Roth IRA Conversions At A Discount

Roth IRA Conversions At A Discount

The stock and bond markets are off to a rough start in 2022. The odds are that your portfolio has taken a haircut since the beginning of the year, particularly for investors with a passive buy-and-hold strategy. While watching your portfolio drop in value may be painful, the recent pullback may have a silver lining. A Roth IRA conversion strategy can be an effective lifetime tax minimization plan. 

When your IRA account declines, it can be your opportunity to implement a Roth conversion strategy and incur fewer taxes than you would have before the market correction. If you have already started a Roth conversion strategy, lower account values can be an opportunity to accelerate phases of your plan.

START WITH THE BASICS

When you contributed to your traditional IRA or 401(k), you likely did so with pre-tax dollars, which reduced your taxable income in the years you made the contributions. Contributing to your Retirement plan with pre-tax dollars is a powerful incentive for you to save a portion of your income for your retirement years.  

Additionally, your IRA account grows tax-deferred, meaning you won’t pay taxes on the growth until you withdraw funds from your account, typically in your retirement years.

BENEFITS OF ROTH IRA ACCOUNTS

While reducing taxes in the years you make the contributions, traditional IRA’s and 401(k)’s can increase your tax bill later in life when you withdraw funds from your account. Not only are your initial contributions taxed, but so is all the growth accumulated over the years.  

Even if you don’t need to withdraw funds from your traditional IRA for living needs, tax laws require you to start. Required Minimum Distributions at age 72. Afterward, you will pay taxes on the required distributions every year for the rest of your life. 

On the other hand, you fund Roth IRA and 401(k) accounts with after-tax dollars, meaning that you pay taxes in the year that you make your contribution or convert from a traditional to a Roth account. However, Roth accounts provide potentially significant benefits later in life.

For one, when you withdraw funds from Roth accounts in retirement, the withdrawals are tax-free. Not only can you withdraw your initial contributions or conversion dollars tax-free, but also years of potential investment gains.   

Another benefit of Roth accounts is that tax laws do not require you to withdraw funds at age 72. You can continue to invest the funds for many more years, continuing the tax-free benefits for your and your spouse’s needs later in life.

Finally, if your heirs inherit Roth accounts, they can withdraw funds tax-free. Meanwhile, if they inherit traditional IRAs, they will have to pay taxes at ordinary income rates on withdrawn funds. Even if leaving a legacy is not your highest priority, a portion of your IRA is likely to pass to the next generation, making Roth accounts a highly tax-efficient way to transfer your wealth.

SO WHY DOES THE DECLINING MARKET HAVE A SILVER LINING?

When your IRA account declines with the market, it can be your opportunity to implement a Roth conversion strategy and incur fewer taxes than you would have before the market correction. 

HOW DOES IT WORK?

At the beginning of the year, let’s assume your traditional IRA account was valued at $1 million. Further, suppose that you plan to convert $200,000 each year to a Roth account, so all of your traditional IRA is converted in the next five years. 

If your lifetime tax plan includes a Roth conversion component, you may want to consider implementing a portion when stocks and bonds are at depressed levels. If, for example, your IRA account dropped to $800,000, you can accomplish the same goal in the next four years by converting the same $200,000 annually.

Another reason many are considering Roth conversions today is the tax environment. While no one can know what will happen to tax rates, the current tax law, the Tax Cuts and Jobs Act of 2017 (TCJA), lowered rates for most families.

Unfortunately, TCJA is only temporary. Tax rates are scheduled to revert to 2017 levels beginning in 2026. Performing Roth conversions today at lower tax rates can significantly reduce your taxable income later in life when rates are designed to increase.

BEFORE JUMPING INTO A ROTH CONVERSION STRATEGY

You should have a well-thought-out lifetime tax minimization plan. It is difficult to determine if Roth conversions make sense for your situation unless you do some reasonably sophisticated analysis, typically using specialized software. 

Roth conversion strategies can significantly affect your lifetime tax minimisation plan. Executing conversions when portfolio values are depressed can mean significant tax savings. 

Are your plans appropriate in the current market, economic, and tax environment? Consider seeking a second opinion from a wealth manager with tax planning expertise to refine your Roth conversion or lifetime tax minimization plan. 

By: John Hollahan

DISCLOSURE & ACKNOWLEDGEMENT

To be an “accredited investor,” an individual must have had earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years and “reasonably expects the same for the current year.” Or, the individual must have a net worth of more than $1 million, either alone or together with a spouse, excluding one’s primary residence

The information included in this material is for informational purposes only and should not be relied upon for any financial or legal purposes. Arlington Capital Management Inc, dba Arlington Wealth Management (AWM) is an investment adviser registered with the U.S. Securities and Exchange Commission.  Our registration with the SEC or with any state securities authority does not imply a certain level of skill or training, nor are we selling you any product.  Rather, we are seeking to provide you with advisory services.   Please consult with your own tax and legal advisers before investing. AWM cannot and does not guarantee the performance of any investment.  Past performance is no guarantee of future results.

Comparing 1031 Exchanges vs. Qualified Opportunity Funds

While both strategies can help real estate investors reduce taxes, there are several differences between a 1031 Exchange and a Qualified Opportunity Fund that you should understand before investing in either method.

100 YEARS OF 1031 EXCHANGE

The 1031 Like-Kind Exchange, also known as 1031 Exchange, has been around for quite some time. Since its inception in 1921, it has become one of the most popular tax strategies used by taxpayers when relinquishing their real estate property. For generations, investors have used 1031 Like-Kind Exchanges to swap investment properties and defer taxable gains.

However, there is now a relatively new option that defers or even potentially eliminates a portion of capital gains for real estate investors. Created under the Tax Cuts and Jobs Act of 2017, the Qualified Opportunity Fund, or QOF, provides taxpayers an alternative way to postpone and eliminate certain taxable gains.

In addition, it allows individuals to invest their capital gains in real estate or business development projects within designated communities known as Qualified Opportunity Zones. Both strategies can be great tools for investors, but there are differences between the two. Let’s go over some of these differences that you should know before investing in either one of these options.

WHAT ASSETS ARE ELIGIBLE FOR EACH STRATEGY?

Only real estate held for investment purposes can qualify for a 1031 Exchange. Personal property is excluded because this specific asset class is not eligible for the exchange written in a set of rules determined by the Internal Revenue Service.

On the other hand, Qualified Opportunity Funds allow for potential capital gain tax deferral on a broader range of eligible assets, including stocks, bonds, real estate, collectibles, partnerships, and private business interests.

Essentially any investment whose sale would result in a taxable capital gain can qualify for a Qualified Opportunity Fund. It is important to note that for both strategies, only the profits accumulated from the disposition of the listed assets are eligible to receive the respective tax benefits of the 1031 Exchanges and investments in Qualified Opportunity Funds.

HOW ARE PRINCIPAL AND GAINS HANDLED?

1031 Exchanges require investors to swap both the principal (cost basis) and the gains accumulated. A Qualified Opportunity Fund only requires the gains to be transferred. The principal is not required to be rolled into the fund. This has the potential to free up assets and can be beneficial to those who need liquidity.

For example, suppose you sell an eligible asset worth $1 million with a $200,000 cost basis.  In this case, a 1031 exchange requires you to transfer the $1 million sale proceeds into a like-kind property to avoid all taxable gains in a 1031 exchange (you can exchange less, but you will have to pay capital gain taxes on the portion you withdraw).  However, you are only required to move the $800,000 gain into a Qualified Opportunity Fund to avoid a taxable gain.  The $200,000 cost basis can be withdrawn tax-free. 

WHAT ARE THE ELIGIBLE INVESTMENTS FOR EACH STRATEGY?

Sellers can swap into any qualifying investment property in a 1031 Exchange, meaning the replacement property does not have to be from the same asset class, adding diversity to your investments. Once again, this excludes personal property for the same reason as stated with eligible assets. In the case of QOF, individuals are investing in a Qualified Opportunity Zone or QOZ.

The IRS defines an opportunity zone as an “economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatments.” Generally, individuals invest in a pooled set of commercial real estate funds, housing, infrastructure, and businesses within a QOZ. The primary purpose is to spur economic development and job creation within the distressed community.

WHAT IS THE RULE ON REPLACEMENT PROPERTY?

To complete a 1031 Exchange, real estate investors must follow a specified time frame to purchase the replacement properties. You have 45 days to identify a replacement property after you sell the original investment property. Once identified, you must close on that property within 180 days of the sale. The rule on replacement property for a Qualified Opportunity Zone is different. You do not have to identify the replacement property; however, you must reinvest the capital gain in a QOF within 180 days.

WHAT HAPPENS WITH CAPITAL GAINS TAX?

1031 Exchanges provide tax deferral, not forgiveness. You defer the taxable gain until you sell the replacement property. You can eventually eliminate the capital gain if you continue to perform 1031 Exchanges up to the time you die. Your heirs receive a step-up in the cost basis to the date of your death, eliminating the capital gain tax.

With a Qualified Opportunity Fund, there are a few moving parts. First, you can defer the capital gain tax until you sell the Qualified Opportunity Fund or until December 31, 2026, whichever occurs first.  There is no limit on the number of gains that you can defer in this manner.

Qualified Opportunity Funds also have the potential to reduce capital gains through a step-up in cost basis. If you invest in a Qualified Opportunity Fund before December 31, 2021, and hold until 2026 you can receive a 10% step-up in your original cost basis.

Finally, Qualified Opportunity Funds provide you an opportunity to eliminate any additional capital gains on the new investment.  Specifically, if you hold the Qualified Opportunity Fund for at least ten years, you will not pay any capital gain on the new investment, regardless of the potential profit size.

While both strategies can help reduce your taxes, there are several differences between a 1031 Exchange and a Qualified Opportunity Fund that you should understand before investing in either method. An elite wealth manager who understands the unique needs of real estate investors and what you want to accomplish moving forward can help lead you in the right direction.

DISCLOSURE & ACKNOWLEDGEMENT

The information included in this material is for informational purposes only and should not be relied upon for any financial or legal purposes. Arlington Capital Management Inc, dba Arlington Wealth Management (AWM) is an investment adviser registered with the U.S. Securities and Exchange Commission.  Our registration with the SEC or with any state securities authority does not imply a certain level of skill or training, nor are we selling you any product.  Rather, we are seeking to provide you with advisory services.   Please consult with your own tax and legal advisers before investing. AWM cannot and does not guarantee the performance of any investment.  Past performance is no guarantee of future results.