The Roth IRA
by Hugh Bromma
A new law, effective on January 1, 1998, has definitely changed the opportunity
for real estate investors to effect tax free income in the future. By now,
everyone has heard of the Roth IRA.
The Roth IRA is intended to stimulate savings among Americans in a new tax-free
vehicle. There are some limitations which are important, and may exclude some
individuals as a result of income constraints. The rules are important and may
be advantageous to some now, and perhaps to others later.
"Almost" Tax-Free Income
The Roth IRA does not do away with traditional IRA's. It is intended to help
individuals with annual incomes up to $110,000 (joint incomes $160,000) produce
retirement income that is almost entirely tax-free. "Almost" simply means that
the contributions or deposits made are taxed when you deposit them. All
income you make on the contribution will be tax-free forever.
One also has to keep the Roth IRA for five years. If one wishes to convert a
traditional IRA (the tax deferred kind) one may do so by paying the tax on the
value of the assets in the IRA today. That IRA is converted to a new Roth IRA,
and the income derived therefrom in the future will be distributable tax-free in
the future. This bodes well for someone who currently has valuations of assets
which may be significantly less than what they will be later. Leveraged real
estate is certainly a good bet to convert, as valuation is on a net basis.
In order to convert, your income has to be $100,000 or less in the year you are
converting. You have an additional advantage in 1998 as a conversion year: You
may pay the taxes over a graduated four-year period. This is not available in
1999. If you have already paid taxes on contributions prior to converting to a
Roth IRA, you don't have to pay taxes on the contribution again, just the income
you earned on them.
Why Convert?
If you meet or are able to fit within the rules, it makes sense if:
- You expect a high return on your investments. If you are doing flips on rehabs,
for example.
- You have more than ten years to save until you believe that you want to take
distributions from your IRA. A great bonus in the Roth IRA is that you don't
have mandatory distributions at age 70 1/2, and you can make contributions as
long as you meet the earned income standards above.
- You expect to be in the same or higher tax bracket when you start taking
distributions.
- You will pay tax on the conversion amount from funds outside your IRA, and
- At the time of conversion your annual gross income (W-2) is less than $100,000.
One deal alone may pay for the conversion. Even if you start with a new Roth,
properly constructed deals can make all the difference in the long run.
Conventional returns are based on an average return on investments over time.
The average S&P 500 market basket return has been slightly over 11% over the
last 70 years. The results are relatively even, and do not anticipate returns of
100% or more.
In real estate deals, we have seen fairly substantial returns, particularly in
rehabs. If one leverages such transactions, the results are magnified.
Considering that these investment results are tax-free, there is a definitive
advantage over tax deferred returns.
If you are looking to convert your qualified plan to a Roth IRA, a two-step
process is mandated. First you have to convert to a traditional IRA, then pay
the tax, and then convert. It is a relatively easy process, but may save and
make you money over time.
A Recent Example
One of our most recent examples of how a conversion worked is as follows: In
this case the client paid the tax from her plan proceeds: Our client had a
$100,000 Profit Sharing Plan (Keogh), which she rolled to a traditional IRA to
convert to a Roth IRA. She paid $23,000 in tax from the $100,000, which left her
with $77,000. This was used to purchase a town home, and make $6,000 in
improvements. She sold the unit in four weeks and netted $112,000 from the
transaction, for a $12,000 profit after all taxes were paid. She now has the
$112,000 and its earning potential in a tax-free vehicle, the Roth IRA.
There are numerous real estate deals which can be effective for Roth IRA
treatment. It is merely a matter of understanding the rules, and having the
right transactions to make it work for you.
Bio:
Hubert (Hugh) Bromma is CEO of Entrust Administration, Inc. He has decades of
experience on the cutting edge of investment education. His business philosophy
is providing quality education to enable his clients to enhance their
investments. Hugh has written several books on tax-free and tax-deferred
investing and has an extensive background in economics and investing.