When Does It Make Sense For You To Convert Your Traditional IRA To A Roth IRA?

THE MOST DIFFICULT ASPECTS OF DECIDING WHETHER OR NOT TO CONVERT YOUR TRADITIONAL IRA TO A ROTH IRA IS WHEN TO REALIZE THE TAX PENALTY, AND IF IT MAKES SENSE FOR YOU AND YOUR RETIREMENT PLANS.

For those of you who are unfamiliar with this concept, I would compare it to winning Powerball, and deciding between the lump sum or the annuity. In other words, you are deciding to either pay the taxes now or at some point in the future. It all comes down to two basic questions, when do you think you will need the money, and when is the optimal time to pay the taxes? Well, seeing that the tax component is an inevitability, the real questions should be is there a way to reduce your tax exposure, and how can it be done effectively?

Before we get into the technical aspects of this strategy, let’s first understand how a Roth IRA works, and why the conversion makes sense for those with enough time and the prerequisite assets to start down this winding road.

ROTH IRA

In 1997 a forward-looking Senator from the state of Delaware named William Roth had a vision to attract younger investors to the world of savings and investment. “It is in the national interest both for the economy and the family that we have significant savings,” Roth was quoted telling Gobind Daryanani, author of “Roth IRA Book: An Investor’s Guide,” in 1998. The Roth would soon become a popular vessel used to accumulate after tax dollars, which subsequently grow tax deferred and can later be withdrawn completely tax free. The only issue was there were income limitations placed on single and married contributors, as well as those looking to convert their 401K’s, and traditional IRA to this advantageous alternative.

Fast forward to 2010 when the IRS lifted the income restriction on Roth IRA conversions as a result of the Tax Increase Prevention and Reconciliation act of 2005 (TIPRA) which resulted in a title wave of billable activity for Accountants and Advisors across the country. In fact, $64.8 Billion dollars went from traditional IRA’s to Roth IRA’s that year alone, which represented an 800% increase from the previous tax year. Approximately 57% of the conversions during this period were from people with incomes of six- figures or greater. You don’t have to be Alan Greenspan to understand what was happening. Savy investors, and individuals with good financial insight or guidance, saw this as a great opportunity to reduce their future tax exposure at a time when the effective tax rates were at historic lows.

Well, if this is one of the greatest tax opportunities to save money during retirement, why isn’t everyone doing it now? Basically, you’re playing a guessing game, because no one knows for sure what the taxes will be like in the future. The only way to ensure that the scales are assuredly tipped in your favor is to significantly reduce the tax bill associated with the conversion. Sounds easy enough right? Well, lets discuss how the Fair Market Value of certain retirement assets are appraised, and how they can be adjusted.

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FAIR MARKET VALUE

The textbook definition of Fair Market Value, in its most basic form, translates to the specific selling price of an item or security to which an interested buyer, and a motivated seller can agree. There are several factors that can greatly affect this inherent value, and to the same end significantly adjust the price of the underlying security. At this point, you might be asking yourself, what does valuation have to do with saving taxes on my Roth Conversion? To answer that question, let’s first understand how assets are held inside of your Roth IRA, and then take a closer look at how these assets work to better understand this complex relationship.

Loosely defined, the U.S. Tax code allows individuals to purchase a wide variety of securities offered by established Banks, Brokerages, and mutual fund companies inside of your retirement plan. These include (but are not limited to) stocks, bonds, mutual funds, ETF’s, and Alternative Investments such as UIT’s, REIT’s, and even Real Estate. You are prohibited from purchasing collectables such as a painting by Picasso, rare and obscure antiques that you might find on Antiques Road Show and other prohibited items that are not traded on a recognized exchange. Subjective factors such as condition, and authenticity make it difficult to pinpoint the actual value of these banned assets.

Ironically, Alternative Investments are sanctioned for ownership with in your retirement plan. These assets maintain a certain degree of subjective valuation, but their appraisal requirements fall well with in approved SEC guidelines. The pure fact that these assets can be found and listed on recognized securities exchanges, it becomes easier to assess their intrinsic value at any given point in time.

Valuation Adjustment Considerations

There are many considerations when attempting to calculating FMV for various alternative assets held inside of fully self-managed IRA’s and other retirement plans. Due to the very composition of these alternative investments, various adjustment factors can help when discounting the FMV if applied to real estate transactions or calculating ownership interests. If the situation occurs where a larger current discount is available, one can anticipate a nominal income tax strain during the distributions.

I took the time to highlight the top three valuation adjustment instances that can be used to discount the FMV of various Alternative Assets:

1. Minority Interests – If less than a 10% ownership interest is represented with in the IRA Plan from any one owner. Let’s say Henry has a 10% ownership interest in his family’s software company, with nine other owners each owning the same amount. He is an owner, but he lacks a controlling interest over the other shareholders, and the business as a whole. This affects the value of his shares.

2. Lack of Marketability – Securities that are not traded on a recognized exchange (i.e. NASDAQ, NYSE) have limited liquidity because they are not traded between millions of investors over a specified stock or commodities exchange. It could take a long time to find a buyer for a diluted ownership interest or rental real estate in order to convert to cash. If you are unable to quickly locate a buyer for your shares or your ownership interest, then the value of the underly security is adjusted accordingly.

3. Fractional Interests – Undivided fractional interests in real estate, even if you have a majority holding, tend to be more of a challenge to find a buyer than if you were selling the whole unit. Let’s say Uncle Monopoly died, and left a 46-unit apartment building to 8 different nieces and nephews. If one of the nieces decided to put her ownership interest on the open market, her share now comes with 7 other owners, each with their own agenda. These complications can greatly reduce the value of her share of the apartment building.

Appraisal and Valuation

To ensure that the FMV reporting is accurate, the actual value of the Alternative Asset held within your retirement plan has to be verified by an unaffiliated, independent 3rd party appraiser who has relevant expertise. Your personal tax professional, or attorney will often have contacts available to make such a recommendation. Often times your tax professional will be equipped to confirm the validity of this transaction at a very high level, due to their background and training.

Let’s look at a case study to better understand the mechanics of appraising an alternative asset held inside of a retirement plan, and what that means for fractional share holders of the asset during a conversion. There is a saying in the art world, that beauty lies in the eye of the beholder. Essentially, this states that an

item is only worth whatever someone is willing to pay for it, or in this case how much value a professional appraiser is willing to assign. This concept rings true in the matter of discounting alternative assets.

Let’s take a look at a closely held Limited Liability Corporation, that has been in existence for generations with many owners with varying proportional share values. In this scenario, Laura and Ted each own 20% of an LLC. The remaining 60% is owned by an Irrevocable Family Trust. The LLC owns Modular Homes, and transportation equipment with a book value of $2,500,000. Laura dies, and her shares would be passed along to Ted per the terms of the buy-sell agreement. They have hired an appraiser who specializes in modular homes to help them establish a fair market value for their respective ownership interests.

The appraiser determines that the FMV of the modular homes and equipment is $3,800,000. However, there are a few factors to take into consideration, most importantly, an established exchange for her shares does not exist, and Laura is not a majority owner. Additionally, their holdings represent a fractional ownership of the LLC. This inherent lack of marketability, makes it extremely difficult to assign the appropriate value for their shares, so the appraiser would likely apply a deep discount to the value of their holding for this very reason.

The appraiser subsequently applies a 40% discount to their shares which translates to a FMV of $304,000 as opposed to $760,000. This represents a $456,000 discount to the taxable income that the estate tax is based upon. In this instance the FMV calculation is justified, documented and supported.

CONCLUSION

Fully self-directed IRA’s and 401(k)’s offer a host of benefits, including real control over one’s financial future, real choice over the assets one can invest in, real diversification of one’s retirement portfolio, real asset protection and real tax advantages. When one considers that, at any moment, Congress could ring in a whole new round of federal income tax increases, positioning oneself to side-step the additional liability becomes that much more compelling. By coupling the many benefits available for self-directed IRA & 401(k)’s with the valuation adjustment techniques applicable to alternative assets held in such accounts, a real opportunity exists to preserve one’s accrued wealth for posterity’s sake.

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