Roth Conversions — Who, Why, and How

There are many opportunities to help you maximize your retirement investment earnings. One technique many can take advantage of is converting assets from a traditional IRA to a Roth IRA. With a traditional IRA, your yearly contributions are tax deductable now, but you will have to pay income tax on all distributions later on. You will also be required to take a yearly distribution once you reach age 70 ½. With a Roth IRA, you have to pay income tax on your contributions now, but aren’t subject to a tax on withdrawals once you reach age 59 ½. While you aren’t required to take a yearly distribution for a Roth IRA, you still have to leave your funds in your account for at least five years before taking any distributions to avoid penalty, even if you’ve reached the 59 ½ mark. Depending on your income level now and what you expect your income level at retirement to be, a Roth conversion could make sense for you. Below are guidelines to help you decide if you should convert your traditional IRA funds to a Roth IRA.

Who qualifies?

The IRS recently lifted the income cap on Roth conversions, so even high income earners can convert their assets into a Roth. However, just because you can convert doesn’t mean you should. Because you will be taxed on any converted funds coming out of your traditional IRA and won’t be taxed later on distributions from a Roth, it generally makes more sense to convert if you are in a lower tax bracket now than what you expect to be at retirement. If you are in your peak earning years, the taxes you pay on your conversion will be higher than the taxes you would owe at retirement when you start your traditional IRA distributions. If you think you’ll be in the same tax bracket at retirement as you are now but think congress will raise the income tax by the time you reach retirement, it also may make sense to convert to a Roth now.

Why convert?

As explained above, one reason to convert is to save on taxes. Another reason why someone would want to convert is if they were planning on entrusting the IRA to children or grandchildren upon death. This way, the inheritors wouldn’t owe taxes on the funds and could withdraw any time as long as the account met the five year requirement.

Six things to keep in mind

  1. The deadline for converting your traditional IRA to a Roth IRA is December 31st. Don’t confuse this with the deadline to contribute to a Roth IRA, April 15th.
  2. If you need to take a minimum required distribution the year you convert, you must take the distribution before you move any funds.
  3. If you are younger than 59 ½ and use IRA funds to pay for the conversion tax, you will be subject to a 10% fee. It is suggested that you use another source to pay for the tax to avoid unnecessary penalty.
  4. Even though you may qualify for a Roth conversion, there are still income restrictions on direct contributions to the account.
  5. There are no restrictions on how much you can convert or how many times you can convert. If you are going to be in a lower tax bracket for a few years, you can make a conversion each year that doesn’t bump you up to the next tax bracket and save even more on taxes with this method.
  6. Any post-tax funds in your IRA aren’t eligible for conversion.

Converting IRA funds to a Roth IRA may be beneficial to you in the long run, but it is recommended that you talk with your financial advisor about your individual situation before making any final decisions.

Should You Use Your Self-Directed IRA to Buy Investment Properties While Interest Rates are Low?

The ability to invest in real estate is one of the most common reasons why retirement savers first start becoming interested in the self-directed IRA. An individual retirement account with a self-directed IRA custodian such as Quest Trust Company individuals to out their retirement funds to work in investments that traditional IRA custodians simply wouldn’t allow.

Adding to the desirability of investment real estate for retirement savers is that interest rates on mortgages and other types of borrowing continue to be quite low.

UBTI

Even if interest rates are low, you may not be able to derive the benefit you hope from borrowing money to buy real estate with your self directed IRA. This is because the tax laws that authorize individual retirement accounts put some limitations on how those accounts may be used. In particular, the activities of IRAs must be related to the fundamental purpose of the account, and that means to make investments. Borrowing money to make investments, however, is called out as an activity that’s at odds with the fundamental investment purpose.

As a result, when an IRA borrows money, the investment gains that result from that borrowing are considered to be unrelated business taxable income (or “UBTI”), which means that you’ll face a current year tax bill because of your investment borrowing. In many cases, this can greatly reduce or even exceed the advantages you gain by taking out a mortgage.

Investment Quality

If you choose to borrow money within your self-directed IRA in order to invest in real estate, be sure you are doing so because you are presented with a quality investment opportunity, rather than simply because interest rates are low. You should have a plan for how each piece of property you acquire is going to become a productive part of your portfolio, and your anticipated timeframe for that to occur.

Note that this doesn’t necessarily mean every piece of investment property you acquire needs to be productive right away. “Fixer uppers” are certainly appropriate for investment; just be sure you take into account any repair or remodeling costs into your financial analysis.

Fees

Regardless of how you choose to use your self-directed IRA to acquire investment properties, you should have a comprehensive understanding of the costs and fees that come with holding the property. For example, many real estate investors will tell you that as they build larger portfolios of property, they find that their costs on a per property basis tend to decline. This is because they are able to leverage certain economies of scale when it comes to property managers, repair and maintenance professionals, and other types of support they need in maintaining those properties.

Low interest rates can be a factor in deciding whether or not to buy investment real estate with your self-directed IRA, but it should not be the only factor.

Real Estate Alternatives to Consider With Your Self-Directed IRA

Real estate is one of more popular types of investments that retirement savers choose to make with their self-directed IRAs. Custodians who offer self-directed IRAs, such as Quest Trust Company, offer also offer many other legally permissible investment options that other traditional custodians don’t offer, and which allow individuals the greatest ability to apply their investment philosophy to their retirement savings.

But direct investments in real estate might not be suitable for every investor’s portfolio or investment profile. The key to successful investing, whether in the context of retirement planning or even general investing, is to find investments that are suited to your needs and to your investment approach. Fortunately, there are ways to invest in real estate assets without having to meet the administrative challenges of managing direct real estate holdings.

Real Estate Investment Trusts

One option for being able to invest in real estate without having to take on the risk of doing so directly is to purchase shares of a so-called “real estate investment trust” or “REIT.”

A real estate investment trust is an actively managed trust that itself invests in real estate of various types. Shares of a REIT are generally traded like shares of stock on the major exchanges, and are typically structured and operated in order to receive special tax breaks – the most significant of these is that the REIT offers high yield to investors. For investors who are looking for current income, REITs can be a great option.

Most REITs are generally focused on a particular type of property (such as multifamily residential or commercial) or real estate mortgages. But there are some REITs that try to take a hybrid approach by investing in physical properties as well as mortgages.

Investment Partnerships

Another way to invest in real estate without having to hold property is to commit a portion of your portfolio to private investment partnerships that focus on real estate investments. Rather than buying property yourself, you are buying an interest in an investment partnership that has its own administrative structure in place to buy and manage properties for the benefit of the partners. While you’ll likely be able to vote on many of the decisions he investment partnership makes, it’s vitally important that you are comfortable with the partnership management structure that’s in place.

Private Mortgage Lending

When you have a self-directed IRA you can make private loans as another type of investment. You’ll probably want to stick to loans that are secured (meaning that the borrower pledges collateral that you can take possession of if they fail to meet their loan repayment obligations), and this includes private mortgage lending. This is yet another way to invest in real estate alternative investments and not have to hold property directly.

The term “real estate” means a specific type of investment class to many investors. There are in fact a wide range of real estate alternatives that you can invest in with your self-directed IRA without having to hold property directly.