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Supercharging Your IRA - Roth Conversion

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Supercharging Your IRA - Roth Conversion by

Frank L. Bridges. J.D. Heritage Design Law Group LLC

199 Wells Avenue, Suite 302 Newton, MA 02459

617-630-5700

www.heritagedesignlaw.com © 2011-2012 Frank L. Bridges

Converting a traditional IRA to a Roth IRA has the important advantages of providing tax-free distributions, tax-free accumulation of growth and income, and no required minimum distributions for the Roth owner at age 70½. The only benefit a traditional IRA has in common with its Roth cousin is the tax-free accumulation of growth and income. Distributions from a traditional IRA are subject to income tax, and minimum distributions are required at age 70½.

As an inheritance, a Roth IRA also has important advantages over a traditional IRA. Although beneficiaries of an inherited Roth must take out minimum distributions based on their life expectancy, the distributions are still tax free, and, of course,

accumulations during their lifetime are tax-free as well.

Converting a traditional IRA to a Roth IRA has one major obstacle, of course. The assets transferred to the Roth in the conversion are treated as having been distributed from the traditional IRA to its owner. Consequently, all assumptions of timing, tax rates and investment returns being equal, minimum distributions from a Roth turn out to be less than minimum distributions received from a traditional IRA.

For example, let’s compare a traditional IRA account with a converted Roth side-by-side. Here are the assumptions:

9 An IRA owner converts $100,000 in assets in a traditional IRA by transferring them to a qualified1 Roth IRA at age 61.

9 The IRA owner treats the transfer as a taxable distribution and does not “re-characterize” the conversion by transferring them back to the traditional IRA.

9 The IRA owner withdraws the money to pay the income tax on the conversion from the qualified Roth after the conversion. 2

1

By “qualified” we mean that the Roth has been in existence for at least 5 years. 2

We will ignore the results of tax free accumulation on the Roth funds between the time of conversion and the time of withdrawal to pay the taxes.

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9 Both accounts accumulate for 20 years at the rate of 8%, compounded annually, tax free.

9 Both accounts are inherited during the 20 year period by a taxpayer who begins receiving minimum distributions at age 41 (a 24.4 year life expectancy according to the IRA tables).

9 Both taxpayers pay tax at the rate of 28% on their taxable distributions. Here’s what happens:

Table 1

Qualified Roth After Conversion Traditional IRA

Year 1 Fund Year 20 Fund Min Dist. After Tax Year 1 Fund Year 20 Fund Min Dist. After Tax 72,000 335,589 13,764 13,764 100,000 466,096 19,102 13,764

In other words, all assumptions being the same, the after tax minimum distributions are identical.

Suppose, however, that the tax burden at the time of the conversion were reduced, for example, by 25%. That’s what happens if the value of a private investment declines by 25% during the term of the investment, but regains its value plus comparable returns before it is liquidated and distributions begin. In that case, the Roth distribution is greater than the traditional IRA because the tax on the income is reduced. Here’s what happens:

Table 2

Qualified Roth After Conversion Traditional IRA

Year 1 Fund Year 20 Fund Min Dist. After Tax Year 1 Fund Year 20 Fund Min Dist. After Tax 79,000 368,216 15,091 15,091 100,000 466,096 19,102 13,764 (The difference is $1,337)

Consequently, one key to enhancing the value of a Roth conversion is to reduce the owner’s income tax burden at the time of the conversion. That’s where the self-directed retirement account (“SDRA”) comes in.

A SDRA is a retirement account held by specialized custodian that permits the purchase of private investments, rather than publicly traded securities. For example, a SDRA can hold a parcel of real estate, stock in a private company, commodities and the like.

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Often private investments are held in the form of partial interests in ventures with multiple unrelated investors.

A SDRA investment should be chosen as part of an investment policy that includes private ventures with solid business plans with the expectation of favorable long-term returns on the investment. However, investments in private ventures with multiple unrelated investors, by their nature, often lack the marketability of publicly traded securities held in traditional retirement accounts, and at the same time the individual investor has little control over management of the venture. Why?

First, the best interests of the investors are served when other investors cannot influence the management and operation of the venture. Unrelated investors depend on the experience and expertise of the business managers in making their investment choices. Consequently, such offerings often limit the control that can be exercised by investors. In effect, the investors, regardless of the percentage owned, may have the same limited influence as a minority owner of a closely held business.

Second, the best interests of unrelated investors are also served when other

investors are not permitted to withdraw their funds, or to sell their interests in the venture. Withdrawals by investors could jeopardize the viability of the venture; and resale to third parties is often restricted due to the private nature of the offering in order to avoid

securities law violations. Therefore, interests in private ventures have little or no liquidity or marketability.

Typically, because of the lack of liquidity, marketability and control characteristic of private investments, the value of such assets – valued by appraisal after the investment is completed – is less than the original amount invested. These adjustments in value for lack of liquidity, marketability and control are often referred to as “valuation discounts.” By contrast, investors in publicly traded assets generally have little control over

management, but they vote with their investment. Their lack of control is made up for by the marketability and liquidity of the investment.

Valuation adjustments may seem counter-intuitive at first blush. Why isn’t the value of the business interest received identical to the cash invested? The reason is that the character of the asset has been changed. Cash has been committed to a long-term investment where the anticipated return is greater than what otherwise would be

available. The price of the anticipated return is the current lack of liquidity, marketability and control. The investor is willing to accept this reduction in the current value of his or her assets as the price of a greater long-term return. The investment was chosen on its merits consistent with the investor’s chosen investment policy. The investor is not interested in withdrawing the investment and looks forward to the projected returns.

IRA assets invested in private ventures are no different from other investments from this point of view; and they are subject to the same valuation adjustments as are non-retirement assets.

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When an IRA custodian makes a transfer of assets in a Roth conversion, the custodian is required to report (on Form 1099-R) the fair market value of the assets transferred in the conversion as a distribution. When an IRA’s interest in a private venture is appraised, and the appraisal is provided to the custodian, the custodian will report the value as indicated on the appraisal. Consequently, when private venture business interests are transferred from a traditional IRA to a Roth in the conversion

process, the value reported may be significantly less than the original amounts invested in the venture. Since asset values are less, the taxable income is less, and the income tax is less.

So, what is the valuation adjustment? Privately held business interests are

typically appraised by qualified business appraisers to be worth as little as 50% - 75% of the original amount invested (and sometimes less), based on information available to them through research about investments with similar liquidity, marketability and control characteristics.

So, let’s assume a traditional IRA SDRA invests $100,000 in a private venture with low liquidity, and with minority interest and marketability restrictions. Let’s also assume that the term of the venture is unlimited, but that the expected term of the venture is 10 years before the property is sold or the venture anticipates a public offering or other liquidity event. An appraiser might appraise the value of the investment at 75% of the amount originally invested.

Remember, the investment was chosen on its merits consistent with an appropriate investment policy. The investor is not interested in withdrawing the investment and looks forward to the projected returns. Also, please note that a business venture established solely for the purpose of providing the tax benefits of valuation discounts would most likely be unsuccessful in doing so. Valuation adjustments created solely for tax purposes generally will not be recognized by the IRS and other taxing authorities.

Nevertheless, let’s say that the appraised value of the investment established through arms-length bone fide business dealings is $75,000. If the IRA owner now converts the IRA to a Roth, the value of the converted business interest must be reported at the appraised value by the custodian on Form 1099-R. The IRA owner also reports the value of the investment as taxable income on his or her income tax return; but his or her taxable income is 75% of what it would have been if publicly traded investments had been involved.

That is the result shown in Table 2. For illustration purposes Table 3 compares the benefit of valuation adjustments at various levels on a $100,000 investment. The first two lines represent the traditional IRA and the converted Roth without valuation adjustment. Lines 3-5 show discounts of 25%, 40% and 50% respectively.

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5 Table 3 Adjustment Type Taxable Value at Conversion Year 1 Fund Year 20 Fund After Tax Distribution

N/A Trad. IRA N/A 100,000 466,096 13,764

None Roth IRA 100,000 72,000 335,589 13,754

25% Roth IRA 75,000 79,000 368,216 15,091

40% Roth IRA 60,000 83,200 387,792 15,893

50% Roth IRA 50,000 86,000 400,842 16,428

Because of the valuation adjustments the after tax benefit of distributions in our example varies from 9.7% to 19.4% greater than the straight conversion of publicly traded assets.

That’s what we mean by “Supercharging IRA-Roth Conversions.”

If you’d like to find out more about how Roth conversions fit into the context of SDRA investments, and retirement and estate planning, be sure to attend “SDRA Basics™” at Heritage Design Law Group LLC. Check out our calendar at

References

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