Avoid Unavoidable Tax Hikes with Roth Conversions

Feb 10, 2015 at 03:55 pm by Staff

Convert highly taxed IRAs into tax-free Roth’s

High income and high net-worth taxpayers should know the benefits of converting highly taxed IRAs to Roth IRAs with tax-free income, but why have so few done so? Probably because investors and their advisors do not understand Roth conversion taxation, or when to take advantage of IRS rules. The IRS specifically allows Roth Conversions with tax-saving of up to 66 percent compared to traditional Roth-Conversions. This tax savings is also reflected in reduced estate-tax and reduced Medicare Part B Premium.

The “Substantially Discounted Roth-Conversion” was recently presented the at the Florida Bar Tax-Section’s annual conference. The basis of this income-tax and estate-tax savings technique has been written in tax code since 1959. This will be presented at the Tax-Section Continuing Legal Education (CLE) teleconference in March, 2015.

Why Roth Conversion?


Tax Deferred Growth Tax Free Growth

Income - Taxed in Highest Bracket Tax-Free Income

Forced Required Distributions (RMD) No Withdrawals Required

Fully Taxable for Estate Tax (Death Tax) Estate Tax Reduction of up to 66 percent, or more

Increased Medicare Part B Tax Decreased Medicare Part B Tax

Have you converted your highly taxed IRA to a Roth? Probably not - because you believe the income-tax on converting would be confiscatory, right? Well, it depends on the investments in your IRA, or investments you may want to consider which could allow your IRA to be converted with up to a 66 percent, or more reduction in income-tax and the estate-tax attributed to your IRA or Roth.

Roth-Conversions make sense:

Traditional IRA income is taxable at the highest tax rates, while Roth income is tax-free.

Traditional IRAs do not grow tax-free; they are tax-deferred meaning you pay more tax later, while Roth’s grow truly tax-free.

Traditional IRAs are subject to required minimum distributions (RMDs) forcing taxpayers to take withdrawals in higher tax brackets whether they need the income or not. Roth’s do not require RMDs, allowing a greater growth.

Traditional IRA income increases Medicare Part B premiums by increasing the MAGI (Modified Adjusted Gross Income). Tax-free Roth income reduces Medicare Part B.

The IRS specifically allows conversion of highly taxed IRAs to Roth-IRAs with tax savings of up to 66 percent.

There is NO Maximum Income Limitation to convert to a Roth.

You Think Income Taxes are going up?

The more income-tax rates rise, the greater the benefit with tax-free Roth income.

Maximum Federal income-tax brackets have soared from 28 percent in the 1990’s to 44 percent - over 52 percent in a few states, as a result, many taxpayers retire into the highest tax-bracket.

Income-taxes are expected to increase substantially just to cover our burgeoning Federal Debt, ObamaCare, Social Security and other Entitlement Programs.

Experts suggest that we could see income taxes in the 70 percent to 80 percent range (again). In the 1960’s the Federal income-tax peaked at 91 percent, on taxable income of only $200,000.

“The Federal debt could double, forcing huge increases in your taxes,” said David M. Walker, past U.S. Comptroller General and head of the GAO.

“U.S. debt held by the public is on an unsustainable path,” according to the Government Accountability Office.

A Better Option -The “Substantially Discounted Roth-Conversion”

IRS Revenue Ruling 59-60 (and others) requires a Fair Market Valuation (FMV) for IRA RMDs, Roth-Conversions and at the death of the IRA owner. This ruling specifically allows certain assets to be valued with substantial discount from the investment price. The FMV dictates the actual taxable value of the IRA for income and estate-tax purposes.

FMV Discount Means Tax-Savings.

Many of our IRA clients converting at the end of 2014 received FMV discounts in excess of 75 percent meaning they only paid tax on about 25 percent of the converted IRA value.

FMV Roth-Conversion Case Study #1

A well-known local attorney converted his $800,000 IRA to an income-tax free Roth with a 91 percent discount in conversion-tax because of IRS Fair Market Valuation (FMV) rules. This reduction in Fair Market Value DOES NOT reduce income on the $800,000. The FMV is only for tax purposes and dictates the taxable amount on a Roth-Conversion. In this case, the taxpayer only pays tax on the FMV of $70,000, not the $800,000. This was a very unique case; however there may be thousands of taxpayers with very similar situations.

It is possible with advanced planning to create this situation and tax-break for many taxpayers.

FMV Roth-Conversion Case Study #2

An IRA owner, in a 52 percent tax-bracket, investing $100,000 in an Oil & Gas Program would have received a FMV discount of a little over 75 percent, making the taxable value for a Roth-Conversion only about $25,000, instead of $100,000. The tax on converting his IRA to a tax-free Roth would be only $13,000 (52 percent on the FMV of $25,000) compared to income–tax of $52,000 a traditional conversion (52 percent on $100,000). The tax-savings of about 75 percent could be a big deal to high-income taxpayers, especially with larger IRAs. On a $1,000,000 Roth Conversion this FMV conversion would have saved over $390,000 in income-tax.

With a combination of various alternative investments even multi-million dollar IRAs, may be converted to Roth’s with income-tax and estate-tax savings of up to 75 percent, or more.

Real Estate Investment Trusts, or REITs, are popular investments both in and out of IRAs, corporate and municipal pension plans and Endowments. We’ve seen many REITs receive FMV discounts of 40 percent, or more. If this REIT were in a $100,000 IRA it could be valued at about $60,000. If this IRA were converted to a Roth the taxpayer would pay tax on $60,000 instead of $100,000. This FMV Roth Conversion could reduce income-tax by $17,600 (44 percent income tax rate on the $40,000 discount).

The World Runs on Oil

With the lowest oil prices in five-years this may be the best time to invest in oil & energy. Even with the recent drop, oil prices have outpaced the S&P 500 almost five-fold since January 1999.

If you wonder why you’ve not heard about Oil and Energy IRA’s and Substantially Discounted Roth-Conversions it could be because only a small percentage of financial advisors are licensed and approved to offer Oil & Gas Programs, Alternative Assets and tax-shelter programs best suited for large tax-savings made possible with the Substantially Discounted Roth-Conversion.

Oil & Gas Programs offer tax-benefits and potentially high income while receiving FMV discounts of up to 75 percent. If a taxpayer converted a $1,000,000 IRA owning these programs, they may expect to pay conversion tax on only $250,000 instead $1,000,000, a $390,000 tax savings compared to a traditional Roth Conversion.

A few Oil & Gas Programs are designed specifically for IRAs, and do not generate UBTI and do not have the risk of general partnerships.

With use of other popular tax-shelter programs the conversion income-tax may be completely eliminated.

Proper use of IRS Fair Market Value Rules in Roth Conversions may save taxpayers a significant amount in income-tax during his/her lifetime, with a substantial amount of estate-tax savings at death - leaving more to family and favorite charities.

In most cases high net-worth taxpayers have never included their IRAs in estate-planning. The “Substantially Discounted Roth-Conversion” is an excellent way to reduce estate-tax attributed to IRAs by up to 75 percent.

For high net-worth taxpayers who will never need IRA income this Roth Conversion combined with specially designed, tax-free life insurance can be a great way to not only eliminate Required Distributions, but by converting to Roth and setting up a tax-elimination trust which removes assets from the grantors taxable estate, then using tax-free Roth income to fund the trust, at death this trust could mature to 3 to 6 times the value of the IRA when it is paid to the taxpayers family or favorite charities complely tax-fee.

It’s a tax break on a tax-break – like double tax-free.

Scott L. Olson is president of Atlantic Financial Advisors, LLC, and is a Registered Investment Advisor. With 36 years’ experience in Financial and Estate-Planning, Wealth Preservation and Wealth Transfer, Scott has been a popular speaker across the U.S. to groups of Attorneys, CPAs, Financial and Estate Planning professionals. He provides Continuing Education courses to Attorneys, and CPAs. Scott’s expertise includes, not just Roth-Conversion, but tax-free, or “Substantially Discounted Roth-Conversion©” and the Annuity Arbitrage, a tax-favored income and estate-tax free wealth transfer technique. He can be reached at scott@atlanticfinancialadvisors.com

This information is for educational purposes only and NOT an offer to sell any security or insurance product and is NOT an endorsement of any specific Alternative Asset.

Securities offered through Financial West Group (FWG) - member FINRA/SIPC. Atlantic Financial Advisors, LLC, Registered Investment Advisor not FWG affiliated.

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