Tag Archives: Partial Contribution

Self-Directed Roth IRA, Self-Directed Traditional IRAs

Do Roth Conversions Make Sense? How to Analyze the 2010 Roth Conversion Opportunity

By: H. Quincy Long           

            How would you like to have tax free income when you retire?  Would you like to have the ability to leave a legacy of tax free income to your heirs when you die?  The great news is that there is a way to achieve these goals – it is through a Roth IRA.

            Historically, because of income limits for contributions to a Roth IRA and for converting a Traditional IRA into a Roth IRA, high income earners have not been able to utilize this incredible wealth building tool.  Fortunately, the conversion rules are changing so that almost anyone, regardless of their income level, can have a Roth IRA.  But is it really worth converting your Traditional IRA into a Roth IRA and paying taxes on the amount of your conversion if you are in a high tax bracket?  For me, the answer is a resounding yes.  I firmly believe it is worth the pain of conversion for the tremendous benefits of a large Roth IRA, especially given the flexibility of investing through a self-directed IRA.

            For Traditional to Roth IRA conversions in tax year 2009, the Modified Adjusted Gross Income (MAGI) limit for converting to a Roth IRA is $100,000, whether you are single or married filing jointly.  However, the Tax Increase Prevention and Reconciliation Act (TIPRA) removed the $100,000 MAGI limit for converting to a Roth IRA for tax years after 2009.  This means that beginning in 2010 virtually anyone who either has a Traditional IRA or a former employer’s retirement plan or who is eligible to contribute to a Traditional IRA will be entitled to convert that pre-tax account into a Roth IRA, regardless of income level.

            Even better, for conversions done in tax year 2010 only you are given the choice of paying all of the taxes in tax year 2010 or dividing the conversion income into tax years 2011 and 2012.  If you convert on January 2, 2010, you would not have to finish paying the taxes on your conversion until you filed your 2012 tax return in 2013 – more than 3 years after you converted your Traditional IRA!  One consideration in deciding whether to pay taxes on the conversion in 2010 or dividing the conversion income into 2011 and 2012 is that 2010 is the last tax year in which the tax rates are at a maximum of 35%.  Tax rates are scheduled to return to a maximum tax rate of 39.6% in 2011, and other tax brackets are scheduled to increase as well, so delaying the payment of taxes on the conversion will cost you some additional taxes in 2011 and 2012.  The benefit of delaying payment of the taxes is that you have longer to invest the money before the taxes need to be paid, whether the payment comes from the Roth IRA or from funds outside of the Roth IRA.

            The analysis of whether or not to convert your Traditional IRA to a Roth IRA is a complex one for most people, because it depends so much on your personal tax situation and your assumptions about what might happen in the future to your income and to tax rates, as well as how you invest your money.  From my own personal perspective, I make the simple assumption that tax free income in retirement is better than taxable income.  I can afford to pay my taxes now (not that I like it), and I would like to worry less about taxes when I retire.  I also don’t believe that tax rates will be going down in the future.  For me, the decision comes down to whether I want to pay taxes on the “acorn” (my Traditional IRA balance now) or the “oak tree” (my much higher IRA balance years in the future as I make withdrawals). 

            The way I analyze whether or not to convert to a Roth IRA is to calculate my “recovery period” – that is, the time it takes before my overall wealth recovers from the additional taxes I have to pay on the conversion.  If I can recover the cost of the taxes on the conversion before I might need the money in the Roth IRA, then I say it is worth doing, especially since the gains after the conversion are tax free forever.  Fortunately, with a self-directed IRA you are in total control of your investments, and the recovery period can be quite short.  There may also be a benefit if you are able to convert an asset now that may have a substantial increase in value later.

            Using my own situation as an example, I have been planning on doing a conversion in 2010 ever since the passage of TIPRA was announced in 2006.  My first step was to immediately begin making non-deductible Traditional IRA contributions.  Even though I am covered by a 401(k) plan at my company and earn more than the limits for making a deductible Traditional IRA contribution, this does not prevent me from making a non-deductible contribution since I am under age 70 ½.  The main reason I have been making non-deductible contributions to my Traditional IRA is to have more money to convert into a Roth IRA in 2010.  The best thing about this plan is that only the gains I make on the non-deductible contributions to the Traditional IRA will be taxed when I convert to a Roth IRA, since I have already paid taxes on that amount by not taking the deduction.

            I plan on converting approximately $100,000 in pre-tax Traditional IRA money in 2010.  The actual amount converted will be more like $150,000, but as I noted above my wife and I have been making non-deductible contributions to our Traditional IRAs since 2006, so the actual amount we pay taxes on will be less than the total conversion amount.  This means that my tax bill on the conversion will be $35,000 if I pay it all in tax year 2010 or $39,600 divided evenly between tax years 2011 and 2012, assuming I remain in the same tax bracket and Congress doesn’t make other changes to the tax code.

            To help analyze the conversion, I made some calculations of how long it would take me to recover the money I had to pay out in taxes at various rates of return, assuming a taxable conversion of $100,000 and a tax bite of $35,000.  I calculated my recovery period based on paying the taxes with funds outside of the IRA (which is my preference) and by paying taxes from funds withdrawn from the Roth IRA, including the early withdrawal penalty I would have to pay since I am under age 59 ½. 

            If I pay taxes with funds outside of my Roth IRA and can achieve a 12% return compounded monthly, my Roth IRA will grow to $135,000 in only 30 months, at which point I will have fully recovered the cost of the conversion.  A 6% yield on my investments will cause my recovery period to stretch to 60 months, while an 18% yield will result in a recovery period of only 20 months!  Of course paying taxes with funds outside of the IRA reduces my ability to invest that money in other assets for current income or to spend it on living expenses.  But if I have to withdraw the money from the Roth IRA to pay taxes and the early withdrawal penalty, the recovery period for my Roth IRA to achieve a $39,000 increase ($35,000 in taxes and a $3,900 premature distribution penalty) increases to 50 months at a 12% yield and 99 months for a 6% yield.  Paying the taxes from funds outside of my Roth IRA will result in a much larger account in the future also since the full $100,000 can be invested if taxes are paid with outside funds, while only $61,000 remains in the Roth IRA after withdrawal of sufficient funds to pay the taxes and penalties.

            I believe that since my IRAs are all self-directed I can easily recover the cost of the conversion (i.e. the taxes paid) in less than 3 years based on my investment strategy.  From that point forward I am building tax free wealth for me and my heirs.  How can I recover the taxes so quickly?  It’s easy!  Self-directed IRAs can invest in all types of non-traditional investments, including real estate, notes (both secured and unsecured), options, LLCs, limited partnerships and non-publicly traded stock in C corporations.  With a self-directed IRA you can take control of your retirement assets and invest in what you know best.

            In my retirement plan I invest in a lot of real estate secured notes, mostly at 12% interest with anywhere from 2-6% up front in points and fees.  I also own some stock in a 2 year old start up bank in Houston, Texas which is doing very well, and a small amount of stock in a Colorado bank.  As the notes mature I plan on purchasing real estate with my accounts, because I believe now is the best time to buy.  In some cases I may purchase the real estate itself and in other cases I will probably just purchase an option on real estate.  The bank stock will be converted at the market price in 2010, but when the banks sell in a few years I expect to receive a substantial boost in my retirement savings since banks most often sell at a multiple of their book value.  In the meantime, the notes and the real estate will produce cash flow for the IRA, and if I have done my investing correctly the real estate will also result in a substantial increase in my Roth IRA when it sells in a few years.

            Note that I have written this article from the perspective of someone who is in a high tax bracket.  A lower tax bracket will reduce the recovery period and is an even better bargain, especially if you can afford to pay the taxes from funds outside of the Roth IRA.  If you take advantage of the opportunities afforded to you by investing in non-traditional assets with your self-directed Roth IRA, you can truly retire wealthy with a pot of tax free gold at the end of the rainbow.

            H. Quincy Long is Certified IRA Services Professional (CISP) and an attorney and is President of Quest IRA, Inc., with offices in Houston, Austin,  and Dallas, Texas. In addition to Texas, Qunicy has opened an office in Mason, MI this year in December of  2011 and is planning to open an office in Seattle, Washington within the next 12 months.  He may be reached by email at Quincy@QuestIRA.com Nothing in this article is intended as tax, legal or investment advice.

Health Savings Accounts, Self-Directed Roth IRA, Self-Directed Traditional IRAs

How to Pay for Education Expenses With Tax-Free Dollars

Many people are under the mistaken impression that a Roth IRA is the only type of self-directed account from which tax free distributions can be taken.  However, distributions from Health Savings Accounts (HSAs) and Coverdell Education Savings Accounts (ESAs) can be tax free if they are for qualified expenses.  In this article we will discuss the benefits of the Coverdell Education Savings Account and, more importantly, what investments you can make with a self-directed ESA.
Contributions.  Contributions to a Coverdell ESA may be made until the designated beneficiary reaches age 18, unless the beneficiary is a special needs beneficiary.  The maximum contribution is $2,000 per year per beneficiary (no matter how many different contributors or accounts) and may be made until the contributor’s tax filing deadline, not including extensions (for individuals, generally April 15 of the following year).  The contribution is not tax deductible, but distributions can be tax free, as discussed below.  Contributions may be made to both a Coverdell ESA and a Qualified Tuition Program (a 529 plan) in the same year for the same beneficiary without penalty.
To make a full contribution to a Coverdell ESA, the contributor must have Modified Adjusted Gross Income (MAGI) of less than $95,000 for a single individual or $190,000 for a married couple filing jointly.  Partial contributions may be made with MAGI as high as $110,000 for an individual and $220,000 for a married couple filing jointly.  Since there is no limit on who can contribute to a Coverdell ESA, if your MAGI is too high consider making a gift to an individual whose income is less than the limits, and they can make the contribution.  Organizations can make contributions to a Coverdell ESA without any limitation on income.

Tax Free Distributions.  The good news is that distributions from a Coverdell ESA for “qualified education expenses” are tax free.  Qualified education expenses are broadly defined and include qualified elementary and secondary education expenses (K-12) as well as qualified higher education expenses.

Qualified elementary and secondary education expenses can include tuition, fees, books, supplies, equipment, academic tutoring and special needs services for special needs beneficiaries.  If required or provided by the school, it can also include room and board, uniforms, transportation and supplementary items and services, including extended day programs.  Even the purchase of computer technology, equipment or internet access and related services are included if they are to be used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in elementary or secondary school.

Qualified higher education expenses include required expenses for tuition, fees, books, supplies and equipment and special needs services.  If the beneficiary is enrolled at least half-time, some room and board may qualify for tax free reimbursement.  Most interestingly, a Qualified Tuition Program (a 529 plan) can be considered a qualified education expense.  If you believe that contributing to a 529 plan is a good deal, then contributing that money with pre-tax dollars is a great deal!

One thing to be aware of is that the money must be distributed by the time the beneficiary reaches age 30.  If not previously distributed for qualified education expenses, distributions from the account may be both taxable and subject to a 10% additional tax.  Fortunately, if it looks like the money will not be used up or if the child does not attend an eligible educational institution, the money may be rolled over to a member of the beneficiary’s family who is under age 30.  For this purpose, the beneficiary’s family includes, among others, the beneficiary’s spouse, children, parents, brothers or sisters, aunts or uncles, and even first cousins.

Investment Opportunities.  Many people question why a Coverdell ESA is so beneficial when so little can be contributed to it.  For one thing, the gift of education is a major improvement over typical gifts given by relatives to children.  Over a long period of time, investing a Coverdell ESA in mutual funds or similar investments will certainly help towards paying for the beneficiary’s education.  However, clearly the best way to pay for your child’s education is through a self-directed Coverdell ESA.

With a self-directed Coverdell ESA, you choose your ESA’s investments.  Common investment choices for self-directed accounts of all types include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, limited liability companies, limited partnerships, trusts and much more.

With the small contribution limits for Coverdell ESAs, you might wonder how these investments can be made.  Often these accounts are combined with other self-directed accounts, including Traditional, Roth, SEP and SIMPLE IRAs, Health Savings Accounts (HSAs) and Individual 401(k) plans, to make a single investment.  For example, I combined my daughters’ Coverdell ESAs with our Roth IRAs to fund a hard money loan with 2 points up front and 12% interest per year.

One client supercharged his daughter’s Coverdell ESA by placing a burned down house under contract in the ESA.  The contract price was for $5,500 and the earnest money deposit was $100.  Since the ESA was the buyer on the contract, the earnest money came from that account.  After depositing the contract with the title company, the client located another investor who specialized in rehabbing burned out houses.  The new investor agreed to pay $14,000 for the property.  At closing approximately one month later, the ESA received a check for $8,500 on its $100 investment.  That is an astounding 8,400% return in only one month!  How many people have done that well in the stock market or with a mutual fund?

But the story gets even better.  Shortly after closing, the client took a TAX FREE distribution of $3,315 to pay for his 10 year old daughter’s private school tuition.  Later that same year he took an additional $4,000 distribution.  Assuming a marginal tax rate of 28%, this means that the client saved more than $2,048 in taxes.  In effect, this is the same thing as achieving a 28% discount on his daughter’s private school tuition which he had to pay anyway!

The Coverdell ESA may be analogized to a Roth IRA, but for qualified education expenses only, in that you receive no tax deduction for contributing the money but qualified distributions are tax free forever.  Investing through a Coverdell ESA can significantly reduce the effective cost of your child or grandchild’s education.  As education costs continue to skyrocket, using the Coverdell ESA as part of your overall investment strategy can be a wise move.  With a self-directed ESA (or a self-directed IRA, 401(k) or HSA for that matter), you don’t have to “think outside the box” when it comes to your ESA’s investments.  You just have to realize that the investment box is much larger than you think!

H. Quincy Long is a Certified IRA Services Professional (CISP) and an attorney.  He is also President of Quest IRA, Inc., with offices in Houston Dallas, Texas.  He may be reached by email at Quincy@QuestIRA.com .  Nothing in this article is intended as tax, legal or investment advice.