Protecting Your IRA – Part 3: Saving Big on a Roth Conversion
When you withdraw the money, the deductible contributions you made to a traditional IRA and the income that's been earned inside the IRA will be taxed, as ordinary income. But there is an alternative that you can elect. New rules (effective starting in 2010) make that alternative available to everyone with a traditional IRA.
Rather than waiting to be taxed at retirement, you can convert all or part of your traditional IRA to a Roth IRA. If you do, you pay tax now on the value of what you convert (minus any non-deductible contributions you've made). But when you start withdrawing money from your Roth (at age 59½ or later), it comes out to you tax free.
So your choice with an ordinary IRA is (i) pay the full tax now on a Roth conversion or (ii) pay the full tax later, when you withdraw money from your traditional IRA.
If you do a little arithmetic, you'll find that converting to a Roth is the winning strategy if you are going to be paying tax at a higher tax rate later than you are paying now. Many investors expect that their tax rate will be going up simply because they expect higher tax rates in general. If that's the case, then bare calculation advises converting to a Roth now.
A sensible approach. But it based on an assumption of higher rates, and reasonable as that assumption is, it is still a maybe.
Cut the Cost of a Roth Conversion
An Open Opportunity IRA can remove any doubt that a Roth conversion is the smart way to go. It settles the question by cutting a third or so off the tax cost of making the conversion now. The Open Opportunity structure replaces the choice of "pay full tax now or pay full tax later" with "pay 65% or less of full tax now or pay 100% of full tax later." That's a big improvement.
An Open Opportunity IRA uses a structure that is extraordinarily powerful and flexible and that provides a cornucopia of advantages. The structure is beautifully simple. Instead of holding a laundry list of investments, the IRA owns just one – a limited liability company (LLC) that you manage. This puts you in charge, with your hands on the LLC's checkbook. Your IRA is no longer limited to passive investments; you, as Manager of the LLC your IRA owns, can make it an active investor. You can run your IRA more like a business and exploit your skills and energy.
You also get to decide on the rights and powers that come with each share in the LLC, and that positions you to save a bundle on converting from a traditional IRA to a Roth.
It's All About Fair Market Value
The income tax bill for a Roth conversion is based on the "fair market value" of the property that is moving from the traditional IRA to the Roth. With the Open Opportunity structure, you can cut the fair market value of that asset (shares in the LLC) by borrowing on the lessons learned by specialists in estate planning over the last 30 years. They've produced a body of clear rules about "fair market value," and when you convert a traditional IRA with an Open Opportunity structure to a Roth, those rules can work strongly in your favor.
Here's what every estate planner knows and what you can use to cut the tax cost of a Roth conversion.
Gift and estate tax is levied on the fair market value of the property that is given or bequeathed. Fair market value means the price that a knowledgeable buyer and a knowledgeable seller would agree upon. In the case of shares in an LLC, fair market value may be much less than the assets inside the LLC.
A now common technique for reducing gift and estate tax is to place assets in a limited liability company and then make a gift of a less-than-controlling interest in the LLC. Because the interest has no participation in management of the company, and because there's no ready resale market for the interest and because the LLC's manager may delay distributions to the owners for as long as he pleases, the fair market value of the shares being transferred is much less – 35% to 50% less – than the value per share of the assets inside the LLC. In other words, when gift or estate tax is levied, the shares in the LLC gets a valuation discount of 35% to 50%.
With an Open Opportunity IRA, you can benefit in a big way from that concept. Suppose that you move $300,000 in cash and stocks from a traditional IRA with the ordinary structure to a traditional IRA that follows the Open Opportunity structure. By properly setting the rights and powers that come with each share in the LLC, you can reduce the fair market value of those shares to just $200,000. If you then convert to a Roth, your tax bill will be based on $200,000 of income, not $300,000. You'd save thousands in taxes (you'd save $40,000 if you're in a 40% Federal and state tax bracket).
Should you convert your traditional IRA to a Roth? If you are going to be using the Open Opportunity structure, the answer is an emphatic YES.
I'd be overstating things if I said that an Open Opportunity is a bottomless well of advantages. But you would need to dig long and hard and pay close attention to what you turn up before you would find them all.
In Part IV, "Your Own Personal Tax Haven," I'll show you how the Open Opportunity structure can let you run your IRA even more like a business, so that the rewards for your efforts flow to your IRA's very friendly tax environment.
(If you missed the earlier Parts of Protecting Your IRA, you can find them starting at Protecting Your IRA – Part 1: The Danger.)
Editor's Note: The story on the Open Opportunity IRA (Part III of Terry Coxon's editorial appears in this issue) keeps getting better. Why wouldn't you convert a traditional IRA to a Roth if there is a way to cut the tax bill by a third? To learn more about the Open Opportunity concept and how can turn a Roth conversion into an easy decision, we recommend you that buy and read Unleash Your IRA. This carefully prepared report explains all that you can accomplish with your IRA when you adopt the Open Opportunity structure, including a tax-efficient Roth conversion. The report is available only online. You can find details at Unleash Your IRA. The cost of the report is tiny compared to what most IRA owners can save on a Roth conversion.
Posted by Drm on 08/01/10 03:03 PM
I asked Certified Financial Planner Michael Kitces, director of research at Pinnacle Advisory Group in Columbia, Md., if this was a scam. He says no. But the strategy Coxon describes, while possible, is "very aggressive," Kitces told me via e-mail.
"The IRS has been fighting many of these types of valuation discounts VERY hard in the estate tax world, and would likely fight them here as well," Kitces says. The upshot: The discount may be disqualified by the IRS, or you just may end up losing money defending your position.
Kitces says the discounting strategy is iffy when the LLC is owned by 1) the IRA and 2) the IRA owner. In his words:
"The discounting for the LLC occurs typically through multiple owners. So you create an LLC. Your IRA owns 49 percent of it. You personally own 51 percent of the LLC. Now your IRA owns a minority share. You can also put restrictions on the salability of the LLC and the transferability of the LLC. The combination of minority non-controlling interest, with restrictions on salability and transferability, reduces its value. ... 'Ideally,' an unrelated third party would own the majority controlling share; of course, most people don't like that in the real world, because then they REALLY CAN'T CONTROL how the LLC is invested. The reflection of those fears -- when they're really applicable -- is WHY there are such minority discounts. The unfortunate reality is that many taxpayers try to have their cake and eat it too -- get the discount for minority and lack of control, but not 'really' give up control -- and that's where the problems tend to arise."
Here's what I get out of it: The open opportunity IRA sounds like an open invitation to get into trouble with the IRS.
Posted by John Wheeler on 07/30/10 07:03 PM
Is this "book" you are offering for about $100 simply an "e-book" (text by e-mail), stappled pages or a legitamate hard-bound printed pages.
How about telling prospective customers number of pages, size (8" x 10" or 3" x 4"), font or text size, pictures or graphs? Would you expect your average customer to be a computer artist? Reply please.
Posted by Michael S Harrell on 07/30/10 12:32 PM
Terry, I would like to point out that I believe timing is very important if one is making a standard conversion. I invest in Precious Metal Junior Canadian traded stocks and I watch the trading price very carefully before I convert a stock over to my ROTH. I wait till the MM or shorters drive the price down and then I make the conversion. This method has saved me a good deal of taxes since the cost is a 'snap shot' at the time of transfer.
I would never just do a lump sum transfer from my IRA to my ROTH.
Posted by Paul Bertan on 07/30/10 10:45 AM
Will the IRA to ROTH conversions be allowed in 2011 and with permission to pay taxes over two years ??
paulbertan@Click to view link