Escaping the Tax Deferral Trap, Part 2

“I am proud to be paying taxes in the United States. The only thing is, I could be just as proud for half of the money.”
–Arthur Godfrey

Take the Sting out of Taxes with An Innovative Roth Conversion

Last week in “Escaping the Tax Deferral Trap, Part 1,” we busted the myth that tax-deferred retirement plans save money in the long run. (Not unless taxes go down and/or you earn less in retirement.) We looked at the truth about traditional 401(k)s and IRAs and explored some of the ways you can free your money from a tax-deferred account.

However, there are many situations where it pays to KEEP your dollars in a tax-deferred account, such as:

• Your income is higher than normal this year and you’ll pay a higher tax rate by doing a conversion now. If you know, for instance, that you’ll be temporarily leaving employment and making a transition, that could be a good time to do the conversion.
• You can’t afford to pay the taxes right now, but you foresee being able to pay them in the future.
• You have mutual funds which may be at a market “peak” and you plan to stay in the same type of investment. A perfect time to convert and pay taxes on an account is after it’s balance has fallen. (However, you can sell funds when they are high, and use the innovative strategy below to re-position assets for further growth while reducing your taxes.)

What can you do if your money is already trapped in a tax-deferred qualified plan environment? Last week, we discussed three options:

1. Early retirement exceptions for those who have left their employment;
2. Substantially equal periodic payments (IRS Rule 72t, also known as SEPP); and
3. Bringing the “fair market value” balance down with new investments outside of the tax-deferred qualified plan / stock market environment.

In this article, we continue detailing strategies to free your Benjamins with Roth Conversions, including a new strategy that actually slashes your tax bill! First, let’s look briefly at “regular” Roth conversions. What are they and how do they work?

In a Roth conversion, money from a traditional IRA (which is funded with pre-tax dollars) is transferred to a Roth IRA. In the process, the owner of the account pays income taxes on the money that is converted. Once in the Roth IRA, under current rules, funds grow and can be withdrawn (typically after age 59-1/2) income tax free.

One benefit of the Roth conversion is that many “high-income” earners cannot contribute to a Roth IRA due to income limits. However they do have the ability to “convert” their Traditional IRA to a Roth IRA by paying the income tax in the year that they convert. For most pre-retirees, this can be of great value.

Some additional benefits of converting to a Roth IRA include:

• Increased control and flexibility. There are no required minimum distributions. No one tells you when you have to take your money from the account. However, Roth IRAs require that the first contribution be at least five years before qualified distributions begin.
• No unwelcome tax surprises. Once you’ve paid the tax, the account as well as the growth of the account is now “tax-free” forever and unaffected by tax hikes.
• Wealth transfer advantages. When someone inherits a traditional 401(k) or IRA, they must pay income taxes when they withdraw funds. Depending on your heir’s incomes, they might even pay higher taxes than you would have! Heirs will also pay no income taxes on Roth account disbursements, and till then it will continue to grow tax-free.
• No false sense of security. What you see is what you get in your retirement account. You don’t have to make mental calculations of how much is yours and how much belongs to the government. Nor will you make assumptions about future tax rates that might turn out to be very inaccurate.

The Roth Conversion

A typical Roth conversion can be as simple as contacting the brokerage that holds your IRA account and making the transfer. They will transfer the money, and you’ll be responsible for paying taxes, of course. The brokerage can withhold a percentage (generally not less than 10%) for taxes, or you can request none to be withheld, in which case you will pay the tax later. You open up the Roth IRA (if you don’t already have one), indicate the fund or investment you’d like to transfer the money into, and Voila, it’s done!

However, we highly recommend getting OUT of mutual funds and into alternative investments if you’re ready to get out of the stock market AND ready to get out of a traditional IRA. Doing a self-directed IRA with our strategy below could potentially save you some taxes!

The Life Settlement Roth Conversion

With a self-directed IRA, you have the option of investing in a life settlement fund, which can give you some unique benefits. While we won’t discuss life settlements in any detail here, you can read THIS and listen to THIS podcast to find out more. A few of the benefits of investing in a life settlement fund include:

• Life settlements are non-correlated to the stock market, housing market, interest rates, and other external factors. They are immune from market swings.
• Returns are historically in the low double-digits or very high single digits.
• These funds rely on only the most sound and stable underlying investments – life insurance contracts.

Here’s how the Life Settlement Conversion works and saves you taxes. Let’s assume that you’re interested in converting your Traditional IRA to a Roth IRA. If your IRA is invested in any investment for which there is a “sophisticated secondary market,” like a brokerage account, money market account, or simply CDs or savings account, then the value of your IRA is exactly the “market value” of the account. In other words, a $100k IRA invested in CDs is worth $100k and that amount would be used to calculate the amount of tax that you would owe when converting. Assuming that you’re in a 30% income tax bracket, then you would owe approximately $30k in income tax in the year that you convert.

However, when the underlying asset is illiquid, the IRS allows the investor to get an appraisal or “valuation” of the asset and this value may be used for purposes of computing the amount of tax due on the conversion. For example, some people have real estate or raw land as an investment inside of their traditional IRA. If you owned land, or any other illiquid investment in your IRA, the IRS allows you to have an appraisal done to compute the fair market value. This fair market value is now the basis amount that is used for paying the income tax.

In the real estate example above, if you purchased a piece of raw land for $100k using your Traditional IRA and you now want to convert your Traditional IRA to a Roth IRA. You would be allowed to get an appraisal on the “assets” in the IRA, in this case, the raw land. Now, even though you paid $100k for the asset, say that the appraisal comes in at $70k. For your purposes, you know that the land will be worth far more than the appraisal, however, you can have your IRA Custodian reduce the value of the assets in your IRA to $70k for purposes of converting to a Roth IRA. You would then pay the income tax on the $70k and not on the $100k purchase price, thereby saving the tax on $30k. In the case of a 30% taxpayer, that savings is $9k that you don’t have to pay in income taxes upon conversion.

This strategy is not for everyone. It’s for investors who have a minimum of $50k to invest, and who meet the qualificatinos to invest. Investors must be accredited or, at minimum, “suitable” investors. (Accredited investors have a net worth of one million and $200k annual income, $300k/couples, suitable investors have at least $250k net worth.) However, if you understand the value of non-correlated investments and freeing your dollars from the tax deferral trap, we invite you to learn more about using life settlements to help you save on taxes while doing a Roth conversion. (You can also use life settlements in a self-directed Traditional IRA, or outside of the qualified plan environment.)

Is It Time to Escape the Tax Deferral Trap?

Contact us if we can help you explore this unique strategy. We’re here to help! We also encourage you to explore the resources below to learn more about Life Settlements:

Article: “Life Settlement Investments: Pros and Cons and Facts”
Podcast: “An Introduction to Life Settlements”

Partners for Prosperity specializes in alternative investments outside of the stock market for asset growth and income, and also high cash value insurance contracts that help you keep control of your liquidity.