The Advantages of a Self-Directed Roth IRA

Individuals who are actively saving and planning for their own retirements have a number of account choices available to them. Many of us have access to 401(k) plans at work (or possibly traditional pension plans), and every taxpayer with earned income can start their own individual retirement account (“IRA”).

Most people are at least somewhat familiar with the IRA vehicle, but might not know much about the different account structures and options that are available. For example, there are traditional self-directed IRAs and Roth self-directed IRAs. Unfortunately, when it comes to deciding what type of account is most suitable for them, many retirement savers focus only on the contribution differences between the two accounts; namely that contributions to traditional IRAs are sometimes tax deductible, whereas contributions to Roth IRAs are never tax-deductible.

Here is a brief summary of some of the most important advantages that a self-directed Roth IRA as over a traditional account.

No Taxes on Distributions with self-directed Roth IRAs

Interestingly, one of the most significant advantages of a self-directed Roth IRA is the complement of one of the things that lead some investors to initially become more interested in Traditional IRAs. Earnings within a Roth IRA are never taxed, even when they’re withdrawn from your account, and this is the consequence of the fact that Roth contributions are never tax-deductible when they’re made.

Over the twenty or thirty years that many retirement savers have their self-directed IRAs, most of their account balances will be comprised of investment earnings (and earnings on those earnings) rather than contributions. In the long run, the aggregate tax benefit of having tax-free withdrawals is likely to exceed the benefit of having tax-deductible contributions.

No Required Minimum Distributions with a Self-Directed Roth IRA

Traditional IRAs are subject to certain rules regarding required minimum distributions. In essence, these rules provide that once the holder of the IRA reaches age 70½, they must begin taking distributions from their account. It’s important to note that these minimum distributions are required, regardless of whether the account holder wants or needs to remove those funds from their account, and failure to do so will cause the account holder to incur financial penalties.

Roth IRAs are not subject to these distribution rules. This means that if the account holder has other adequate sources of retirement income, they can continue to let their Roth IRA grow on a tax-free basis.

Flexible Estate Planning with Self-Directed Roth IRAs

Self-directed Roth IRAs provide you with another way to reach your estate planning goals. In fact, if you name your spouse as the beneficiary of your self-directed Roth IRA, then they’ll be able to easily convert the account into their own self-directed Roth IRA, and take advantage of all the benefits that go along with the account. In some cases this can allow for account assets to grow for additional decades on a tax-free basis.

If you’re interested in learning more about what a self-directed Roth IRA can help you achieve, contact Quest Trust Company today.

Quest Trust Company helps change people’s lives and financial future through self-directed IRA investment education. Quest Trust Company helps people invest in what they know best and build their financial future on their own terms.

Roth or Traditional: Strategies for Converting Your Traditional Self-Directed IRA into a Roth Account

Regardless of whether you currently have a Roth or traditional self-directed IRA, you’re benefitting from one of the most valuable retirement savings tools. The combination of long term growth that’s free from yearly taxation, the potential for tax deductible contributions to the account, and the investment freedom that a self-directed IRA custodian such as Quest Trust Company can provide you.

But for many individuals debating Roth or Traditional, the Roth self-directed IRA is a preferable structure. Arguably the only advantage that a Traditional IRA has over a Roth IRA is that contributions to the traditional IRA can sometimes be deductible in the year they’re made. In contrast, with a Roth IRA your investment earnings will grow on a tax free basis (rather than a tax deferred basis as with a traditional IRA), you won’t be subject to the rules on required minimum distributions, and you’ll have greater options for using your account to achieve your estate planning goals.

Fortunately, it’s not necessary for all of the funds in your Roth self-directed IRA to come from direct contributions. The IRS permits you to convert any funds you have in a traditional IRA account to a Roth IRA, provided that you pay taxes on the fair market value of the traditional IRAs being converted.

Roth or Traditional: Timing Your Conversion. The biggest downside of an IRA conversion is the current year tax bill that you’ll be faced with. If possible, you’ll want to time your conversion so that your tax burden is as light as possible. For example, if your adjusted gross income varies significantly from year to year (as is the case with sales professionals), then you could benefit from timing your conversions so that they occur during years when your tax rate is comparatively low. However, you must also consider that the longer you wait to make the conversion, the larger the balance in your Traditional IRA can grow – and thus the bigger tax bill you’ll face.

Roth or Traditional: Paying Your Tax Bill. Because a conversion will cause you to owe additional taxes on the amount of the conversion, you’ll need to have a source of funds to pay that bill. Avoid taking an early withdrawal of money from your account in order to pay the tax bill, as this amount will incur a 10% penalty and taxes on that amount itself, as well as reduce the amount in your account. The best strategy is to plan ahead for the tax bill and to save money to cover the additional financial obligation.

Roth or Traditional: Selective Conversion. One of the potential downsides in converting a self-directed IRA to a Roth IRA is the possibility of paying taxes on the fair market value of your account assets at the time of conversion, but having them decline in value. Recharacterization (basically returning your Roth account back to a traditional IRA) can solve this, but the recharacterization can only be done with respect to what you converted in the first place, so if you convert your entire account then you’d need to recharacterize the entire account to undo the conversion. A better strategy may be to convert different asset classes or type from your Traditional IRA to separate Roth IRAs, so that you can selectively recharacterize your conversions later if you need to.

Even though the conversion process is relatively straightforward, it’s important not to inadvertently make the process more expensive for yourself than it needs to be.

Quest Trust Company helps change people’s lives and financial future through self-directed IRA investment education. Quest Trust Company helps people invest in what they know best and build their financial future on their own terms.

Traditional or Roth – Which type of self-directed IRA is for you

Traditional or Roth – this is a question every investor asks at least once in his life. Most investors ask this question several times over the course of the lifetime – traditional or Roth -which type of investment is the best? Figuring out whether a traditional or Roth IRA structure is best suited to your goals and needs is fundamental to your retirement. Here are some tips for how to decide whether a traditional or Roth IRA is best for you.

Tax Rates – Current vs. Future. A significant factor in your decision between a traditional or Roth IRA will certainly be your current income tax rate, in relation to what you expect that rate to be during your retirement. Contributions to a traditional IRA are sometimes tax deductible in the year you make them (more on that later), while contributions to a Roth IRA are never tax-deductible. Conversely, withdrawals from a Roth IRA are tax-free, while withdrawals from a traditional IRA are subject to current year income tax. In general, the more your current income tax rate exceeds your expected rate during retirement, the more advantageous it may be to choose a traditional IRA

When making this determination, it’s important to note that if you are also covered by a retirement plan (such as a 401(k)) at work, and your income exceeds a certain level, then you will not be eligible to take the above mentioned current year deduction for a traditional IRA – and in such case a Roth IRA will likely be preferable.

Other Retirement Savings and Assets. Another deciding factor between traditional or Roth IRAs is determining the aggregate retirement savings you have in other non-IRA accounts. The longer you can wait before withdrawing money from your IRA, the longer it will have to grow, and a longer time frame generally favors the Roth IRA structure.

Required Minimum Distributions. In addition, Roth IRAs are not subject to the rules on required minimum distributions (RMDs). With a traditional IRA, once you reach age 70½, you need to begin withdrawing a specified percentage of your account value each and every year. Individuals with Roth IRAs and who have other retirement assets to draw upon can allow their IRAs to grow significantly larger because they don’t have to take RMDs.

Estate Planning. Estate planning can play a huge role in your decision of choosing a traditional or Roth IRA. It’s important to note that the rules on RMDs can flow down to certain heirs of your IRA after you pass away. If you anticipate your IRA being a significant portion of your estate, then you may wish to investigate whether the additional flexibility that comes with a Roth IRA can better help you meet your estate planning goals.

Conversion. If you decide that a Roth IRA is a better fit for your situation, but your account is currently set up as a traditional IRA, don’t worry. You are permitted to convert your account from a traditional IRA to a Roth IRA, provided that you pay taxes on the amount of the conversion. Even if that tax bill is sizable, conversion could still be the best financial decision for you.


Quest Trust Company helps change people’s lives and financial future through self-directed IRA investment education. Quest Trust Company helps people invest in what they know best and build their financial future on their own terms.

Should I convert to Roth in 2013? Roth conversion 2013 facts to help you make a decision

When you first set up an individual retirement account, you’ll be faced with a number of different choices to make, long before you ever have to be concerned with whether you should convert to Roth. First you’ll need to decide whether to open your new account with a traditional IRA custodian, or a self-directed IRA custodian such as Quest Trust Company. Choosing a self-directed IRA will give you the greatest investment flexibility.

You’ll also need to decide on the type of account – a traditional IRA form or a Roth IRA. While many of the basics features for each account are similar, there are some important differences between the two. Traditional IRAs have the advantage that contributions are sometimes tax deductible in the year they’re made. On the other hand, withdrawals from Roth IRAs are completely tax free (unlike traditional IRAs), and Roth accounts are not subject to the rules on required minimum distributions. For many retirement savers, a Roth IRA is a better long term solution to their needs.

Unfortunately, some people only come to this conclusion after they’ve already opened and grown one or more traditional IRAs. Fortunately, it’s possible to convert to Roth from a traditional IRA. The process is very straightforward, although the account owner will be responsible for paying a current year tax (based on their income tax rate) on the amount of the conversion.

Here are some Roth conversion 2013 tips for deciding whether or not this is the year you convert your to Roth from your traditional IRA.

How do your current tax rates compare to your expected future rates? Generally speaking, if you anticipate that your tax rates during retirement will be higher than your current tax rates, then a Roth account is preferable, and perhaps you should convert to Roth. Paying taxes now at a lower rate to avoid paying taxes later at a higher rate (and, in fact, to avoid paying taxes at all on withdrawals from a Roth IRA) can save you significant amounts of money.

Are the rules on required minimum distributions likely to affect you? Be sure to take into account the effect that required minimum distributions (“RMDs”) may have on your overall retirement plan. The IRS rules on RMDs state that an owner of a traditional IRA must begin taking certain minimum withdrawals from their account once they reach age 70½. If you have other sources of retirement income besides your IRA, and would prefer to let the money in your IRA continue to grow on a tax-preferred basis, then you may want to convert to Roth.

What’s Your Expected Rate of Return? Finally, your investment returns on your IRA may influence your decision. If your expected rate of return is high, then the value of having a Roth IRA and never having to pay taxes on investment earnings can be significant.

Deciding whether it’s appropriate to convert to Roth from your traditional IRA should be done every year. For example, if your income varies significantly from year to year, then you may want to target a relatively low-income year as one in which a conversion may be appropriate.

Quest Trust Company helps change people’s lives and financial future through self-directed IRA investment education. Quest Trust Company helps people invest in what they know best and build their financial future on their own terms.

How to Stretch a Roth IRA to Last More Than 150 Years

I have a philosophy, which is that if you can create win-win situations you should always do so. My daughter, Briana, is 12 years old and has been invited to travel to Europe next summer to be a Student Ambassador through the People to People program ( One of the requirements I am making for Briana to go is that she must raise one-half of the finds for the trip. Since Briana needs funds for her trip, and my company, Quest Trust Company, Inc. needed help stuffing envelopes to send out our quarterly statements, Briana came to work for us to help stuff envelopes. This earned her money for her trip and at the same time reduced my taxable income – a definite win-win scenario.

You may be asking, “What does this have to do with IRAs?” As her father and as a professional in the area of self-directed IRAs, of course it immediately struck me that Briana now has earned income and is therefore eligible for a Roth IRA, even at age 12. This got me thinking about how long a Roth IRA could last under a certain set of circumstances.

The original owner of a Roth IRA never has to take distributions from that Roth IRA. Briana can therefore accumulate funds in her Roth IRA for her entire life without ever having to take a distribution. This is one of the benefits of a Roth IRA over a traditional IRA. With a traditional IRA distributions must begin no later than April 1 of the year following the year the IRA owner reaches age 70 1/2. When she dies, Briana can leave the Roth IRA to anyone she wants (although she may need her spouse’s consent in certain circumstances if she lives in a community property state). An IRA inherited by someone is sometimes referred to as a “Beneficiary IRA” or a “Stretch IRA,” especially if the person is very young.

Unlike Briana, who never has to take distributions during her lifetime, if a non-spouse beneficiary inherits her Roth IRA they must take required minimum distributions (RMDs) based on the beneficiary’s life expectancy as determined by the IRS. The good news is that if Briana has had a Roth IRA for at least 5 tax years when she dies, required minimum distributions from the inherited Stretch Roth IRA to the beneficiary who inherits the account will be tax free, even if they are under age 59 1/2 at the time of the distributions.

So how might this work out in Briana’s situation? Let’s assume Briana makes exactly $1,000 in earned income for tax year 2008. Roth IRA contributions can be made based on the amount of her earned income (her investment income, if any, doesn’t count), up to a maximum of $5,000 for people under age 50 by the end of the year for 2008. In Briana’s case, since she earned less than the $5,000 contribution limit, she can only contribute $1,000.

If we assume that Briana will live to age 87, and she never makes another contribution to that Roth IRA, the value of the Roth IRA upon her death (75 years from the start of the Roth IRA) would be as follows:

Initial Contribution     Annualized Yield        Result After 75 Years

$1,000                                 6%                  $         89,013.00

$1,000                                12%                 $    7,748,834.00

$1,000                                18%                 $659,839,065.00

For purposes of our discussion, I will assume an annualized yield of 12%. Some may argue that this isn’t realistic, but in fact at Quest we see much higher yields in self-directed IRAs than just 12%. For example, my Mom’s self-directed IRA has achieved a yield of more than 13% per year over the last couple of years by simply doing hard money lending (but that is the topic of a different article). If your calculator holds enough numbers, multiply the appropriate amount from the above chart times 5 or 6 for a full single year contribution depending on the age of the contributor (ie. $5,000 for those under age 50, and $6,000 for those age 50 or older). Of course the results on the chart above do not even account for continuous contributions during Briana’s lifetime, which she will almost certainly make based on the financial education she is going to get from me!

If Briana has a daughter at age 31 (although how she is going to have a child before she’s ever allowed to date I’m not sure), and her daughter delivers her granddaughter at age 31, who in turn gives birth to her great granddaughter at age 31, Briana will be age 81 when her great granddaughter is born (we’ll call her Samantha). If Briana updates her beneficiary designation to leave Samantha her huge Roth IRA, Samantha will be age 6 when Briana dies at age 87. By December 31 of the following year, when Samantha is age 7, required minimum distributions must begin from the inherited Stretch Roth IRA.

To calculate Samantha’s required minimum distributions, her life expectancy must be determined from the IRS Single Life Expectancy Table (Table 1 in the back of IRS Publication 590). Once the appropriate Life Expectancy Factor is found on the table, Samantha must take the value of the account as of December 31 of the prior year and divide it by the factor. For a beneficiary who must begin distributions from an inherited IRA at age 7 the Life Expectancy Factor from the IRS table is 75.8. Samantha’s first year distribution is calculated as follows:

Prior Year End Balance ($7,748,834)

Life Expectancy Factor (75.8) = Required Minimum Distribution ($102,227.36)

In subsequent years the factor is reduced by 1, and in each year the balance on December 31 of the prior year is divided by the new factor (ie. the Life Expectancy Factor is 74.8 in year 2, 73.8 in year 3, etc.). Since the original Life Expectancy Factor was 75.8, after a total of 76 years the inherited Stretch Roth IRA must be completely distributed, either to Samantha or to Samantha’s heirs if she doesn’t live that long.

The best part is that Samantha is not required to just let the money sit there earning nothing for the 76 years of required minimum distributions. As long as there is sufficient funds in the account to meet the annual required minimum distributions, the account can continue to be invested in real estate, notes, private company stock and limited partnerships, among many other choices, so that it continues to grow. In Samantha’s inherited Stretch Roth IRA, for example, during the first year of distributions if the account earns a 12% annualized yield, the income will be $929,860, while Samantha’s required minimum distribution would only be $102,227, resulting in an increase in the account balance of $827,633.

The following chart shows how powerful an inherited Stretch Roth IRA of just $100,000 can be if distributed over a long period of time:

Starting Principal        Beginning Life Expectancy Factor     Yield   Total Distributions

$100,000.00                                     75.8                               6%     $       2,033,743

$100,000.00                                     75.8                             12%    $     80,496,367

$100,000.00                                     75.8                             18%    $3,420,454,810

If an annualized yield of 12% can be maintained for the entire life of Briana and Samantha so that the beginning balance of Samantha’s inherited Stretch Roth IRA is $7,748,834.00, total distributions from the account for Samantha and her heirs would be a staggering $6,237,497,033 – and under current law it is all TAX FREE! This is obviously an incredible estate planning tool. A lifetime of tax free income is quite a gift to leave to your heirs.

It should be noted that I have ignored for the purposes of this article the estate tax and generation skipping tax issues in order to illustrate the power of an inherited Stretch Roth IRA. No one can predict what tax law changes will take place over the next 75 years, or what the estate tax and generation skipping tax limitations will be if they continue to exist for that long. However, you should never avoid estate and tax planning simply because the law might change. We can only plan based on what we know right now. One thing is for sure – to fail to plan is to plan to fail.

H. Quincy Longis an attorney who holds the designation of Certified IRA Services Professional (CISP) and is President of Quest Trust Company, Inc., a third party administrator of self-directed IRAs serving clients in the State of Texas and throughout the nation with offices in Houston and Dallas.  He may be reached by email at  Nothing in this article is intended as tax, legal or investment advice.

How Can My Minor Child Have a Roth IRA?

“How can my minor child have a Roth IRA?” If I only had a million dollars for every time I have been asked this question, I would be a very rich person!  When entrepreneurial people learn of the myriad of possibilities for non-traditional investments within a self-directed IRA, they usually immediately see the benefit of starting on their child’s retirement now in addition to utilizing their own IRAs.  In this article I will discuss the benefits of starting an IRA early, how a minor can qualify for a Roth IRA, the tax filing requirements for a minor with earned income, and what can be done with the IRA once the money is deposited in the account.

First, let me briefly discuss the benefits of starting early on retirement savings.  Assume your 15 year old daughter starts off her Roth IRA with $1,000 from her earnings and adds $1,000 per year until she retires at age 67.  If she can earn an average return of just 10% per year, her tax free Roth IRA will be worth $1,552,472 at retirement – not bad for only investing a total of $52,000 over 52 years.  Contrast this with an individual who starts saving at age 35 and puts $5,000 in for 32 years with the same annual return of 10%.  His Roth IRA will be worth approximately $1,111,253 when he retires at age 67, and his contributions will total $160,000.  No matter what your age and annual return assumptions are, one thing is very clear – the earlier you start saving the better!

Before you get too excited and start writing your IRA custodian or administrator checks to open Roth IRAs for your minor children, you must make sure that they qualify to make a contribution.  In order to contribute to a Roth IRA, a single individual must have earned income (compensation) at least in the amount of the contribution and Adjusted Gross Income of no more than $122,000 (for 2011).  For example, if your daughter earns $1,000 babysitting in 2011, she can contribute a maximum of only $1,000 to her Roth IRA, even though the contribution limit for individuals under age 50 is $5,000.

How can a minor earn money so they qualify to contribute to a Roth IRA?  The younger your child is, the more difficult it will be to justify compensation if the IRS questions the contribution.  I have heard of parents hiring their minor children as a model for advertising purposes in the parents’ trade or business, but if you intend to do this make sure that you actually use the photos in your advertising.  Keep track of how and when you use the photos, and have adequate documentation in your file as to what reasonable compensation would be for a model doing an advertising shoot with unlimited use of the photos.  By the age of 8 or 9 children can be of some use to their parents’ businesses by doing things like cleaning up trash in the yard of rent houses, collating materials if the parent teaches classes, stuffing and stamping envelopes, or other menial tasks.  At age 7 my daughter helped me with artwork to put on t-shirts by carefully writing in crayon “Do you have a self-directed IRA?  I do!”  I then had her wonderful artwork turned into a silk screen for the back of t-shirts with my company logo on the front.  I gave away hundreds of the shirts to my clients.  With the unusual writing on the back of the shirts, people asked a lot of questions about self-directed IRAs and it turned out to be one of my most effective advertising campaigns!  Other ways for minors to earn money include cutting grass, babysitting, or working at restaurants and offices when they are a little older.  If you are hiring your minor children in your own business, be sure that you always document the time spent working and pay them a reasonable wage.  The importance of good records cannot be overstated.

The next questions I get asked when discussing Roth IRAs for minors are “What is the tax effect of my child earning compensation?” and “Does my child have to file a tax return?”  I will briefly summarize the rules here, but always check with your CPA or tax professional.  More information may also be found in IRS Publication 929, Tax Rules for Children and Dependents.  A minor child who is a dependent on someone else’s tax return cannot claim a dependency exemption, but can still claim the standard deduction on their tax return if they are required to file.  The standard deduction for a single dependent minor varies between $950 and $5,700 for 2010, depending on the type and amount of income.  In general, for 2010 a dependent minor must file a tax return if 1) unearned income, such as interest and dividends, was over $950, 2) earned income was over $5,700, or 3) if the minor has both earned income and unearned income, the gross income was more than the larger of $950 or the earned income (up to $5,400) plus $300.  If the dependent minor worked at an employer who withheld income taxes from their paycheck, in most cases they will want to file a return to collect a refund of this amount, even if there was no filing requirement.

There are situations where a dependent minor has to file a tax return regardless of the above filing requirements.  One of the more common circumstances is when the dependent minor has net earnings from self-employment (such as from babysitting or cutting grass) of $400 or more.  Net earnings from self-employment for IRA contribution purposes are calculated by taking the net Schedule C income and subtracting one-half of the self-employment taxes due and the contribution to any self-employment retirement plan such as a SEP IRA.  If this amount is $400 or more, the dependent minor will owe Social Security and Medicare tax on that income and will have to file a tax return to pay the tax.  For example, a recent tax client of mine who was 18 years old and still a dependent on her mother’s tax return earned $3,183 doing clerical work, for which she received a 1099-MISC.  She was not treated as an employee by the person who hired her, and she was required to file a dependent tax return to report this income.  Because her Adjusted Gross Income was below $5,700 she owed no federal income tax.  Unfortunately, she still owed $487 in Social Security and Medicare taxes.  If she had been treated as an employee, the employer would have paid its portion and withheld her portion of the Social Security and Medicare tax from her paycheck.  In that case she would not have had to file a federal tax return, unless she wanted to claim a refund for any federal income taxes withheld.

There is an interesting exception to the requirement that a dependent minor pay Social Security and Medicare tax on their earned income.  If a child under age 18 works in their parent’s trade or business and their parent’s business is either a sole proprietorship or a partnership in which the parents are the only partners, the income is exempt from Social Security and Medicare taxes, as well as federal unemployment taxes (FUTA).  This exception does not apply if the business is incorporated or if the partnership includes persons other than parents.  The exemption is extended to those under age 21 for work other than in a trade or business, such as domestic work in the parent’s private home.  So if a minor earns compensation of less than $5,700 working in their parent’s trade or business or for domestic work in the parent’s private home and they have no other income, no federal income tax or Social Security and Medicare taxes would be due.  This means that no tax return would have to be filed, but they would still qualify to contribute to a Roth IRA up to the amount of their earned income, subject to the $5,000 maximum contribution!  However, just to be safe it may be advisable to go ahead and file a zero tax due return for documentation purposes.  Always check with your CPA or tax advisor to find out if your child will owe state or local income taxes on this income.  More information on the family employee exception to Social Security and Medicare taxes may be found in IRS Publication 15, Circular E, Employer’s Tax Guide, Chapter 3.

What you can do with the money once in a Roth IRA?  The beauty of a self-directed IRA is that even small amounts can be invested in non-traditional investments.  There are at least four ways a small Roth IRA can be invested.  The Roth IRA may be combined with IRAs of other people to make a single investment.  The most IRAs I have seen participate in a single note investment was 10 different accounts, with the smallest IRA investor contributing only $2,000.  That note had a yield of 12% per year!  Another investment which is common in small IRA accounts is an option to buy real estate.  Once you have an option, you may let it lapse, exercise the option and close on the property, sell the option to a third party for a fee if the option agreement allows this, or even release the option for a cancellation fee from the property owner.  Another variation on this idea is for the Roth IRA to enter into a sales contract, then assign that contract to a third party for a fee.  Finally, the IRA could buy a property with a loan, either from taking over the property subject to the seller’s existing financing, negotiating non-recourse seller financing, or obtaining a non-recourse loan from a private party or another non-disqualified IRA.  However, if the IRA either owns debt-financed property or operates a business of any type (including a real estate dealer business), it may be required to file IRS Form 990T and pay Unrelated Business Income Tax (UBIT).  Always be sure and have your child’s IRA pay the taxes if they are due.  It is great to use the tax law to your advantage, but do not abuse the law, because the IRS has what it takes to take what you have.

If your child qualifies, there is no doubt that one of the best things you can do for them is to open a Roth IRA.  Perhaps the best part of this strategy is the time you will spend with your child teaching them the benefits of saving early and the methods of investing their money wisely. This is truly a win-win situation for both you and your child.  Happy investing!

Do Roth IRA 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 nontraditional 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 26% 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 Trust Company, Inc., with offices in Houston and Dallas, Texas. He may be reached by email at Nothing in this article is intended as tax, legal or investment advice.