibited transactions,  according to IRS officials. They also said that the 2013 Tax Court ruling in  Peek v. Commissioner (see text box) sets a useful precedent for  increased IRS enforcement of the prohibited transaction in more complex,  higher dollar value cases. Building on Peek, SB/SE is working on  honing procedures for examiners to use in determining whether an IRA  case may have violated prohibited transactions that are similar to the  Peek case. IRS examination officials said that the process would help IRS  make decisions about the validity of transactions without having to go to  DOL for every case. They said that Peek will help them more confidently  identify prohibited transactions and encourage custodians as well as IRA  owners and their advisors to be more aware of what is noncompliant. As  of September 2014, IRS said the fact-pattern was an ongoing effort.

Two individuals, Lawrence Peek and Darrell Fleck, each established traditional  IRAs, rolled over funds from existing retirement accounts, set up a new  corporation, and sold all of the stock of the corporation to the IRAs. They then  used the funds from the sale of the stock to buy the assets of a business and  executed personal loan guaranties with respect to that purchase. Thereafter,  Peek and Fleck converted their traditional IRAs into Roth IRAs funded by the  same stock. The Roth IRAs subsequently sold the now-significantly appreciated  stock of the corporation and treated the gain as deferred. IRS asserted  deficiencies against Peek and Fleck on the grounds that the loan guaranties  were prohibited transactions. The Tax Court agreed and held that Internal  Revenue Code § 4975(c)(1)(B) prohibits taxpayers from making loan guaranties  either directly to their IRAs or indirectly to their IRAs through an entity owned by  the IRAs. The Court further held that the IRAs ceased to qualify as IRAs when  the prohibited transactions originally occurred and therefore the Roth IRAs were  also void because the prohibited transaction continued as to those accounts. The  Court also upheld accuracy-related penalties imposed by IRS.

Peek and Fleck appealed the Tax Court decision. As of October, 10, 2014, the  case before the Tenth Circuit Court of Appeals was still pending.

In 2009, the IMT proposed several legislative changes to address  enforcement challenges IRS encounters in auditing IRA activity. These  include: (1) limiting the types of investments IRAs can make to publicly  traded or otherwise marketable securities with a readily ascertainable fair  market value; (2) expanding the definition under “disqualified person” to  address work performed by the IRA beneficiary’s siblings on behalf of the  IRA-owned entity or operation; and (3) expanding the statute of limitations  in Internal Revenue Code Sec. 6501 to 6 years for all IRA activity. The  team’s 2009 legislative recommendations were approved by the Service- wide Compliance Strategy Executive Steering Committee in 2010.2012, the issue management team met again to study abusive IRA trends  and continued to recommend legislative change. As of September 2014,  no further action has taken place. Ultimately, Treasury has to review all   In  tax legislative proposals and presents the administration’s tax proposals  for congressional consideration. In the fiscal year 2014 and 2015  budgets, Treasury proposed an overall cap on tax-favored retirement  saving accumulations.

As IRS begins collecting data on nonpublic IRA assets from Form 5498, it  will be positioned to quantify the number of IRAs and associated FMV  held in hard-to-value asset types with greater compliance risk. As  discussed above, the new asset-type data—if available electronically— will help IRS in selecting examination cases. IRS examination officials  said that research using the new data could aid in developing the  business case for further action to address noncompliance. Specifically,  additional research by IRS could help to evaluate the feasibility of the  proposals to require greater disclosure of potentially undervalued asset  types as transactions of interest or require reporting of prohibited  transactions as listed transactions. Moving forward with a service-wide  strategy to target enforcement efforts would hinge on IRS first conducting  the research to understand how many taxpayers and the reported  amounts of IRA assets are at risk of noncompliance.

section_title: IRS Outreach and Education Increase Taxpayer Understanding of Complex IRA Rules but Are Not Explicit about the Risk of Alternative Investment Noncompliance
paragraphs: IRS has included taxpayer service and outreach in its strategies to  improve compliance with IRA tax laws. As we reported in 2008, financial  industry organizations and advisor representatives we interviewed  complimented IRS Publication 590 Individual Retirement Arrangements  (IRAs) (Publication 590) for translating the many complicated IRA  contribution and distributions rules into “plain English” to help taxpayers  comply.minimum distribution requirements and IRA contribution limits.

IRS continues to target outreach to help taxpayers understand  Insights about noncompliance detected by enforcement can help IRS  identify opportunities to educate taxpayers on how to better comply. IRS  has a system for examiners to communicate issues to IRS’s external  communication office, Communication and Stakeholder Outreach. ATTI  chairs an emerging issues team that meets quarterly to address new  compliance risks and may identify issues for the communications office.  Research identifying the numbers and types of custodians and taxpayers  holding hard-to-value assets could also help IRS target outreach activities  and strategies for improving compliance with IRA asset valuation and  prohibited transaction requirements. For example, IRS could provide  notices targeting custodians and taxpayers with nonpublic IRA assets  with a reminder about their responsibilities and the potential tax  consequences of engaging in self-dealing and other prohibited  transactions.

Examination officials said one challenge in educating the public is a  promoter industry that advertises IRAs with alternative assets that also  give taxpayers “checkbook access” (i.e., more control over IRA  investment choices compared to other IRAs). These promoters might not  disclose the compliance risks and responsibilities taxpayers take on when  investing in nonpublicly traded assets. The promoters’ advertising may  leave less sophisticated taxpayers at risk for unintentional noncompliance  with IRA laws. IRS guidance targeting attention on the compliance  responsibilities and risks inherent in investing in nonpublic IRA assets and  directly controlling IRA assets could help taxpayers make more informed  decisions. In 2009, IRS issued a revised publication explicitly warning that  it does not approve or endorse particular types of assets for IRAs.  Targeted at protecting taxpayers from fraudulent IRA sales pitches, this  notice advises taxpayers to proceed with caution when encouraged to  invest in a general partnership or limited liability company. Publication  590 describes what prohibited transactions are but does not make the  explicit connection that certain asset types pose greater potential for  prohibited transactions. As a result, some taxpayers may be unaware that  certain IRA investment decisions have greater risks for committing  prohibited transactions that could trigger loss of their IRAs’ tax-favored  status. In contrast, for custodians, the IRS instructions for Forms 5498  and 1099-R plainly state that nonpublic assets and assets under IRA  owner control have a greater potential for prohibited transactions. General  reminders are a low cost way to draw attention and caution taxpayers  about the compliance risks associated with certain IRA choices.

section_title: Conclusions
paragraphs: Congress envisioned IRAs as a moderate tax benefit to help individuals  not covered by employer-sponsored plans to obtain income sufficient for  a secure retirement, not as a vehicle for accumulating significant tax- preferred wealth. Without further consideration from Congress, individuals  with these limited, occupationally related opportunities to engage in  sophisticated investment strategies may accumulate considerable tax- preferred wealth in IRAs. The result is a revenue loss to the federal  government through a circumvention of the longstanding rationale for IRA  contribution limits. However, Congress can reorient existing laws to  address the excesses of these strategies, so that all taxpayers have  similar opportunities to reap the benefits of IRAs. Congress could, for  example, address the build-up of unnecessarily large IRAs in a variety of  ways: by limiting the types of investments held in IRAs, enforcing  standards such as a minimum required value for investments in an IRA,  or by setting a ceiling on accumulations in an IRA and requiring an  immediate distribution of balances above that ceiling. Without such a  readjustment, the intended broad-based tax benefits of IRAs will continue  to be skewed towards a select group of investors.

With respect to individual taxes, IRS has dedicated enforcement  resources to identifying taxpayers who may be building IRA balances  improperly. It is critical to collect data on alternative IRA assets with a  higher risk of noncompliance, given that the valuation issues at the heart  of the strategies to build large IRAs pose high costs for IRS enforcement  and carry a risk of IRS failing to prove wrongdoing in court. Moving  forward, IRS has the opportunity to use the data to further research IRA  noncompliance, such as whether IRAs invested in nonpublicly traded  shares are predicated on noncompliance, as industry stakeholders we  spoke with allege. Such research is a necessary step toward designating  strategies leading to high-dollar IRAs as problematic and targeting  examination resources efficiently. Positioning IRS to take full advantage  of the new Form 5498 data hinges on IRS digitizing the data for  compliance case selection and examination. While IRS estimates  capturing the data for the relatively few paper filing would add small costs  to processing the forms, the benefits—in terms of less forgone revenue, a  greater perception of a fair tax system, and better use of enforcement  resources—would outweigh those costs.

Existing data from DOL and SEC on employer-sponsored plans and the  performance fees charged by private equity firms and hedge funds  provide information that could also assist IRS in assessing the valuation  of assets in IRAs. We previously recommended that DOL and others  improve the usefulness, reliability, and comparability of Form 5500 data in  part by providing more transparency into assets held in employer- sponsored plans. Providing this information is important because it helps  regulators better understand the types of assets held in tax-favored  retirement accounts. If DOL were required to improve the transparency of  assets held in employer-sponsored plans, IRS could have better  information on where the assets in a large IRA may have originated. In  addition, data about how private equity firms and hedge funds distribute  their carried interest could also be of use to IRS as it decides whether to  move forward with a case against an IRA owner based on valuation.

The new asset-type data also gives IRS more information about IRAs at  greater risk for self-dealing abuse and other prohibited transactions. As  IRS increases it examination presence, evidence on the obstacles  encountered in pursuing prohibited transactions and noncompliant activity  engaged in for years may demonstrate whether it would be worthwhile to  change the current 3-year statute of limitations for tax assessment with  regard to IRAs.

In an environment where less-sophisticated taxpayers can be lured by  “checkbook access” to IRAs invested in unconventional assets, IRS has  an opportunity to warn taxpayers about the added responsibilities and  compliance risks inherent in investing and managing alternative assets in  IRAs. Current IRA guidance aimed at taxpayers does not acknowledge  the greater risks for committing prohibited transactions—even though  Form 5498 instructions for custodians plainly make this point. Without an  explicit caution, taxpayers may continue to make un-informed decisions  about IRA investments that put them at a greater risk of noncompliance  and loss of their IRAs’ tax-favored status.

section_title: Matter for Congressional Consideration
paragraphs: To promote retirement savings without creating permanent tax-favored  accounts for a small segment of the population, Congress should  consider revisiting the use of IRAs to accumulate large balances and  consider ways to improve the equity of the existing tax expenditure on  IRAs. Options could include limits on (1) the types of assets permitted in  IRAs, (2) the minimum valuation for an asset purchased by an IRA, or (3)  the amount of assets that can be accumulated in IRAs and employer- sponsored plans that get preferential tax treatment.

section_title: Recommendations for Executive Action
paragraphs: We are making five recommendations to the Commissioner of Internal  Revenue.

To improve IRS’s ability to detect and pursue noncompliance associated  with undervalued assets sheltered in IRAs and prohibited transactions,  we recommend that the Commissioner of Internal Revenue:

Approve plans to fully compile and digitize the new data from  electronic and paper-filed Form 5498s to ensure the efficient use of  the information on nonpublicly traded IRA assets.

Conduct research using the new Form 5498 data to identify IRAs  holding nonpublic asset types, such as profits interests in private  equity firms and hedge funds, and use that information for an IRS- wide strategy to target enforcement efforts.

Work in consultation with the Department of the Treasury on a  legislative proposal to expand the statute of limitations on IRA  noncompliance to help IRS pursue valuation-related misreporting and  prohibited transactions that may have originated outside the current  statute’s 3-year window.

To help taxpayers better understand compliance risks associated with  certain IRA choices and improve compliance, we recommend that the  Commissioner of Revenue:

Building on research data on IRAs holding nonpublic assets, identify  options to provide outreach targeting taxpayers with nonpublic IRA  assets and their custodians, such as reminder notices that engaging  in prohibited transactions can result in loss of the IRA’s tax-favored  status.

Add an explicit caution in Publication 590 Individual Retirement  Arrangements (IRAs) for taxpayers about the potential risk of  committing a prohibited transaction when investing in nonpublicly  traded assets or directly controlling IRA assets.

section_title: Agency Comments
paragraphs: We provided a draft of this report to the Secretary of the Treasury, the  Commissioner of Internal Revenue, the Secretary of Labor, and the Chair  of the SEC for comment. In a September 18, 2014, letter (see app. VI),  the IRS Deputy Commissioner for Services and Enforcement generally  agreed with our recommendations. On October 2, 2014, the Associate  Director and Chief Counsel for SEC’s Division of Investment Management  voiced various legal and other concerns regarding implementation of a  recommendation, designed to assist the IRS for tax reporting purposes, to  expand reporting requirements on private equity firms and hedge funds to  require disclosure of a general partner’s agreements for distributing  carried interest. As a result, we redirected the recommendation to IRS as  part of an existing recommendation that IRS conduct research using new  Form 5498 data on non-public IRA assets. We shared the revised  recommendation with IRS officials, who continued to agree with it. IRS,  Treasury, SEC, and the Department of Labor provided separate technical  comments, which we incorporated in our report where appropriate.

In the IRS letter, the Deputy Commissioner emphasized that rules  governing IRAs can be complicated for both the IRS and taxpayers. The  Deputy Commissioner also highlighted efforts that IRS has undertaken to  conduct enforcement, such as the AUR program and compliance initiative  projects. The Deputy Commissioner acknowledged that IRA  noncompliance can span IRS units and that the issue management team  allowed cross-functional coordination to address noncompliance.

IRS agreed with our assessment that digitizing IRA information return  data could improve case selection. However, the Deputy Commissioner  said that IRS is faced with competing funding priorities and will continue  to evaluate the priority of digitizing additional Form 5498 information.

IRS also agreed to conduct research using the new Form 5498 data to  identify IRAs holding nonpublic assets and use the information for an   IRS-wide strategy to target enforcement efforts. The Deputy  Commissioner said that the SB/SE Abusive Transactions and Technical  Issues function has begun to develop research objectives to refine  enforcement efforts using the additional information that IRS will obtain  from the revised Form 5498 data.

The Deputy Commissioner agreed that legislation to extend the period of  limitations for assessment of tax associated with IRA noncompliance  would remove an obstacle to IRS efforts to pursue identified IRA  noncompliance. The Deputy Commissioner added that IRS will discuss  with Treasury proposals regarding the statute of limitations on assessing  tax associated with IRA noncompliance.

The Deputy Commissioner said IRS agreed to build on research data on  IRAs holding nonpublic assets to identify options to provide outreach,  such as reminder notices. The Deputy Commissioner said that as IRS  analyzes the data, it will identify options to provide targeted outreach to  taxpayers with IRAs holding such assets to increase awareness of  prohibited transaction rules and penalties for failure to comply with these  rules.

The Deputy Commissioner agreed with our recommendation to add an  explicit caution in Publication 590 for taxpayers about the risk of  committing a prohibited transaction when investing in nonpublicly traded  assets or directly controlling IRA assets.

As arranged with your office, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days from the  date of this letter. At that time, we will send copies to Secretary of the  Treasury, Secretary of Labor, IRS and SEC. In addition, the report will be  available at no charge on the GAO website at http://www.gao.gov.

If you or your staff has any questions about this report, please contact  James R. McTigue, Jr. at (202) 512-9110 or Charles A. Jeszeck at (202)  512-7215. You may also reach us by email at mctiguej@gao.gov or  jeszeckc@gao.gov. Contact points for our offices of Congressional  Relations and Public Affairs are on the last page of this report. GAO staff  members who made major contributions to this report are listed in  appendix VII.

section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: This report: (1) describes the number and types of taxpayers with  individual retirement accounts (IRA) and the size of IRA balances in terms  of aggregate fair market value (FMV), adjusted gross income (AGI), filing  status and age; (2) examines how IRA balances can become large; and  (3) assesses how the Internal Revenue Service (IRS) ensures that  taxpayers with IRAs comply with IRA tax laws.
subsections: section_title: Measuring IRA Balances and What Is Considered Large
paragraphs: To describe the taxpayers with IRAs by the accumulated balances in  terms of FMV, AGI, filing status and age, we used an Internal Revenue  Service (IRS) Statistics of Income (SOI) sample of individual income tax  returns for tax year 2011 (the most recent year available) as well as IRS  “IRA Contribution Information” Form 5498 data associated with the SOI  sample. Our analysis of SOI statistical data is subject to sampling errors  because the SOI data are based on a sample of tax returns as filed. In  addition, the data do not reflect IRS audit results. The SOI sample of  individual income tax returns does not include those who do not file a  return. However, some IRA custodians submitted Form 5498s on  nonfilers. An IRS official said SOI attempts to include additional  information on nonfilers by sampling documents, including Form 5498s,  which have no associated individual income tax returns. Form 5498 filings  without a matching return were sampled at approximately 1:1,000. In  2011, about 3,800 nonfilers were sampled, none of whom had unusually  large IRA balances.

We aggregated the total FMV for all IRAs associated with a return  (including inherited IRAs as IRS data do not readily identify inherited  IRAs) to obtain an accumulated IRA balance. We used the taxpayers as  our unit of analysis. Taxpayers filing joint returns are treated as a single  unit and the IRAs owned by both spouses are aggregated. Our analysis  of SOI data is subject to errors from sampling as well as from the small  sample of returns with higher IRA balances. About 99 percent of  taxpayers with IRAs have accumulated balances of $1 million or less.  However our group of interest was that small group of taxpayers with  large IRA balances and estimates based on this small group may not be  precise and have very wide associated confidence intervals. Because of  the skewness of the distribution for taxpayers with IRA balances greater  than $25 million, we used a statistical technique referred to as  bootstrapping or resampling to estimate the confidence interval.

About 5 percent of the estimated taxpayers with IRAs had at least one  associated IRA with blank FMV information. We treated the blank FMVs  as zeros. If these IRAs did not, in fact, have zero balances, they could  affect our estimates’ upper bound considerably. However, IRS officials  told us they generally treat blank FMVs as zeros based on their  understanding of IRA custodians filing practice. We compared Form 5498  information for particular IRA owners to information from their income tax  and Form 1099R information returns. Working with IRS, we identified a  number of reasons why blank FMVs could be zeros such as: (1) the entire  account balance was distributed; (2) the balance was rolled over to  another IRA; (3) the owner of the IRA was deceased and IRA assets were  transferred to a beneficiary; (4) tax year contributions were made to a  new IRA account for a prior calendar year.

In addition to the number of taxpayers and FMVs for their aggregated  IRAs, we presented the data for two separate groups: 1) those with IRA  balances of $1 million or less and 2) those with IRA balances of more  than $5 million and the confidence intervals associated with the  estimates. We do not report on taxpayers with IRA balances greater than  $1 million to $5 million to avoid disclosure of taxpayer information.

We compared the two groups on three types of IRAs—traditional, Roth,  and other IRAs that included employer-sponsored SEP and SIMPLE  IRAs. We used eight categories of AGI, which is the individual’s gross  income minus adjustments that include deductions for trade or business  expenses, losses from the sale or exchange of property, contributions to  pension and other retirement plans and alimony payments. Our AGI  categories were $0 or less, $1 to $20,000, $20,001 to $50,000, $50,001 to $100,000, $100,001 to $200,000, $200,001 to $500,000, $500,001 to $1,000,000, and

Greater than $1,000,000.

About 1 percent to 2 percent of the taxpayers reported zero AGI. We did  not use the modified AGI used to determine eligibility for IRA contributions  which added certain items such as foreign housing expenses and student  loan deductions back to the AGI. For the filing status comparison, we  used three categories—single, married filing jointly and others, which  included married filers who were filing separately, head of household, and  qualifying widow(er). For the comparison of age we used 2 categories:  those younger than age 65 and those age 65 and older. As our unit of  analysis was the taxpaying unit, our age-65-and-older category included  the filer, spouse, or both who were age 65 or older. To assess the  reliability of the data we used, we reviewed IRS documentation and  interviewed agency officials familiar with the data. We determined that  these data were sufficiently reliable for the purposes of this report.  However, the IRS SOI sample may not provide a precise estimate of the  number of taxpayers or other quantities when the number of taxpayers in  a particular reporting group is very small.

The predominant type of defined contribution (DC) plan, the 401(k) plan, became  available in 1980. Prior to 1987, DC plans had a single limit on employer and employee  contributions. The Tax Reform Act of 1986 imposed a limit on employee deferral  contributions, but still maintained the total limit on annual contributions. scenarios are intended to illustrate the upper bound on total contributions  over time based on the statutory annual limits for each type of tax- preferred retirement account and do not reflect how much individuals  typically choose to contribute. Our scenarios illustrate balances  accumulated by an individual in an IRA or DC plan. For a married couple  filing jointly, both spouses in concept could contribute at the statutory  maximum.

To illustrate how much an individual could accumulate under each  scenario, we reviewed historical stock returns, specifically the Standard &  Poor’s 500 broad stock index return. Intended to illustrate possible  accumulations based on the upper bounds on contributions, the two  contribution scenarios assuming 100 percent investment in the stock  market are not intended to represent how individuals typically choose to  invest. As shown in table 7, we also looked at a range of other possible  asset allocations: (1) a 70-percent investment in the S&P 500 and a 30- percent investment in corporate bonds; (2) a glide path starting with a 70- percent investment in the S&P 500 and a 30-percent investment in  corporate bonds, and shifting over time to end with a 30-percent  investment in the S&P 500 and a 70-percent investment in corporate  bonds; (3) a 30-percent investment in the S&P 500 and a 70-percent  investment in corporate bonds; and (4) a 100-percent investment in  corporate bonds. For the asset allocations with a mix of stocks and  bonds, the portfolio was rebalanced annually. We also calculated the DC  contribution scenario with investment returns equal to historical interest  rates reported by the Social Security trustees for special-issue  government bonds as a proxy for an accumulation with a less aggressive  investment allocation. The scenarios do not reflect any investment or  administrative fees and expenses. Likewise, the scenarios do not reflect  any leakage from withdrawals or employer plan loans over the period.

We also calculated the rate of return necessary to accumulate a balance  of $1 million or $5 million under each scenario.

section_title: How IRAs Can Become Large
paragraphs: To examine how IRA balances can become large, we conducted literature  reviews on IRA investment strategies and held semistructured interviews  with more than 60 finance industry stakeholders, government officials,  and academics. We conducted initial literature reviews on general topics  and key words related to IRAs, contribution limits, and tax policy. We  selected a first round of interviewees from these literature reviews and  from referrals from GAO stakeholders who have conducted work on  retirement, finance, and tax policy. We sought referrals for additional  interviews from our first round of interviewees, as well as from more  targeted literature reviews based on our initial reviews.

We also searched for documentary evidence of the IRA investment  strategies we identified through our interviews and literature reviews. We  could not determine IRA investment strategies from IRS data because the  IRS does not collect data on asset types held in IRAs. Given this  limitation, we searched publicly available filings with the Securities and  Exchange Commission, such as the Form S-1 filed by companies seeking  to conduct an initial public offering of their stock on public markets, to  research the number of nonpublicly traded shares beneficially owned by  directors, executive officers, and holders of more than five percent of any  class of the company’s voting securities. These individuals often comprise  the company’s founders. We also searched publicly available Form 5500  filings with the Department of Labor (DOL) for the employer-sponsored  DC retirement plans of selected private equity firms and hedge funds,  primarily 401(k) and profit sharing plans. Specifically, we searched the  filings of private equity firms and hedge funds that (1) reported holding  partnership interests; (2) are members of the Private Equity Growth  Capital Council, an advocacy, communications, and research  organization and resource center for the private equity industry; or (3) are  cited in the Forbes list of the highest earning hedge fund managers and  traders of 2013. The findings of this analysis cannot be generalized to the  entire population of private equity firms and hedge funds operating in the  United States but provides insights into one potential alternate strategy  for accumulating large IRAs.

Our framework for evaluating the performance of tax expenditures draws  on long-standing criteria we have described—economic efficiency, equity,  simplicity, transparency, and administrability—that can be used to  evaluate tax policy. In our review, we focus primarily on (1) the extent to  which strategies a few individuals may use to accumulate large IRA  balances align with the intended purpose of IRAs; (2) whether tax  treatment of individuals who may engage in these strategies is fair and  equitable, and (3) the consequences for the federal budget of these IRA  strategies.

To provide context for how certain types of nonpublicly traded shares and  partnership interests can generate IRA balances of tens of millions of  dollars, we constructed two examples. The first example demonstrates  how a company founder can invest in nonpublicly traded shares of a  newly created company using an IRA, and how these nonpublicly traded  shares can grow in value if the company raises capital from outside  investors and becomes a publicly traded corporation. The second  example demonstrates how a key employee at a private equity firm can  invest in a particular type of partnership interest called a profits interest  using an IRA or DC plan, and how these profits interests can grow in  value if the private investment partnership is successful.

section_title: Assessing IRS Enforcement
paragraphs: To assess IRS’s examinations of IRA rules and provisions, we developed  criteria for evaluating an enforcement program on IRAs. Generally, the  basis for the criteria included relevant laws and our previous work on tax  administration and policy as well as our previous work and other  organizations’ work on good management practices. From our research,  we concluded that the seven criteria in table 7 were appropriate. We  shared the criteria with IRS examination officials. In response to the  officials’ comments, we considered potential resource and budget  limitations in applying the criteria.

To apply the criteria, we collected documentation on IRS enforcement  procedures, such as relevant sections of the Internal Revenue Manual  and other IRS publications on guidance for IRA compliance. We also  interviewed relevant IRS enforcement officials with Small Business/Self- Employed (SB/SE); Wage and Investment (W&I); the SB/SE Lead  Development Center; Large Business and International Global High  Wealth industry; National Research Program; IRS Chief Counsel;  Research, Analysis and Statistics; Estate and Gift Tax; and Tax Forms  and Publications. We then compared the findings of our research with the  criteria. Table 8 summarizes our determination of how IRS performed on  the criteria.

We used statistics from several databases in our work on assessing IRS  enforcement, including the Audit Information Management System,  Examination Operational Automation Database, Publication 6961 data,  Information Return Program Case Analysis System, and Lead  Development Center database. To ensure the data’s reliability, we  reviewed documentation on the databases and, where necessary,  interviewed agency officials. We determined that these data were  sufficiently reliable for the purposes of this report.

We conducted this performance audit from June 2013 through October  2014 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.

section_title: Appendix II: Illustration of Earnings and Tax Effects of Traditional and Roth Individual Retirement Accounts
paragraphs: Figure 10 shows the benefits a taxpayer might receive for investing in a  tax-advantaged traditional or Roth individual retirement account (IRA)  compared to taxable account or investments, given certain assumptions  in four different types of investments: a traditional IRA, a Roth IRA, an  investment or account that is taxed annually at ordinary income tax rates,  and an investment that is subject to capital gains tax rules. The figure  uses a simplified model to show the after-tax rates of return that result  from these scenarios over a 20-year period. Each case assumes  earnings of $1,000 before taxes for contribution in year 1 and distribution  of the accumulated balance in year 20. Investment earnings over the 20- year period are assumed to be a constant pretax 5 percent. Assuming a  constant federal ordinary income tax rate of 25 percent, the traditional  IRA and Roth IRA achieve similar results although the tax benefits have  different paths. For the traditional IRA, the individual can invest a $1,000  tax-deductible contribution in year 1, and taxes on the contribution and  investment earnings are deferred until distribution. For the Roth IRA, the  individual can invest $750 after tax with investment earnings tax-exempt  at later distribution. While the amount contributed to the account is  greater in the first year for the traditional IRA owner, the amount that is  available for the taxpayer for consumption after taxes on distribution is the  same for the traditional owner and the Roth owner. The traditional IRA  owner puts the tax saving in the account to grow to ultimately pay the tax  on the account; the Roth owner pays the tax upfront and has no further  tax liability. For both Roth and traditional IRA accounts, the after-tax rate  of return is 5 percent. In contrast, the taxable account, which is subject to  taxes on both the original earnings contributed as well as the annual  investment earnings, has an annual after-tax rate of return of 3.75  percent. If an investment were held outside of a retirement account and  subject to capital gains taxes only, there would be no initial deduction of  amounts invested. Similar to the case of a traditional IRA account where  tax on income is deferred until distribution, no capital gains tax would be  owed until the asset was sold and gain was realized, which in the  example happens at the end of the 20-year period. Upon sale, any gain  would be subject to the capital gains tax rate. The capital gains tax rate is  generally lower than the ordinary income tax rate that is applied to  distributions from a traditional IRA. As a result of the deferral of tax until  sale and the preferential capital gains tax rate, the after-tax rate of return  for the capital gains asset would be 4.5 percent, less than if the asset  were held in an IRA of either type but higher than if the investment had  been made in a taxable account where income earned was taxed  annually at ordinary income tax rates.

The simplified example above showed how contributions to traditional and  Roth accounts can earn the same rate of return after taxes if tax rates do  not change over time. If tax rates vary over time, this equivalence may not  hold. For example, if an individual or household is subject to a relatively  high tax rate when a contribution is made and a low tax rate when  earnings are distributed, a traditional account would result in a higher rate  of return. On the other hand, if tax rates are low when a contribution to a  Roth account is made and rates are higher when funds are distributed,  the Roth account would result in a higher rate of return.

section_title: Appendix III: Tables from Statistics of Income Data for Tax Year 2011
paragraphs: This appendix shows the confidence intervals for our analysis of the  Statistics of Income (SOI) data about individual retirement accounts  (IRA).

section_title: Appendix IV: Examples of Strategies to Accumulate Large Individual Retirement Accounts
paragraphs: The two examples below demonstrate how a small number of individuals  could generate large individual retirement account (IRA) balances by  leveraging their access to nonpublicly traded shares and profits interests.
subsections: section_title: Example 1: onpublicly Traded Shares
paragraphs: Figure 11 illustrates an example of how founders of successful  companies can generate IRA balances of tens of millions dollars by  investing in nonpublicly traded shares in their newly created company.  The example is based on Securities and Exchange Commission (SEC)  filings detailing the transactions of a technology company founder and  assumes the following:  In 2008, the founders of a newly created company authorize the  issuance of up to 100 million shares with an initial value of $0.00125  per share.

One company founder opens a Roth IRA with an after-tax contribution  of $5,000, and uses the Roth IRA to purchase 4 million nonpublicly  traded shares in the company.

The following year, the company raises money by selling nonpublicly  traded shares to a private equity fund that focuses on venture capital  opportunities (venture capital firm) for $10 per share. As part of this  transaction, the company founder sells 1,000,000 shares from her  Roth IRA. The founders stipulate that they will retain an “additional  consideration” in these shares if the outside investors can someday  sell them for more than $30 per share. Specifically, the company  founder will receive 20 percent of the profits above $30 per share.

In 2012, the company offers shares to outside investors through an  initial public offering of shares at a price of $25 per share.

By 2014, the company has enjoyed continuing success and its shares  trade on public stock exchanges at $60 per share. The founder retires  and sells the remaining shares in her Roth IRA. Additionally, the  outside investors of the venture capital firm sell the shares they  purchased in 2009 for $60 per share.

section_title: Example 2: Profits Interest
paragraphs: Figure 12 illustrates an example of how a key employee of a private  equity firm can generate an IRA balance of tens of millions of dollars by  investing in a profits interest that gives him or her the right to a portion of  the general partner’s carried interest in a successful fund. The example  assumes the following about a general partner entity consisting of 10 key  employees:  In 2004, the general partner of a private equity firm that focuses on  buy-out opportunities contributes $10 million to start a new $1 billion  buy-out fund. The general partner raises the rest of the capital  needed to start the fund from outside investors, known as limited  partners.

The general partner negotiates a performance target that needs to be  met in order to get paid for managing the fund. If the general partner  meets this performance target, the limited partners pay the general  partner a performance fee equal to 20 percent of the fund’s total  profits, called the general partner’s carried interest in the fund.

One key employee of the private equity firm rolls over $500,000 from  a former employer’s 401(k) plan to an IRA and uses it to purchase a  profits interest in the general partner. In exchange, the general partner  will distribute 5 percent of its carried interest to the key employee if  the fund is successful.

The general partner and key employees successfully invest in  portfolio companies over a 10-year period and exceed the  performance target set for the limited partners.

On the last day of the fund, the general partner distributes initial  contributions and 80 percent of the fund’s profits to the limited  partners.

The general partner retains its initial contributions and 20 percent of  the fund’s profits as a carried interest. The general partner then  distributes 5 percent of this carried interest to the key employee’s IRA.

section_title: Appendix V: Printable Figure 9 on Form 5498
paragraphs: The figure below is a printable version of figure 9 found earlier in the  report.

section_title: Appendix VI: Comments from the Internal Revenue Service

section_title: Appendix VII: GAO Contacts and Staff Acknowledgements
subsections: section_title: GAO Contacts

section_title: Staff Acknowledgements
paragraphs: In addition to the contact named above, Tamara Cross and MaryLynn  Sergent (Assistant Directors), Eric Gorman and Tom Moscovitch  (analysts in charge), Amy Bowser, Bertha Dong, Monika Gomez, Gene  Kuehneman, Ed Nannenhorn, Albert Sim, Walter Vance, Sonya  Vartivarian, and Craig Winslow made key contributions to this report. Also  contributing to this report were James Bennett, Joanna Berry, Rachel  DeMarcus, Ellen Grady, David Lin, Donna Miller, Karen O’Conor, Stewart  Small, Frank Todisco, and Kathleen van Gelder.


Question-summary annotations: questions: question: How widely are IRA accounts used?
answer: For tax year 2011 (the most recent year available), an estimated 43 million taxpayers had individual retirement accounts (IRA) with a total reported fair market value (FMV) of $5.2 trillion.
child_questions: question: How common are accounts with aggregated balances exceeding $5 million?
answer: As shown in the table below, few taxpayers had aggregated balances exceeding $5 million as of 2011.
child_questions: question: What characteristics do most of these account holders share?
answer: Generally, taxpayers with IRA balances greater than $5 million tend to have adjusted gross incomes greater than $200,000, be joint filers, and are age 65 or older.

question: How could an account accumulate over $5 million?
answer: Large individual and employer contributions sustained over decades and rolled over from an employer plan would be necessary to accumulate an IRA balance of more than $5 million.

question: What limits exist on IRA accumulations and rollovers?
answer: There is no total statutory limit on IRA accumulations or rollovers from employer defined contribution plans.

questions: question: How have some taxpayers accumulated larger IRA balances?
answer: A small number of taxpayers has accumulated larger IRA balances, likely by investing in assets unavailable to most investors—initially valued very low and offering disproportionately high potential investment returns if successful.
child_questions: question: How does this affect taxation?
answer: Individuals who invest in these assets using certain types of IRAs can escape taxation on investment gains. For example, founders of companies who use IRAs to invest in nonpublicly traded shares of their newly formed companies can realize many millions of dollars in tax-favored gains on their investment if the company is successful.

question: To what extent does this affect government tax revenue?
answer: With no total limit on IRA accumulations, the government forgoes millions in tax revenue.

question: How does this reality compare to Congress's goals regarding retirement funds?
answer: The accumulation of these large IRA balances by a small number of investors stands in contrast to Congress's aim to prevent the tax-favored accumulation of balances exceeding what is needed for retirement.

questions: question: How does the IRS ensure IRA compliance?
answer: The Internal Revenue Service (IRS) has enforcement programs covering specific aspects of IRA noncompliance, such as excess contributions and undervalued assets.
child_questions: question: How does the IRS plan to review nonpublicly traded IRA assets?
answer: As recommended by an internal task team, IRS plans to collect data identifying nonpublicly traded assets comprising IRA investments.
child_questions: question: How will this data benefit the IRS?
answer: IRS expects the data will help it identify potential IRA noncompliance.

question: How easily can the IRS pursue IRA valuation cases?
answer: IRS officials said IRA valuation cases are audit-intensive and difficult to litigate because of the subjective nature of valuation.

question: What factors limit the effectiveness of pursuing noncompliant IRA activities?
answer: Additionally, the 3-year statute of limitations for assessing taxes owed can pose an obstacle for IRS pursuing noncompliant activity that spans years of IRA investment.

questions: question: How does the use of IRAs affect government tax revenue?
answer: In 2014, the federal government will forgo an estimated $17.45 billion in tax revenue from IRAs, which Congress created to ensure equitable tax treatment for those not covered by employer-sponsored retirement plans.

question: Why did Congress limit annual contributions to IRAs?
answer: Congress limited annual contributions to IRAs to prevent the tax-favored accumulation of unduly large balances.
child_questions: question: How effective have the tax incentives been?
answer: But concerns have been raised about whether the tax incentives encourage new or additional saving.
child_questions: question: How is Congress addressing these concerns?
answer: Congress is reexamining retirement tax incentives as part of tax reform.

question: What was GAO asked to review?
answer: GAO was asked to measure IRA balances and assess IRS enforcement of IRA laws.

questions: question: What does this report address?
answer: This report (1) describes IRA balances in terms of reported FMV aggregated by taxpayers; (2) examines how IRA balances can become large; and (3) assesses how IRS ensures that taxpayers comply with IRA tax laws.
child_questions: question: How did GAO collect data for this report?
answer: To address these objectives, GAO analyzed 2011 IRS statistical data, reviewed IRS documentation and relevant literature, and interviewed government officials, financial industry stakeholders, and academics.
child_questions: question: How did GAO assess IRS enforcement plans?
answer: GAO compared IRS enforcement plans and procedures with law and criteria for evaluating an enforcement program.