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Converting to a Roth IRA? It’s All About the Basis and the Taxes

May 1, 2016

The year 2010 represented one of the most historic events in personal finance history. As of that date, no matter what your earnings, you were eligible to convert any or all of your pre-tax IRAs to a post-tax (Roth) IRA. Before then, tax payers earning more than $100,000 were prevented from making such a conversion.

What has happened in the past six years? A virtual stampede of people converting to a Roth IRA. When the law changed, Roth IRA assets increased over 800% in just one year. When people became aware that with a Roth IRA, you only pay tax before making a contribution and then never again, most opted for the Roth rather than the Traditional IRA. Also, on a conversion, you pay the tax on the value of what is being converted, rather than paying it later on future distributions.

While CPAs and financial advisors are sometimes hesitant to make recommendations to their clients to convert and pay taxes now (something that, I must, admit goes against my instincts), many of our clients are attracted to the concept of never paying taxes on distributions, including their Roth IRA beneficiaries. The opportunity for Roth IRA holders to invest in assets that will have a step up in valuation over time can be extremely attractive.

Here is an example of how several clients have used the Roth IRA to their advantage:

Several self-directed IRA holders have in their portfolio investments in one of several land development companies. As stockholders in these companies, they are provided an annually updated fair market value for their IRA holdings. They noticed that in the early years of the project, expenses of getting the development underway tended to skew the values of the shares lower. The natural cycle of the project, once revenues were received, caused the value of the shares to increase slowly at first, then more rapidly as the development project was nearing completion.

The clients decided to convert their shares at the low point of valuation – and based on a qualified third party appraiser, they converted the shares held in a Traditional IRA to a newly created Roth IRA. They were responsible to pay ordinary income tax on the lower, converted value in the tax year that the conversion took place. It was extremely helpful that one of the clients had a big tax loss in that year, resulting in little tax consequence to him from the conversion.

After five years, the investment has doubled in value, and it still pays a dividend to the Roth IRA account. The true benefit will come once the Roth IRA holder reaches the age of 59 ½. He can take the entire amount out of his account without any tax consequence, or simply leave it in to grow over his lifetime without any mandatory distributions after age 70 ½, which would be required with a Traditional IRA.

No one has a crystal ball to accurately predict which investments will do well and which will not, but it certainly it makes sense to address the possibility of a conversion at least once per year, especially when you own or wish to purchase assets that will likely step up in value, or you have the ability to offset the cost of a Roth conversion with tax losses.

The choice is yours – the advantages of an IRA wrapper around your investments is compelling, Roth or Traditional. As a self-directed IRA holder, you are used to making difficult decisions – and here is yet another. With that said, I have not yet met a NuView IRA client who has done a Roth conversion and wishes they hadn’t.