|As we face an ailing U.S. economy bombarded by the subprime crisis, the rising cost of oil and the products that depend on it, and an expensive, ill-advised war, there is the opportunity for investors to profit from long-term gains at the expense of current economic problems. However, in the context of these current economic conditions, IRA holders can look toward the future and can take advantage of a change to the tax law that takes affect in 2010.
In 2010, regardless of your income, you can convert your traditional IRA assets to Roth IRA assets. Under the current law, you cannot convert a traditional IRA to a Roth if your adjusted gross income (AGI) exceeds $100,000. If any of your assets are currently undervalued, 2010 could be a great opportunity to convert your funds. The assets will be taxed based on their fair market value as of December 31, 2010, and you also have the option of paying your tax bill over two years. You can pay the tax with cash outside of the IRA, which preserves your IRA assets. After the tax is paid, your earnings will never be taxed again.
Roth IRAs offer the added benefit that there are no required distributions. Unlike a traditional IRA, which requires that you begin taking minimum distributions starting at age 70½, with a Roth, you can let your assets sit and continue to grow. In a time when people work longer, you can amass wealth in a non-taxed environment for as long as you want.
Because you can convert as much or as little of your IRA as you want, you can choose to convert only the assets that have a current low value but that you anticipate having more value in the future. For example, if your self-directed IRA has real property that has been decreasing in value in today’s market but you expect a turnaround, that asset may be ideal to convert at the current fair market value.
|Fair Market Value
|Neither the Internal Revenue Code nor IRS regulations provide a general definition of fair market value for income tax purposes. The IRS regulations, however, use the following definition in connection with specific income tax issues as well as for estate and gift taxes:“The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.”
This is the definition adopted for purposes of valuing charitable contributions of property,pension plan assets,and real property interests disposed of by nonresident aliens and foreign corporations.The courts have also followed this definition when addressing tax issues.
You must determine the fair market value before converting your traditional, pre-taxed assets to Roth, post-taxed assets. This value is used to compute the federal tax, and possibly state tax, that you owe. The best way to establish the fair market value is through a qualified appraiser. The appraiser must have an arms-length relationship with the taxpayer and the asset. The IRS might also accept a recent bona fide offer from a third party who is not considered disqualified under IRS regulations involving IRAs and qualified retirement plans.
Debt-financed assets, such as real estate, must be valued at net asset value. This means that the fair market value subtracts the amount of debt remaining after the date of the appraisal or valuation. Private placements should be assessed by persons or firms qualified to make such appraisals. Cash, stocks and bonds, and publicly traded assets use the established values on the date required for valuation.
|Plan Ahead to Minimize Tax and Maximize Gain
|The object is to pay as little tax as is legally required and to pay the tax with non-IRA funds, thus preserving the funds that are never be taxed again. If you can, convert as much as possible, concentrating on assets that have the highest potential of future appreciation or income within your time horizon.Tax planning with a professional is always a good idea, but especially so in 2010 if you want to take full advantage of the new law. The amount you convert is added to your income for 2010, and your tax is calculated on your total adjusted gross income. So in 2010, it behooves you to have as little income as possible and plenty of losses. You can also spread the tax burden and pay part in 2011 and 2012.
After you have converted the asset, you can withdraw all or part of it at any time without paying federal taxes if you are at least 59½ years old. However, you may owe state tax. States differ on how assets in IRAs are taxed, and you should make sure that your have adhered to your state’s tax requirements.
The biggest question you have to think about is how well is your crystal ball working; how well can you and your tax advisors foretell your economic and tax-paying future?
Clearly, the more flexibility that you have and the more time that you have will give you more opportunity for appreciation and improve the possibility of the conversion paying for itself. But if past history and inflationary pressures are any indication, if , for example, your real estate investment is valued at 35% less than when your IRA purchased it, the increase in value over time should not only make up the 35% but even more. So converting now at its lowest fair market value may be a wise investment.
|Doing The Numbers
|It can be daunting to figure out the tax implications when taking inflation and cost of living indicators into account. If your property is in a traditional IRA, when you take distributions, which remember are required, you pay tax on that property at your ordinary income tax rate. Some pundits suggest that your tax rate will be lower when you are older and retire. This may be, but tax rates have hardly decreased over time.Just to take a simple case, let’s say your property has a fair market value of $100,000 today. If the property appreciates as a result of inflation by 2.5% annually over 20 years, the fair market value will be $163,000. You will be paying tax on an asset valued at least 63% higher just due to inflation. Paying tax in 20 years at 35% leaves you with a property worth about $106,000, without taking into consideration any gain as a result of appreciation.
Your cost of living may also increase at a nominal annual rate of 3.5%, based on current rates. That means you have to make up the difference between the fair market value of the property and what your real cost of living is on the amount that you need to live on, or $199,000. In this scenario, you need the property to appreciate to at least $306,000. Tax on $306,000 is $107,000, leaving you with the $199,000 that you need to just break even with the original fair market value. So in this case, you hope for either better appreciation or lower taxes.
The income on the property also plays a big role over time. Let’s say that your property has a 7% net operating income annually. Over 20 years, that equals about $314,000. You also invest the income in money markets that make 4%, adding another $15,000. So when you add your $329,000 in income over 20 years to the fair market value of $306,000, you end up with an IRA worth $635,000! Tax on a distribution of $635,000 at the rate of 35% is about $222,000, leaving you with $413,000, a little more than twice as much than the IRA had in real dollar terms.
If you had paid the tax with money outside the IRA in 2010, you would pay $35,000 (35%) on the $100,000 fair market value. Taking into account how much you could have made on the tax you paid in 2010 over 20 years-we’re using 14.8% compounded annually, which totals about $553,000-and adding that to the $413,000 in the above scenario, your IRA is valued at nearly $628,000 ($996,000 taxed at 35%) rather than $635,000. But that money does not get taxed on distribution. You end up with $628,000 and not $413,000.
| Is It Worth It?
|In summary, if you pay tax in 2010 on a low cost basis, the outcome in the long term can be substantially better if your assets earn a good return and they appreciate in value. If you expect very high appreciation and income, converting to a Roth IRA in 2010 could be profitable. Most importantly, do the numbers with the advice and input of competent accounting and tax professionals. And you also need to think about paying taxes 20 years from now. In our example, the tax bite is $338,000 in 20 years, not $35,000 in 2010. Keep in mind that you can spread the tax over two years. If you plan now, you can possibly minimize your tax burden by managing your income and losses. But who knows, the value of dollar may be relatively the same and render the question moot.