For many tax professionals, the Roth IRA is the ultimate tax shelter solution. The ability to legally shelter all income and gains from tax almost seems too good to be true. Add to the fact that there are opportunities to reduce the tax due on a Roth conversion, which should make performing one even more exciting. The following will detail the key Self-Directed Roth IRA rules and analyze why converting to a Roth could be tax advantageous. In addition, it will explore the most common solutions for reducing tax due on the conversion.
What is a Roth IRA?
A Roth IRA is the newest type of IRA that was created back in 1997. It differs from a traditional plan in several ways. First and foremost, a Roth is funded with after-tax dollars. In other words, you don’t get an upfront tax deduction when making a Roth IRA contribution. However, all qualified distributions from the plan are tax-free! For a distribution to be qualified, you must satisfy two things: be at least age 59 ½, and the Roth account must have been open for at least five years.
Further, it offers great estate planning opportunities since there are no minimum required distributions. The account can continue to grow for as long as you wish. Also, contributions to a Roth can be withdrawn at any time without tax or penalty. This can be a great way to start an emergency fund.
What is a Self-Directed Roth IRA?
A Self-Directed Roth IRA is not a legal term that you will locate in the Internal Revenue Code. It is essentially an IRA that allows for any type of investment, specifically, alternative asset investments, such as real estate. The same rules apply as a “regular” Roth IRA, including contribution limits, distribution practices, and, of course, tax-free qualified withdrawals.
While contribution limits are the same as a traditional IRA, there are income limits that restrict high earners from directly contributing to a Roth IRA:
For 2023, one can make up to a $6,500 Roth IRA contribution plus an additional $1,000 “catch-up” contribution if you are at least age 50. Next year, you may save an additional $500 in an IRA.
If you file as a single, you may fully contribute to a Roth IRA if your earned income is less than $138,000 for 2023 and $146,000 in 2024. If your income is over $153,000 this year or $164,000 next year, you are not allowed to directly contribute to a Roth. If you earn somewhere between those numbers, your maximum contribution is reduced.
Married filing jointly
If you are married and file jointly, you may contribute fully to a Roth IRA if your earned income is less than $218,000 for 2023 and $230,000 in 2024. If your income is over $228,000 for this year or $240,000 for next year, you may not contribute to a Roth IRA directly. Obviously, if you fall between these numbers, the amount you can contribute will be reduced.
The Backdoor Roth IRA
Beginning in 2010, the IRS removed any income restrictions for making Roth conversions. High earners can make a Roth IRA contribution via the Backdoor Roth IRA. To accomplish this, the IRA owner makes an after-tax contribution to a traditional IRA and then immediately converts it to a Roth. There is no tax break on the contribution since it’s after tax, however, no taxes will be due on the amount converted. Note that if you have other pre-tax IRA funds, you will be subject to tax on a pro-rata basis.
Taxation of a Roth IRA Conversion
A Roth conversion occurs when you take savings from a traditional, or pretax, IRA or employer-sponsored retirement plan, such as a 401(k), and convert them to Roth. When converting your pretax savings, you’re including the converted amount as income on your taxes now to get the tax-free growth benefits of a Roth IRA later. A conversion to a Roth IRA results in taxation of any untaxed amounts in the traditional IRA. The conversion is reported on IRS Form 8606.
Converting a Traditional IRA to a Roth Self-Directed Roth IRA has several advantages and can offer you multiple tax and investment benefits.
How to Perform a Roth IRA Conversion
A Roth IRA conversion can be done quite easily. Whether you have an account with a large financial institution or a smaller one, like IRA Financial, the process simply involves completing a Roth IRA conversion form. Your custodian will need to know the amount of traditional IRA funds or assets to be converted to Roth, and will then create a new account and move that amount over to the new plan. If the individual already had a Roth, the custodian would then transfer the funds to the existing plan if you so choose. The custodian would then report the Roth IRA conversion on IRS Form 1099-R, which would notify the IRS of the conversion and a taxable event.
In the case of a conversion of an in-kind asset, such as publicly traded stocks, real estate, or precious metals, it is largely done by “paper processing” versus the actual movement of an asset from one IRA to the other.
For example, in the case of real estate owned by an IRA, the IRA custodian would need the IRA owner to provide the value of the real estate to accurately complete IRS Form 1099-R. The property would then need to be re-titled from the original IRA to the Roth IRA. The real estate does not need to be sold to engage in conversion but must be processed on “paper” in order to document the transfer of the asset.
Should I do a Roth IRA Conversion?
There is no right or wrong answer to the question of whether one should engage in a Roth IRA conversion. A multitude of factors should go into one’s decision on whether it makes sense. Below are some key factors to consider before engaging in a conversion.
- Age: The younger you are, the more tax-free deferral opportunities you will have
- Can you afford to pay the tax on the conversion?
- Type of investments to be made; Cash flow (i.e. rental property)
- The upside of the Roth IRA investment?
- Investment risks?
- Future income level/tax rates at the time of retirement?
- Current income level and tax rates
- Must consider the liability of paying tax up-front on potential gains vs. the benefit of having tax-free income at a later time
Roth IRA Conversion Strategies
The amount of taxable income on a Roth conversion is based on the fair market value of the IRA assets subject to the conversion. Therefore, the lower the fair market value, the less taxes that will be due on the conversion. In general, pursuant to case law, the standard of “fair market value” is an objective test using hypothetical buyers and sellers. Furthermore, in determining the valuation of an LLC, the assets to be valued must be the interests in the entity.
There are several various structures that can be implemented using IRA assets to allow one to take a discount when determining the fair market value of the IRA assets subject to the Roth conversion, thus, reducing the amount of tax you will have to pay on the conversion.
For example, if your Self-Directed IRA owns an LLC which then owns a piece of land, an appraiser may be able to conclude that the LLC interest is worth 20%-40% less than you paid for it based on the lack of marketability or other valuation metrics. Whereas if an LLC held cash or publicly traded securities, taking advantage of a discounted valuation strategy would prove more difficult since the LLC owns an asset that has a marketable daily value.
The Roth Conversion Valuation Discount Strategy is based on tested case law. The valuation discounts applicable to an LLC with IRA assets typically fall into two categories: (1) a discount for lack of control, and (2) a discount for lack of marketability. The tax attorneys at IRA Financial, along with a valuation expert, will help develop a customized Roth conversion tax strategy that will allow you to take a discount of anywhere from 15% to 35% on the value of the IRA assets subject to the Roth conversion. The Roth Conversion Valuation Discount Strategy can save you thousands of dollars in taxes and is based on established case law.
Harvesting Losses Strategy
One way to reduce the amount of tax on a conversion is by using losses to offset the income from the conversion. An ordinary loss that can be used to offset ordinary income is loss realized by a taxpayer when expenses exceed revenues in normal business operations. Ordinary losses are those losses that are not capital losses. An ordinary loss is fully deductible to offset income, thereby reducing the tax owed by a taxpayer. In other words, an ordinary loss, on the whole, offers greater tax benefits than a long-term capital loss. An ordinary loss is mostly fully deductible in the year of the loss, whereas capital loss is not.
For example, an ordinary loss can arise from a business loss which can be used to offset other taxable income. However, one can only apply $3,000 of any excess capital loss to one’s taxable income each year—or up to $1,500 if you’re married and filing separately.
In general, one can only carry net operating ordinary business losses arising in tax years ending after 2020 to a later year. However, there are some limitations on the amount of ordinary business losses carried forward that can be used in a given year.
Income Planning Roth IRA Strategy
The determination of how much one pays on a conversion is based on the amount of aggregate taxable income one has for the year in question. For example, if one is married and filing jointly and earned $75,000 in W-2 salary and performed a conversion of $50,000, they would owe tax on $125,000. Assuming no income tax deductions, in 2024, that would be in the 22% federal income tax bracket. The following are the income tax brackets for 2024:
|Tax rate||Single||Head of household||Married filing jointly or qualifying widow|
|10%||$0 to $11,600||$0 to $16,550||$0 to $23,220|
|12%||$11,601 to $47,150||$16,551 to $63,100||$23,221 to $94,300|
|22%||$47,151 to $100,525||$63,101 to $100,500||$94,301 to $201,050|
|24%||$100,526 to $191,950||$100,501 to $191,950||$201,051 to $383,900|
|32%||$191,951 to $243,725||$191,951 to $243,700||$383,901 to $487,450|
|35%||$243,726 to $609,350||$243,701 to $609,350||$487,451 to $731,200|
|37%||$609,351 or more||$609,351 or more||$731,201 or more|
Hence, the individual would be able to pay the same tax rate if they did additional Roth conversions, up to their net income level of $201,050. Alternatively, if the individual expected to earn a significantly higher salary in a future year, doing a conversion in a year when their income was low would be tax advantageous.
Oil & Gas Roth IRA Conversion Strategy
Oil and gas investments have some of the most generous tax benefits for individual investors. They are one of the few investments where it actually makes more sense to do it outside of a Roth IRA because of the size of the tax deductions generated.
IRC Section 263(c) allows for 100% of the intangible drilling costs (IDCs) to be deductible in the year they are incurred. Just as important, IRC Section 469(c)(3) allows this deduction (loss) to offset ordinary taxable income in the year of investment. In the case of tangible drilling costs, they can either be amortized over five years or due to the 2017 tax bill (TCJA), bonus depreciation can be used to write off 100% of these costs when the well is capable of production.
For some investors, the tax deductions generated by an oil and gas investment is almost as important as the investment returns. Accordingly, using an oil and gas investment in conjunction with a Roth IRA conversion is one of the most innovative conversion strategies. The basic concept behind the strategy, which is highlighted in the table below, is to use the sizable tax deductions generated by the investment to offset the income tax created by the conversion.
|No Oil and Gas Investment||Oil & Gas|
|Roth Conversion Amount||$150,000||$150,000|
|Tax From Conversion (35% Tax Rate)||$52,500||$52,500|
|Tax Deduction From a $125K Investment||N/A||$100,000|
|Tax From Conversion||$52,500||$17,500|
As the example above shows, you can significantly reduce the amount of taxes that would be due when performing a Roth conversion. Of course, this strategy is not right for everyone. It’s important to consult a financial planner to decide if these types of investments fit your portfolio.
Since 2010, the ability for any taxpayer to engage in a Roth IRA conversion has created an enormous tax benefit for many. The opportunity to eliminate 100% of all income and gains from taxation is what makes the Roth such an attractive tax solution. On top of that, the opportunity to reduce, or even eliminate, the tax due from the conversion by employing the tax-reducing strategies highlighted in this article, makes doing a Roth IRA conversion even more attractive.