by Mat Sorensen | Oct 12, 2021 | Entrepreneur, Real Estate & Alternative Asset Investing , Retirement & IRAs, Uncategorized
From my article on Entrepreneur
The proposed $3.5 trillion budget-reconciliation package still working its way through Congress contains two provisions that will restrict IRA investments into startups, small businesses, and real estate LLCs. These provisions came as a surprise to the over one million IRA investors who already invest a portion of their IRA into these non-publicly traded assets. The problematic sections, 138312 and 138314, change more than 40 years of IRA laws and practice, which have allowed IRAs to invest into publicly traded companies as well as privately held small businesses, LLCs, real estate, and startups…
Read the article on Entrepreneur here.
by Mat Sorensen | Sep 20, 2021 | Real Estate & Alternative Asset Investing , Retirement & IRAs, Tax & Legal Updates and Policy Changes, Tax Planning, Uncategorized
There are over one million IRA accounts that invest into real estate, small businesses, start-ups, LLCs, crowdfunding offerings, and private companies. Contrary to news headlines, these savers are not the ultra-wealthy and 98% of them have accounts less than $1M. Current legislation passed in the House Committee on Ways and Means would significantly limit investment choices for these savers who choose to diversify their retirement holdings in assets they value and believe in. The bill will effectively cut off IRA investments into small businesses, start-ups, real estate (using an IRA/LLC), and crowdfunding. Any IRA investor who is already invested into these assets, there are hundreds of thousands, will be forced to sell their asset prematurely or will be forced to distribute it. Early distribution will result in taxes and penalties for most IRA investors that aren’t yet at retirement age.
The proposed House Tax bill has several provisions that affect IRAs but most of them will only affect the very wealthy, cap IRA account balances at $10M (Section 138301), or those who have violated the IRA rules (Section 138313, Section 138315). The policy and political objectives on these provisions makes sense as the bill is designed to curb abuses and raise revenue from the wealthy. Unfortunately, two additional sections added into the bill are going to hurt everyday IRA savers who choose to invest into small businesses, start-ups, crowdfunding offerings, and real estate with an IRA owned LLC. My experience after 15 years in the industry is that those who self-direct their IRA aren’t “wealthy”. They are hard-working Americans trying to catch up to the wealthy by investing in assets and companies they know and believe in.
Two Sections Will Drastically Impact Savers with Small Accounts Who Are Trying to Catch Up to The Wealthy
Unfortunately, the bill contains two sections that will affect everyday IRA savers who choose to self-direct their IRAs into real estate (using LLCs or private funds), small businesses, start-ups, and crowdfunding offerings. It appears that the bill was intended to curb investments made by Peter Theil in growing his Roth IRA to $5 billion. Mr. Theil’s account was reported on by ProPublica and followed closely by democrats in Congress. The bill will curb Peter Theil’s $5B Roth IRA with the $10M cap, but these two problematic provisions are going to harm hundreds of thousands of everyday IRA investors who are only trying to get an IRA to an amount they can retire on. Congress needs the help of self-directed IRA investors and savers to understand that investment choices (not just Wall Street) are important to their IRA and that investing in small businesses, private companies and funds, real estate with an IRA/LLC, and crowdfunding offerings isn’t just something the ultra-wealthy do.
Section 138312 Should Be Removed from the Bill – This section prohibits investments in IRAs when the investment is permitted based on asset or income levels of the investor. This prohibition would effectively ban crowdfunding offerings under federal and state crowdfunding laws (investment amounts under these offerings is based on income or assets, and it’s not just accredited investors). Most crowdfunding investors who use their IRA to invest will invest $5K or $10K at a time and will invest their IRA in companies, people, and innovations they believe in. These retirement savers are everyday working Americans, many of whom make less than $100K a year but will likely be restricted under the legislation as crowdfunding investment amounts are based on income or assets.
This section, if enacted, will also hurt small businesses and innovating start-ups who raise money from accredited investors. Accredited investors are only permitted to invest into private companies, private funds, start-ups, and small businesses because they qualify under securities laws based on their income or assets. If enacted, the IRA laws will say the exact opposite and will say if you qualify to invest under securities laws then you can’t invest under IRA laws. I know, it doesn’t make sense but that’s how the law will be applied. Most IRA savers who we work with and who have invested as an accredited investor into a private offering or fund are working Americans who have saved and who have been able to obtain $1M in total assets over a decade of working and saving and who wish to build their retirement account by investing and diversifying into small businesses, start-ups, and private companies.
Section 138314 Should Be Removed from the Bill – This section prohibits several activities but the most destructive would affect retirement savers who buy real estate with their IRA. The most common real estate investment for an IRA saver is a single-family rental property. There are hundreds of thousands of single-family rentals owned by IRA savers and most of them use a structure known as an IRA/LLC, whereby their IRA owns an LLC 100% and the LLC in turn owns the single-family rental. The IRA owner is typically the manager (officer) of said LLC. Some IRA providers require their account holders to use an LLC when their IRA is buying real estate as they don’t want liability as the IRA provider in holding the asset directly. Under current law, the IRA owner cannot be compensated and cannot work on the property and has zero personal ownership interest but serves in an administrative and management function to sign on things for the LLC that owns the property. This section, it appears, would prohibit an IRA owner from serving as an officer of a company (LLC) that their IRA owns more than 10% of. If this provision passes, IRA savers will be forced to hire financial advisors, tax lawyers, or other professionals to manage (service as officer) their IRA owned LLCs that own real estate. This is something the ultra-wealthy already do and as a result it will only harm working Americans doing these actions for themselves who are trying to build an IRA they can retire on. If passed, the only other method for IRA real estate savers, or others who use an IRA/LLC, is they will need to give control back to their IRA companies to manager the real estate asset. This will increase fees and expenses, further hurting hard-working Americans and will take investment control away from the IRA saver.
What Can I Do to Save My IRA?
The entire industry is working diligently to educate Congress on how these two sections will disproportionately harm IRA savers, 98% of whom have IRAs less than $1M, and 80% who have IRAs less than $300k. I have spoken to multiple members of Congress, Senator staffers, and industry groups this past week. Industry efforts will not be enough. The only way these two sections will be removed is if Congress hears from IRA savers who will be affected. Congress needs to hear from you, their constituents, on how these two sections of the bill impact you.
This is moving fast, write and call your Senators and House member today.
Contact Your House Representative by phone, e-mail, and/or mail? You can look up your representative at the House of Representatives link below and then will need to go to their office’s specific page to get their e-mail, phone, and mailing address.
https://www.house.gov/representatives/find-your-representative
Contact Both of Your Senators by phone, e-mail and/or mail? If you don’t know your Senators (contact both), you can look them up at the link below and then go to their office’s specific page to get their e-mail, phone, and mailing address.
https://www.senate.gov/senators/senators-contact.htm
Once you select your state your two senators should pop-up and there will be a hyperlink called Contact next to each Senator that will take you to their office’s page to make contact by e-mail, web-form, or phone.
Remember, the two problematic sections of the House Tax Bill are sections 138312 and 138314.
FAQs
1. What Should I tell my House Representative or my Senator?
Ask them to save your IRA and to oppose Sections 138312 and 138314 in the House Tax Bill as those provisions take away investment choices for your IRA. It is critical that you let them know the following.
- That you are their constituent. Give your address or leave your City and State so they know they represent you (e.g. I’m Sally Jones from Glendale, AZ).
- There is a misconception in Congress that self-directed IRAs are only something the wealthy do and that this only hurts the wealthy. It’s helpful to be straightforward about who you are and about the size of your account. They need to know that this bill is going to disproportionately hurt IRA savers with IRAs less than $1M. Here are some examples but it may help to put it into your own words and situation explaining how you’re not an ultra-wealthy person using their IRA to invest in hedge funds (that’s what they presume).
- I’m a working American with a $X IRA just trying to get to an account balance I can retire on. Sections 138312 and 138314 in the House Tax Bill will harm my IRA and my ability to grow a retirement account that I can retire and live on.
- I’m a pilot, nurse, retired firefighter, realtor, etc. (insert profession or job so Congress doesn’t think this is just CEOs, doctors, lawyers, and wealthy heirs), and I have diligently contributed to my retirement account. I choose to invest some of my IRA into real estate, small businesses, start-ups, and crowdfunding offerings. These provisions will force me to sale my assets prematurely for a loss or will force me to distribute them where I will be subject to taxes and penalties. Please oppose Sections 138312 and 138314 as they will cause drastic tax consequences for my IRA ,and they will take away future investment choices that are important to growing my account to an amount I can retire on.
- If you think the $10M cap is reasonable, say that so Congress doesn’t presume you’re an ultra-rich person with a $10M plus IRA (like some in Congress presume anyone opposing this bill is). We’re not opposing the $10M cap in our efforts as it effects very few account holders who self-direct.
2. This bill came from the Democrats in the House, Should I contract Republicans or Democrats?
Contract members of Congress from both parties in both the House and Senate. Since this is a democrat-controlled bill (they have majority in the house and senate), it is critical that you write and call your members who are democrats as they are the ones that will negotiate this bill in the end. Republicans have already come out in opposition to the bill in its entirety. It is still helpful to contact Republican members though as they may have a say or may have democratic colleagues who they can help understand this issue in a bipartisan way.
3. How Quickly is this Bill Moving and When Should I Write or Call my Representative or Senator?
You must reach out today. Right now. Take the time now to call, e-mail, and/or mail your Representative and Senator. This bill is being negotiated and voted on now. It could all be wrapped up in one to two weeks but if Congress doesn’t start hearing from self-directed IRA owners now, they won’t understand the issue and how it is going to affect their constituents.
4. What should I do if I am already invested into a LLC I manage without compensation or if I have invested into a private company, small business, private fund or crowdfund offering?
As the bill is currently written, you will be forced to distribute these assets (IRA/LLCs, private company or fund, small business, crowdfunding investment) within two years. We don’t want that to happen as we know it will cause losses, taxes, and penalties to distribute or sell these assets prematurely. The best thing to do is make your voice heard and contact your members of Congress and ask them to save your IRA and not take away investment choices from your IRA.
We are working to educate Congress on how these two sections will disproportionately harm IRA savers, 98% of whom have IRAs less than $1M, and 80% who have IRAs less than $300k. We need you to get engaged and the best method for Congress and their Staffs to understand a bills impact is to hear it from their constituents. This is moving fast, write your Senator or House member today.
5. What if I am looking to invest in a private company, small business, or crowdfunding offering, or use an IRA/LLC for a real estate deal?
You’ll want to seek our your own legal or tax advice but should consider the current bill and how it will affect your future investment options. If the bill passes you will have two years to sell, distribute, or change you investment structure to comply with the new law. We are working hard to get these two provisions out of the bill but won’t know until it is fully considered by the House and Senate.
The best thing you can do now is to write your Representative and Senator today to tell them to oppose Sections 138312 and 138314 so that you can have investment choices off wall street for your IRA.
6. Do you have any resources to share when writing or speaking to members of the House and Senate (and their staff)?
Yes, please see the resource below which is a quick summary of how the bill hurts IRA savers and the economy. We will be adding more resources and information as the bill develops.
Everyday IRA Savers Hurt by IRA Provisions
7. Will There be More Information Coming, How Do I Stay Up to Date?
My partner Mark J. Kohler and I will have a live broadcast this Thursday, Sept 23rd at 4 MTN. Sign-up for our newsletter (see sign up at bottom of page) or follow our social channels for updates and information.
8. Where Can I Read the Bill and the Summary from Congress?
House Tax Bill Summary From Ways and Means Committee (IRA Sections are138301 to 138315) House Ways and Means Tax Title Section-by-Section Explanation
House Bill Full Text House Ways and Means Neal Tax Bill
by Mat Sorensen | Apr 1, 2021 | Retirement & IRAs, Uncategorized
What is the last day to contribute to an IRA for 2020?
Taxpayers now have until May 17, 2021, to contribute to their Individual Retirement Accounts (IRAs), Health Savings Accounts (HSAs), and Coverdell Education Savings Accounts (ESAs), according to a statement by the IRS on Monday, March 29th. Any taxes due on 2020 distributions from IRAs or work-based retirement plans like 401(k)s are also due May 17th.
For those self-employed persons who are sole proprietors, the Solo 401(k) and SEP IRA contribution deadlines are also extended to May 17, 2021, for 2020 contributions.
What does this mean exactly?
It means that you have more time to make contributions to your IRAs, HSAs, and ESAs accounts for 2020. The regular deadline is always April 15th but was extended by the IRS along with other pandemic relief.
The period beginning on April 15, 2021, and ending on May 17, 2021, will be disregarded in the calculation of any interest, penalty, or addition to tax for failure to file the Federal income tax returns or to pay the Federal income taxes postponed by this notice. All penalties begin to accrue on May 18, 2021.
This also postpones the time for reporting and payment of the 10-percent additional tax on amounts includible in gross income from 2020 distributions from IRAs or 401(k)s.
When is the last day I can contribute to an IRA?
You now have until the May 17, 2021 tax deadline to contribute to an IRA, either Roth or Traditional, for the 2020 tax year. The maximum contribution amount for either type of IRA is $6,000, or $7,000 if you are age 50 or older.
Does the extension apply to Solo 401ks and SEP IRAs?
This extension also applies to Solo 401(k) and SEP IRA owners who are sole proprietors. It does not apply to Solo 401(k)s and SEP IRAs who are s-corps, LLC partnerships, or c-corps. However, these Solo(k) and SEP IRA owners can extend their 2020 contribution if they have filed an extension to their company return (the adopting employer of the plan). This requires the filing of an extension of the company tax return. For Solo(k) owners, please refer to 2020 Solo 401(k) Contribution Deadlines: Rules, Steps, and Strategies.
(Also on DirectedIRA.com)
by Mat Sorensen | Sep 11, 2020 | Retirement & IRAs, Uncategorized
Required Minimum Distributions (RMD) from IRAs can be a burden for taxpayers, by raising your annual income levels and possibly boosting you into a higher tax bracket. Using the Qualified Charitable Distribution (QCD) Rule, there is a way for IRA’s to do good. This rule allows IRA owners to exclude their RMDs from their annual income if given to a qualified charitable organization. Essentially, owners can deduct their RMDs on their tax returns if they give the money to a charity. A key benefit to the QCD is you pay zero tax on the distribution. That’s right, it’s a tax free distribution to a charity. You win, the charity wins, and the IRS loses.
Some of the rules and regulations are as follows:
- You MUST be age 70½ or older on the date of the distribution.
- The maximum annual exclusion per individual is $100,000.
- The charity must qualify as a 501(c)(3) organization and be eligible to receive tax-deductible contributions.
- Each check will be made payable to the qualified charity and list your name as donor. Note: You should follow up with the charity directly for a receipt of your donation.
To break it down further, the charitable organization must qualify as a 501(c)(3) organization, which means it is federally tax exempt as a non-profit organization. Of course the owner of the IRA can give a larger sum than $100,00 to the charity of their choosing, though any excess distributions will not be excluded from their Adjusted Gross Income (AGI). It is also very important to obtain a receipt from the selected charity for tax purposes.
Mat has been at the forefront of the self-directed IRA industry since 2006. He is the CEO of Directed IRA & Directed Trust Company where they handle all types of self-directed accounts (IRAs, Roth IRAs, HSAs, Coverdell ESA, Solo Ks, and Custodial Accounts) which are typically invested into real estate, private company/private equity, IRA/LLCs, notes, precious metals, and cryptocurrency. Mat is also a partner at KKOS Lawyers and serves clients nationwide from its Phoenix, AZ office.
He is published regularly on retirement, tax, and business topics, and is a VIP Contributor at Entrepreneur.com. Mat is the best-selling author of the most widely used book in the self-directed IRA industry, The Self-Directed IRA Handbook: An Authoritative Guide for Self-Directed Retirement Plan Investors and Their Advisors.
by Mat Sorensen | May 28, 2020 | Retirement & IRAs, Uncategorized
Roth IRAs can be established and funded for high-income earners by using what is known as the “back door” Roth IRA contribution method. Many high-income earners believe that they can’t contribute to a Roth IRA because they make too much money and/or because they participate in a company 401k plan. Fortunately, this thinking is wrong. While direct contributions to a Roth IRA are limited to taxpayers with income in excess of $137,000 ($206,000 for married taxpayers, 2020), those whose income exceeds these amounts may make annual contributions to a non-deductible traditional IRA and then convert those amounts over to a Roth IRA.
Examples
Here are a few examples of earners who can establish and fund a Roth IRA.
- I’m a high-income earner and work for a company that offers a company 401(k) plan. I contribute the maximum amount to that plan each year. Can I establish and fund a Roth IRA? Yes, even though you are high-income and even though you participate in a company 401(k) plan, you can establish and fund a Roth IRA.
- I’m self-employed and earn over $206,000 a year; can I have a Roth IRA? Isn’t my income too high? Yes, you can contribute to a Roth IRA despite having an income that exceeds the Roth IRA income contribution limits of $206,000 for married taxpayers and $137,000 for single taxpayers.
The Process
The strategy used by high-income earners to make Roth IRA contributions involves the making of non-deductible contributions to a traditional IRA and then converting those funds in the non-deductible traditional IRA to a Roth IRA. This is oftentimes referred to as a “back door” Roth IRA. In the end, you don’t get a tax deduction in the amounts contributed, but the funds are held in a Roth IRA and grow, then come out tax-free upon retirement (just like a Roth IRA). Here’s how it works.
Step 1: Fund a new non-deductible traditional IRA
This IRA is “non-deductible” because high-income earners who participate in a company retirement plan (or who have a spouse who does) can’t also make “deductible” contributions to an IRA. The account can, however, be funded by non-deductible amounts up to the IRA annual contribution amounts of $6,000. The non-deductible contributions mean you don’t get a tax deduction on the amounts contributed to the traditional IRA. You don’t have to worry about having non-deductible contributions as you’re converting to a Roth IRA, so you don’t want a deduction for the funds contributed. If you did get a deduction for the contribution, you’d have to pay taxes on the amounts later converted to Roth. You’ll need to file IRS form 8606 for the tax year in which you make non-deductible IRA contributions. The form can be found here.
If you’re a high-income earner and you don’t have a company-based retirement plan (or a spouse with one), then you simply establish a standard deductible traditional IRA, as there is no high-income contribution limitation on traditional IRAs when you don’t participate in a company plan.
Step 2: Convert the non-deductible traditional IRA funds to a Roth IRA
In 2010, the limitations on Roth IRA conversions, which previously restricted Roth IRA conversions for high-income earners, were removed. As a result, since 2010 all taxpayers are able to convert traditional IRA funds to Roth IRAs. It was in 2010 that this back door Roth IRA contribution strategy was first utilized, as it relied on the ability to convert funds from traditional to Roth. It has been used by thousands of Americans since.
If you have other existing traditional IRAs, then the tax treatment of your conversion to Roth becomes a little more complicated, as you must take into account those existing IRA funds when undertaking a conversion (including SEPs and SIMPLE IRAs). If the only IRA you have is the non-deductible IRA, then the conversion is easy because you convert the entire non-deductible IRA amount over to Roth with no tax on the conversion. Remember, you didn’t get a deduction into the non-deductible traditional IRA so there is not tax to apply on conversions. On the other hand, if you have an existing IRA with say $95,000 in it and you have $5,000 in non-deductible traditional IRA contributions in another account that you wish to convert to Roth, then the IRS requires you to covert over your IRA funds in equal parts deductible (the $95K bucket) and non-deductible amounts (the new $5K) based on the money you have in all traditional IRAs. So, if you wanted to convert $10,000, then you’d have to convert $9,500 (95%) of your deductible bucket, which portion of conversion is subject to tax, and $500 of your non-deductible bucket, which isn’t subject to tax once converted. Consequently, the “back door” Roth IRA isn’t well suited when you have existing traditional IRAs that contain deductible contributions and earnings from those sums.
There are two workarounds to this Roth IRA conversion problem and both revolve around moving the existing traditional IRA funds into a 401(k) or other employer-based plans. Employer plan funds are not considered when determining what portions of the traditional IRAs are subject to tax on conversion (the deductible AND the non-deductible). If you participate in an existing company 401(k) plan, then you may roll over your traditional IRA funds into that 401(k) plan. Most 401(k) plans allow for this rollover from IRA to 401(k) so long as you are still employed by that company. If you are self-employed, you may establish a solo or owner-only 401(k) plan and you can rollover your traditional IRA dollars into this 401(k). In the end though, if you can’t roll out existing traditional IRA funds into a 401(k), then the “back door” Roth IRA is going to cause some tax repercussions, as you also have to convert a portion of the existing traditional IRA funds, which will cause taxes upon conversion. Taxes on conversion aren’t “the end of the world” though as all of the money that comes out of that traditional IRA would be subject to tax at some point in time. The only issue is it causes a big tax bill initially, so careful planning must be taken.
The bottom line is that Roth IRAs can be established and funded by high-income earners. Don’t consider yourself “left out” on one of the greatest tax strategies offered to Americans: the Roth IRA.
Mat has been at the forefront of the self-directed IRA industry since 2006. He is the CEO of Directed IRA & Directed Trust Company where they handle all types of self-directed accounts (IRAs, Roth IRAs, HSAs, Coverdell ESA, Solo Ks, and Custodial Accounts) which are typically invested into real estate, private company/private equity, IRA/LLCs, notes, precious metals, and cryptocurrency. Mat is also a partner at KKOS Lawyers and serves clients nationwide from its Phoenix, AZ office.
He is published regularly on retirement, tax, and business topics, and is a VIP Contributor at Entrepreneur.com. Mat is the best-selling author of the most widely used book in the self-directed IRA industry, The Self-Directed IRA Handbook: An Authoritative Guide for Self-Directed Retirement Plan Investors and Their Advisors.
by Mat Sorensen | Apr 24, 2020 | Real Estate & Alternative Asset Investing , Retirement & IRAs
Roth conversions are popular in 2020. Many Americans are taking advantage of low account values (asset values are low from stocks to real estate) and are converting Traditional dollars and assets to Roth. Others are seeing themselves in lower tax brackets than usual and see it as an opportune time to convert to Roth and pay taxes at a lower tax bracket. If you have a traditional IRA or 401(k), then that money grows tax-deferred, BUT you pay tax on the money as it is drawn out at retirement. And that’s a big BUT. On the other hand, you get zero tax deduction on Roth IRA and Roth 401(k) contributions but they grow and come out tax-free at retirement. What’s better? Well, in the end the Roth account is a much better deal as you’re pulling out what you put in AND the growth of the account after years of investing and saving. That’s likely a larger amount than what you put in so you’d typically be better paying tax on what you put in (or convert) rather than paying tax on the the larger sum that you will take out later. The trade-off of course, is you’re playing the long game. You’re skipping a tax deduction or paying tax now to convert in return for tax-free growth and tax-free distributions at retirement. The Roth seems to be the better deal. Yet, most Americans have been sucked into traditional IRAs and 401(k)s because we get a tax deduction when we put the money in a traditional account, saving us money on taxes now.
For more on the differences between Roth IRA and Roth 401(k), take a look at the video from my Partner Mark J. Kohler:
The good news is that you can convert your traditional IRA to a Roth IRA, or your traditional 401(k) to a Roth 401(k). The price to make that conversion is including the amount you convert to Roth as taxable income for the year in which you make the conversion. So, if I convert $100K from my traditional IRA to a Roth IRA in 2020, I will take that $100K as income on my 2020 tax return, then pay any federal and state taxes on that income depending on my 2020 tax bracket. Many retirement account owners want to move their traditional funds to Roth, but don’t like the idea of paying additional taxes to do so. It can be a big tax hit when you do your taxes. I get it. Nobody likes paying more taxes now, even if it clearly saves you more as your account grows and the entire growth comes out tax-free.
Chunking Conversions
One way to soften the tax blow of the Roth conversion is to chunk the amount you want to convert over two or more years. For example, if you are at the end of the year in November 2018 and you want to convert $100K to Roth, you may decide to convert $50K by December 31, 2020 to have that taxed in the current year and then convert the remaining $50k on January 1, 2021 to have that amount taxed in 2021. This way, you don’t have as much of an income swing and it spreads the tax due over the two years. You could also do $33K each year to spread it out of 3 years.
The following are three cut-and-dry situations of when you should definitely convert your traditional IRA or 401(k) funds to Roth:
1. Up-Side Investment Opportunity – I’ve had numerous clients over the years convert their traditional funds to Roth before investing their account into a certain investment. They’ve done this because they’ve had a tremendous investment opportunity arise where they expect significant returns. They’d rather pay the tax on the smaller investment amounts now, so that the returns will go back into their Roth IRA or 401(k), where it can grow to an unlimited amount and come out tax-free. These clients have invested in real estate deals, start-ups, pre-IPOs, and other potentially lucrative investments. So, if you have an investment that you really believe in and will likely result in significant returns, then you’re far better off paying a little tax on the amount being invested before the account grows and returns a large profit. That way, the profit goes back into the Roth and the money becomes tax-free.
2. Low-Income Year – Another situation where you should covert traditional funds to Roth is when you have a low-income tax-year. Since the pain of the conversion is that you have to pay tax on the amount that you convert, you should convert when you are in a lower tax bracket to lessen the blow. For example, if you are married and have $75K of taxable income for the year and you decide to convert $50K to Roth, you will pay federal tax on that converted amount at a rate of 15% which would result in $7,500 in federal taxes. Keep in mind that you also pay state tax on the amount that you convert (if your state has state income tax), and most states have stepped brackets where you pay tax at a lower rate when you have lower income. If you instead converted when you were in a high-income year, let’s say $250K of income, then you’d pay federal tax on a $50K conversion at a rate of 33% which would result in federal taxes of $16,500. That’s more than twice the taxes due when you are in a lower-income year. Now, you may not have taxable income fluctuations. But, for those who are self-employed, change jobs and have a loss of income, or have investment losses where taxable income is lower than normal for a year, you should think about converting your retirement funds to Roth. You may not have a more affordable time to make the Roth conversion.
3.Potential Need for a Distribution After Five Years – One of the perks of Roth accounts is that you can take out the funds that are contributed or converted after five years without paying tax or the early withdrawal penalty (even if you aren’t 59 1/2). For Roth conversions, the amount you convert can be distributed from the Roth account five years after the tax year in which you converted. The five-year clock starts to tick on January 1st of the tax year in which you convert, regardless of when you convert within the year. So, if you converted your traditional IRA to a Roth IRA in November 2020, then you could take a distribution of the amounts converted without paying tax or penalty on January 2nd, 2025. If you try to access funds in your traditional IRA or 401(k) before you are 59 1/2, then you will pay tax and a 10% early withdrawal penalty even if the amounts you distribute are only the contributions you put in, not the investment gains. Clearly, the Roth account is much more accessible in the event you need personal funds. Keep in mind, you don’t get this perk immediately: You have to wait 5 years from the tax year in which you converted before you can take out the converted amount tax and penalty free.
One final thought to consider when converting to a Roth is that there are no do-overs. You used to be able to do what was called a Roth re-characterization where you could undo a Roth conversion but the ability to undo a Roth conversion was eliminated in 2018 forward. As a result, make sure you’re committed before you convert as there are no mulligans, do-overs, or re-characterizations anymore. Also, if you want the conversion to fall onto your current year tax return, then make sure you convert those sums by December 31.
Mat has been at the forefront of the self-directed IRA industry since 2006. He is the CEO of Directed IRA & Directed Trust Company where they handle all types of self-directed accounts (IRAs, Roth IRAs, HSAs, Coverdell ESA, Solo Ks, and Custodial Accounts) which are typically invested into real estate, private company/private equity, IRA/LLCs, notes, precious metals, and cryptocurrency. Mat is also a partner at KKOS Lawyers and serves clients nationwide from its Phoenix, AZ office.
He is published regularly on retirement, tax, and business topics, and is a VIP Contributor at Entrepreneur.com. Mat is the best-selling author of the most widely used book in the self-directed IRA industry, The Self-Directed IRA Handbook: An Authoritative Guide for Self-Directed Retirement Plan Investors and Their Advisors.
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