When it comes to retirement planning, one strategy for accredited investors with substantial IRA holdings is the discounted Roth conversion. This method is designed for individuals with IRAs exceeding $1 million who are concerned about taxes and are also planning for their retirement and legacy. To make this most of this strategy, it can be helpful to recognize best practices associated with discounted Roth conversions.
Understand the Basics of Roth Conversions
Before looking at the details involved with discounted Roth conversions, you’ll want to be aware of the differences between traditional IRAs and 401(k)s and Roth IRAs. Unlike IRAs and 401(k)s, Roth IRAs offer tax-free withdrawals in retirement, making them an attractive option for investors looking for tax diversification in their retirement portfolios. With IRAs and 401(k)s, you have to take required minimum distributions (RMDs) starting at age 72. With a Roth IRA, you can take funds later, or leave them for the next generation. The conversion process involves transferring funds from a traditional IRA or 401(k) into a Roth IRA, which triggers taxable income in the year of conversion.
Typically, individuals consider Roth conversions between the time of retirement (around age 55) and the onset of RMDs at age 72. The goal is often to carry out tax planning, optimize retirement income streams, and create the opportunity to leave money for heirs.
Choose the Right Investments
When making investments, you can look for assets that align with the J-curve concept. Their value could initially dip, and then increase over time. For instance, development real estate typically follows a J-curve. This will allow you to have a reduced value when the Roth conversion takes place, and also give you the potential to have your investments grow over time without being subject to taxes.
You can also look into private partnerships, as some offer ordinary tax deductions when you make an investment, which could offset the taxes you owe from a Roth conversion. Certain private partnerships undergo a significant book-value discount during part of their lifetime. For instance, you could put some of your dollars from into a private partnership that drops in value during its second year and use that time to convert it into a Roth IRA.
Tax Bracket Management
A key element to discounted Roth conversions is to strategically place as much income as possible below the 32% tax bracket, which represents the highest jump in tax rates from the 24% tax bracket below. Conversions should aim to put as many funds as possible into the 24% bracket. For married couples filing jointly in 2024, the 32% bracket kicks in at $383,901 of taxable income. By structuring conversions to keep taxable income within the 24% bracket, which is for couples filing jointly with an income between $201,051 and $383,900, investors can minimize tax liabilities and maximize the benefits of Roth conversions.
To illustrate, consider a couple with a combined income of $280,000. They might make a $200,000 investment into a real estate development deal and get that amount discounted to $100,000. Their income during the year when they convert to a Roth IRA would only be $380,000. This would keep them in the 24% bracket, rather than pushing them into the 32% bracket, which would be the case if they converted $200,000 and had an income of $480,000, putting them in the 32% bracket.
Leverage Valuation Discounts
Another important aspect of discounted Roth conversions consists of valuation discounts. These play a role in estate and gift tax planning, particularly in the context of transferring assets such as partnership interests. The discounts allow for the reduction of the taxable value of assets, ultimately minimizing tax liabilities.
Here are some valuation discounts to consider for a discounted Roth conversion:
- Lack of marketability: This refers to the difficulty or inability to sell an asset quickly or at fair market value. Certain assets, such as closely held businesses or partnership interests, may lack a readily available market for trading. As a result, their value may be discounted to account for the illiquidity and the challenges associated with finding buyers. Lack of marketability discounts may range from 10% to 40% or more, depending on the specific characteristics of the asset and prevailing market conditions.
- Minority interest: These discounts apply when an individual owns a minority stake in a business or partnership. Minority owners typically lack significant control over decision-making processes and may face limitations on their ability to influence operations or distributions. As a result, the value of minority interests is often discounted to reflect the reduced control and influence that minority stakeholders have. These discounts might range from 15% to 35% or more, depending on the specific circumstances and governing agreements.
- Lack of control: This type of discounts arises when an individual lacks substantial control over the management and operations of an asset, such as a closely held business or partnership. Owners with limited control may have restricted voting rights, limited access to financial information, or little say in major business decisions. The value of their interests may be discounted to reflect the diminished level of control they hold. Lack of control discounts could range from 10% to 35% or more, depending on the facts and circumstances.
By applying these discounts, the value of the investments could be lower when making a Roth conversion. However, it’s important to note that the application of valuation discounts is subject to scrutiny by tax authorities, and you’ll want to get proper documentation and valuation methodologies when carrying out the Roth conversion. This way you can show you were compliant with the tax laws and regulations.
Navigate the Process Carefully
Suppose a couple lives in South Carolina and they are both aged 60. They have a $1 million IRA and an annual income of $200,000. Considering their residence in a state with taxes, their tax burden is going to be higher than other states with fewer taxes. However, through a discounted Roth conversion, they can manage for their tax outcomes.
By carrying out a $400,000 conversion and applying a 50% discount, they effectively reduce their taxable income to $400,000, thus staying within lower tax brackets. Furthermore, by diversifying their investments into assets like private partnerships, they can further mitigate tax liabilities, maximizing the benefits of the conversion strategy.
Timing and Payment
When carrying out a discounted Roth IRA, you’ll want to make sure there is cash outside the IRA to pay for the taxes. This will help you maximize your investment potential. You may also want to spread your conversions over several years to manage the taxes you’ll owe annually. For some high-net worth individuals, however, this isn’t always possible.
Discounted Roth conversions represent a powerful tool for accredited investors looking to optimize their retirement savings while planning for taxes, tax burdens. By understanding the strategy and implementing best practices, you can get certain benefits depending on your facts and circumstances. If you haven’t spoken to a tax advisor about this strategy, it may be time to get a professional opinion.