Roth IRA

Doing the Roth Arithmetic

Viewing a traditional IRA in that light, if the government were willing to sell its share and you could use your directly owned (non-IRA) assets to buy it, would it be smart for you to do the deal? The effect of a buyout would be to move your directly owned assets from their high-tax environment into the shelter of a Roth IRA. And we’ve already established that it is always better to have a dollar in a Roth than to have a dollar in your pocket. So if the government invites you to buy them out, you should almost certainly accept the offer.

In fact, the government is making you such an offer right now. It’s called a Roth conversion. Accept the offer. It’s a migration of assets from a high-tax environment to a zero-tax environment. Unless you believe that income tax rates are going to decline drastically, put your wealth on the boat.

Four More Factors

Moving more of your financial life into a tax-free Roth zone is by itself a compelling reason to make a Roth conversion. But there are several more advantages:

Inflation Protection

The years of rapid price inflation that many of us are expecting will increase the value of an IRA’s tax protection. Inflation generates profits that are accounting fictions but nonetheless are taxable. A stock whose price doubles during a period when what you buy at the grocery store has gotten twice as expensive hasn’t delivered a real profit. But when you sell the stock, your “gain” will be taxed as a capital gain… unless the stock is in your IRA.

The tax picture for interest-earning assets during rapid price inflation is even uglier. Yields on money market instruments tend to rise along with inflation rates, on average leaving the investor with a real, after-inflation return of about 1%. When inflation is running at 14%, for example, you can expect money market returns to be in the 15% neighborhood. But the entire 15%, not just the 1% true return, will be taxed – unless the investment is in a shelter such as an IRA. Avoiding a big tax bill on fictitious income adds to the importance of sending as much of your wealth to Rothland as possible.

No Minimum Distribution Requirement

With a traditional IRA, you must take a minimum distribution every year starting at age 70.5. Your IRA is forced into a slow liquidation, which pushes wealth back into the environment of full taxation. Dollar by dollar, tax deferral comes to an end.

With a Roth IRA, on the other hand, there are no minimum distribution requirements. You can let the money ride as long as you like. In nearly all cases, the best approach is to not touch the Roth until you’ve run out of directly owned assets. For many investors that means letting the Roth grow tax free for years past age 70.5.

Heal the Lame

If any of your contributions to a traditional IRA weren’t tax deductible when you made them, your IRA is, to that extent, lame. The tax cost of moving those contribution dollars to a Roth is exactly zero, and the future earnings of those dollars can come out of the Roth tax free.

Additional Tax Savings

The range of investments that the tax rules permit an IRA to hold is broad – far broader than what you can get with any stockbroker, mutual fund family or insurance company. An IRA is authorized to own real estate of any kind, for example. It can own copyrights, patents and other intellectual property and collect royalties. It can own an equipment-leasing business. It can even have a foreign bank account.

Anyone can gain access to such investments for his IRA by moving it to a custodian that will allow the IRA to own a limited liability company. The individual manages the LLC that his IRA owns, and the LLC buys and owns the investments. It’s a way to free yourself up to invest IRA money in almost any way you choose.

The structure can provide an additional benefit. It can cut the tax bill on a Roth conversion by one-third or more. That is accomplished by adopting a valuation strategy that has become commonplace in estate planning.

The amount of taxable income that you recognize on a Roth conversion is equal to the “fair market value” of the property that moves from the traditional IRA to the Roth. For all tax purposes, fair market value means the price that would occur in a transaction between a willing buyer and a willing seller. If the property is a non-controlling interest in an LLC, its fair market value will depend on what’s in the LLC and also on the terms of the operating agreement that governs the LLC. With the right terms, that fair market value can be pushed far below the interest’s pro rata share of the LLC’s assets.

An example may make this less mysterious.

Suppose you have a traditional IRA that owns an LLC that in turn owns $100,000 worth of marketable stocks. Under the terms of the LLC’s operating agreement:

  • The Manager (you) has the discretion to make distributions at whatever time the Manager chooses.
  • No owner of an interest in the LLC may sell it without the consent of the Manager.
  • The Manager can be replaced, but only with the unanimous consent of the owners.
  • The LLC can be liquidated, but only with the unanimous consent of the owners.
  • The operating agreement can be amended, but only with the unanimous consent of the owners.

How much would anyone be willing to pay for a 50% interest in your IRA’s LLC? Certainly not $50,000. All he would be getting is the right to wait for you to decide to make a distribution, and he would have no power to get rid of you or to change the rules. So the fair market value of the 50% interest would be less than $50,000. How much less? A professional appraiser would tell you the fair market value of the interest is no more than $35,000 (possibly even less than that).

That valuation discount translates into tax savings. Move a 50% interest in the LLC to a Roth, and you recognize taxable income of only $35,000. The following year, repeat the exercise. That will put the entire LLC, with its $100,000 of assets, under the Roth umbrella, and you will be paying tax on just $70,000 of income.

Jumping

The advantages of converting a traditional IRA to a Roth stack up. Move more of your wealth into a tax-free environment. Achieve greater inflation preparedness. Escape the rules on required minimum distributions. Turn non-deductible contributions into a generator of earnings you can withdraw tax free. Cut the tax cost of getting spendable cash from the IRA by using a valuation strategy when you convert.

The advantages stack up so high that if your traditional IRA could read this article, it would be jumping around the room and waving its arms high and shouting “Convert me! Convert me!” I hope you can imagine hearing that advice and taking it. Every time you or anyone else acts on a legitimate opportunity to save on taxes, he deprives the government of the means for more mischief. You’d be doing us all a big favor. I do my part. Now it’s time for you to do yours.

In addition to his role as economist and editor with Casey Research, Terry Coxon is a principal in Passport IRA and the author of Unleash your IRA.

The information included in this article is not to be construed as legal or tax advice; should you consider a Roth conversion, make sure to discuss your plans with your own CPA and tax advisor.

[Another thorny investment area is the world of exchange-traded funds (ETFs); they are not always what they appear to be. This free report on the top ten misleading ETFs will help you avoid the brambles.]

Photo Credit: Chris Potter

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