July 11, 2024
Marc Halpern, Part Time Investors LLC
Roth IRA money (and Roth 401(k) money) is magic money since taxes destroy a significant portion of the value of effective investing. The more highly talented an investor is when using pre-tax IRA or 401(k) money, the more tax liability they create down the road.
I learned this the “hard way” when I did a good job investing self-directed pre-tax 401(k) funds in flips and rentals. In my lecture “Smarter Investing Uses Roth Tracks,” I show how much taxes I could have saved if I would have done a Roth conversion before investing pre-tax 401(k) money in the first investment of a multi-project sequence.
The Basics of Roth Conversion
A Roth conversion is a financial strategy that can significantly benefit investors, particularly when paired with a discounted valuation. This maneuver involves converting a traditional IRA into a Roth IRA, thereby taking advantage of tax-free growth and withdrawals in the future. A discounted valuation Roth conversion further enhances this strategy by allowing investors to convert assets at a lower value, minimizing immediate tax implications. This strategy works for 401(k)’s as well but for the sake of simplicity, we will refer only to IRA’s in this article.
A Roth conversion involves transferring assets from a traditional IRA, which is funded with pre-tax dollars, to a Roth IRA, which is funded with post-tax dollars. This conversion requires paying income tax on the amount converted, but future withdrawals from the Roth IRA, including earnings, are tax-free, provided certain conditions are met. This strategy is especially beneficial if the investor expects to be in a higher tax bracket during retirement or if they anticipate significant growth in the converted assets.
The Advantage of Discounted Valuation
The concept of discounted valuation plays a critical role in optimizing the tax efficiency of a Roth conversion. During periods of market downturns or when the value of investments is temporarily depressed, the market value of assets in an IRA may be significantly lower. Converting assets during these periods means paying taxes on a reduced amount, effectively lowering the tax bill associated with the conversion.
For example, if an investor holds a portfolio worth $100,000 in a traditional IRA, and due to market conditions, the value drops to $80,000, converting during this downturn would result in paying taxes on $80,000 instead of $100,000. If the market rebounds, the value of the investments in the Roth IRA will grow tax-free, enhancing the long-term benefits.
In some cases, discounted valuations can be identified and justified at low levels such as 50% discount or even 80% discount. The benefits can be enormous, but the risk that the asset value can recover may be high as well. So, the decision to implement the strategy of discounted valuation Roth conversion must be made very carefully to make sure that you don’t throw good money after bad money.
Strategic Considerations
Investors considering a discounted valuation Roth conversion should keep several key factors in mind:
1. Market Timing: Timing the conversion to coincide with market downturns requires careful monitoring and sometimes a bit of luck. However, market corrections and periods of high volatility can present ideal opportunities.
2. Tax Implications: While the immediate tax liability is reduced due to the discounted valuation, it’s crucial to ensure that the investor has sufficient liquidity to pay the taxes owed without tapping into retirement funds.
3. Future Tax Rates: If an investor expects future tax rates to be higher, a Roth conversion becomes even more attractive. The tax-free growth and withdrawals from a Roth IRA can provide substantial savings over the long term.
4. Estate Planning: Roth IRA’s do not have required minimum distributions (RMDs) during the owner's lifetime, making them a valuable tool for estate planning. Heirs can also benefit from tax-free withdrawals, enhancing the transfer of wealth.
Justifications for Discounted Valuation Roth Conversion
There are situations in which an investor can execute a discounted valuation Roth conversion without waiting for a decrease in valuation that is easily known to the public, such as when the value of a publicly traded stock or mutual fund drops and is reported in the media. Some justifications for applying a discounted valuation to an asset or investment that is NOT easily available in the public media include:
1. Lack of Liquidity: If the assets are not easily marketable or have restrictions on sale, they might be valued at a discount. This is common with interests in privately held businesses, real estate, or other illiquid investments.
2. Minority Interest: If the IRA owns a non-controlling interest in a business, this minority interest might warrant a discount because the holder lacks control over business decisions and cash flow.
3. Lack of Marketability: This discount applies if the asset cannot be easily sold in the market, which often applies to shares in private companies or other non-public investments.
4. Legal Restrictions: If there are legal or contractual restrictions on the sale or transfer of the assets, these constraints can justify a lower valuation.
5. Economic Conditions: Broader economic conditions affecting the asset’s marketability or value can also be a reason for a discounted valuation.
These justifications must be well-documented and comply with IRS rules to withstand scrutiny, and it is often advisable to get a professional appraisal.
Examples
When considering a Roth conversion using discounted valuation, the goal is to convert assets from a traditional IRA to a Roth IRA at a time when their values are temporarily depressed, minimizing the tax impact. Here are some examples of investments that may be amenable to this strategy:
1. Publicly Traded Stocks: Stocks that have recently experienced a price drop due to market volatility or company-specific issues but are expected to recover in the long term.
2. Real Estate: Properties that have temporarily decreased in market value due to economic downturns or local market conditions.
3. Privately Held Business Interests: Interests in privately held businesses that may have been recently appraised at a lower value due to temporary business challenges or economic conditions.
4. Cryptocurrencies: Digital assets that are known for their high volatility, which can lead to significant temporary declines in value.
5. Collectibles and Artwork: Items whose market values may fluctuate based on trends, market demand, or economic conditions.
6. Venture Capital and Private Equity Investments: Investments in startups or private companies that may have experienced a temporary decline in valuation due to market conditions or specific company challenges.
7. Bonds and Fixed-Income Securities: Bonds that have decreased in value due to interest rate increases or credit concerns but are expected to recover.
Timing the Roth conversion during periods of discounted valuation can significantly reduce the taxable amount, providing a tax-efficient strategy for long-term retirement planning.
Conclusion
A discounted valuation Roth conversion is a savvy strategy for investors looking to maximize the tax efficiency of their retirement savings. By converting assets during market downturns or for certain well-justified reasons, investors can reduce their immediate tax burden and benefit from the long-term advantages of a Roth IRA or Roth 401(k). However, this strategy requires careful planning and consideration of various financial factors, making it advisable to consult with a financial advisor to tailor the approach to individual circumstances. In all cases, written authoritative justification for the discounted valuation at the moment of executing the Roth conversion should be obtained and kept in case of an audit.
