Tax Savings with a Roth IRA Conversion

Background

One of the reasons many of us pursue a path toward real estate investing is the tax benefits we get to enjoy through deductions and depreciation.

What if I told you that there is an additional tax management strategy that we can tap into – one that does not involve acquiring another rental but rather through a series of conversions of our own retirement accounts. Enter the Self-Directed IRA.

There are two tax strategies we can utilize that will either force us to pay monumental taxes later in life or pay less taxes now and watch our wealth grow tax-free into retirement.

We will compare both scenarios to each other and to a baseline measurement that likely describes the situation many of us are facing right now.

Context

I have a SD-IRA (self directed IRA) that contains seven real estate limited partner investments (NDF1 and NDF2).

Complication

  • There is a minor amount of UBIT tax exposure.
  • All SD-IRA (and regular IRA invested in stocks) are taxed as ordinary income at withdrawal, even though most of the gains are long term capital gains.
  • The tax hit in later years is monumental.
  • RMD Requirements require significant distributions which could be difficult with nonliquid assets.

Question

  • What can be done to legally manage these taxes more efficiently?

Answer

  • Move IRA to Self-Directed IRA.
  • Invest in real estate limited partnership(s) like NDF6.
  • Get FMV (fair market value) assessment from a CPA.
  • Legally write down the value of your investment by 35% (or more).
  • Convert to Roth IRA.
  • Pay a small tax bill now.

Enjoy incredible tax savings for the rest of your life.

Following? Here’s a hypothetical portfolio and assumptions:

Baseline

  • $100,000 balance now
  • You are 45
  • All invested at Vanguard or Charles Schwab in stock index fund
  • You want to start to withdraw at 60
  • You take out cash until you are 80
  • Solve to take out equal payments with a only a small balance remaining when you are 80.

Scenario 1

  • Convert to SD-IRA
  • Invest in NDF6

Scenario 2

  • Scenario 1 + do FMV (fair market value) study
  • Pay taxes one time today
  • Convert to Roth IRA

Here’s a hypothetical portfolio and assumptions.

  • If you are not sure of your marginal tax rates, your CPA can help you… or it’s easy to look up on Google.
  • NDF1 is tracking to a 21% annual return (IRR).  NDF2, 3, 4 are tracking to 15-18% annual returns.  NDF5 is current slated for 17.5% returns.
  • The 35% basis write down is based on estimates from CPAs, you unique situation could be different.  It’s based on real estate investment just like NDF5.

Baseline results

Keep money in a traditional IRA in the stock market.  Your $100K today generates $1 million over your lifetime!  The IRS takes $350,000.

Scenario 1 Results

Move to SD-IRA and invest in NDF6.  Your $100K today generates $3.8 million over your lifetime!  The IRS takes $1,400,000.

Scenario 2 Results

Move to SD-IRA, invest in NDF6, convert to Roth.  Your $100K today generates $3.15 million over your lifetime!  The IRS takes $23,000.

Other Tax considerations: Unrelated Business Income Tax (UBIT)

After tax, keep $600,000 more than SD-IRA scenario #1

Other Tax considerations: Required Minimum Distributions (RMD)

What are RMD?

  • RMD are required distributions from an IRA but are NOT required from a (non inherited) ROTH IRA. Failure to make a distribution results in a 25% penalty, or 10% if you withdraw the next year.
  • Generally, these start at the age of 72, or 70 ½ if before 2020.
  • They are based on the Fair Market Value of the account based at the end of the prior year. 

For Example (for illustration purposes only)

Problems:

  • As shown here, there is not enough cash to make the distribution. The only solution is to pay the penalties or distribute the entire building, which will generate a 2m of ordinary income to the recipient, who will then need the money to pay the tax, all at once. This can cause the owner to be forced to sell the building.
  • You will need to determine the Fair Market Value each year, generally through an appraisal, to determine what the Fair Market Value is. 

Conclusion

After comparing the three tax management strategies, there is a clear winner.

Situation two will allow us to invest in an alternative investment such as NDF 6 and watch our wealth accumulate tax-free, allowing us to enjoy a more fruitful retirement and leave behind an even greater legacy to our younger generations.

Interested in learning more about these tax management strategies? Watch the full webinar recording.

If you would like to learn more about our investment funds, you can visit our website at irontoncapital.com.

You may also get in touch directly with our investor relations team, who can help you break down your personal situation, and guide you toward a solution. Please contact [email protected] or [email protected].

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