D. Scott Kenik is the Founder and Principal of Wealth Concepts Group, LLC.
Roth conversions are one of the most powerful financial planning tools available. While they’re not right for everyone, for many investors, a Roth conversion can unlock huge tax savings.
There are lots of benefits to Roth conversions. For example:
• You lock in today’s tax rates and pay the taxes before rates increase.
• The withdrawals are tax-free in retirement.
• Roth conversions eliminate Required Minimum Distributions.
• Your beneficiaries receive their inheritance tax-free, and they can continue to grow their inheritance tax-free for up to 10 years.
• All eight retirement taxes—federal income tax, state income tax, fee/commission “tax,” Medicare/IRMMA tax, Social Security tax, two widow’s penalties, and beneficiary tax—can be significantly reduced or eliminated forever with a Roth conversion.
Analysis Matters
Of course, a Roth conversion may not be right for everyone. Everyone’s financial situation is different. Account values, living expenses and income needs vary, and each can affect the benefits of a Roth conversion.
For that reason, a detailed Roth conversion analysis is vital. A properly prepared analysis compares the cost and financial benefits of doing a Roth conversion versus the cost of not doing a conversion. This way, you can see the value that it will have for you and determine if it is a good option for your financial situation.
Case Study: Roger And June
Let’s take a quick look at a case study for Roger and June.
Roger is 64 and June is 63. They have a $1.3 million IRA. Roger’s monthly Social Security is $3,800, and June’s is $2,600. They have a pension that pays $24,000 per year and interest and dividend income totaling $15,000 per year.
A proper analysis looks at their assets and income and calculates the cost of doing a Roth conversion and compares it to the cost of not converting out to age 90. In their case, it would cost them approximately $480,000 to do a single-year conversion, and $397,000 to do a multiyear conversion. Their savings would be over $1 million.
The downside of a Roth conversion is the tax cost; Roger and June would have to pay $480,040 or $396,438, depending on how they structured the conversion. The amount that they convert becomes taxable income, and they will pay ordinary income tax on the conversion amount.
The cost of conversion depends on your tax bracket; large conversions in higher tax brackets can be very expensive.
A Strategy To Reduce Roth Conversion Taxes
There is a little-known strategy that incorporates an LLC into a self-directed IRA that can reduce the tax cost of Roth conversions by 35%.
The process starts with a self-directed IRA that holds money in cash and investments. Let’s use $1 million for this example.
An LLC is then put into that IRA. It’s just a shell of an LLC—no assets, no business activity, just a shell. The client is the manager of the LLC and the signer on the LLC’s empty bank account. They have complete access and discretion over the investing activities of the LLC, following the rules that apply to all IRAs.
Now, the million dollars in cash and investments gets moved into the LLC. At this point, the only asset in the IRA is the LLC. The million dollars is in the LLC, but it’s invisible to the IRA itself.
To do the Roth conversion, the custodian will ask for a valuation of the LLC. The custodian sees that the only asset in the IRA is the LLC, and the custodian has no idea what the LLC is worth. The valuation of the LLC is the key to the Roth conversion tax reduction.
The operating agreement for the LLC contains restrictions on certain activities of the LLC that make the LLC worth less. The LLC restrictions that are put into place relate to matters of corporate governance—like how you can add or remove a member, under what circumstances you can sell or liquidate the LLC, etc. The restrictions will not impede the ability to invest, access or control the money; they only affect the LLC’s valuation.
Those restrictions qualify the LLC for certain IRS-recognized valuation discounts. These discounts are then applied to the Roth conversion, which results in a discount on the tax. This is how the Roth conversion tax is reduced by 35%.
After receiving the LLC valuation, the custodian then completes the recharacterization of the traditional IRA to Roth, and the custodian sends a 1099 for $650,000 at the end of the year instead of $1,000. This reduces the conversion tax by at least the same 35%—and perhaps more based on your other taxable income.
Not just any lawyer or CPA is qualified to do this, as many have never heard of it. Be sure to work with professionals who are educated and experienced in this strategy.
A Tool For Everyone
This is just one of the tax reduction strategies that very wealthy people use, and it is just as effective on all levels of IRA amounts and income.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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