SDIRA - Roth versus "Regular"?

Question

I am squarely on the fence of whether I should convert my existing SDIRA to Roth, and would love some input from members.

A bit of background: a while back, I rolled over funds from a previous employer's 401(k) to an SDIRA.  I've seen advice on some of the forums that one should just "bite the tax bullet" sooner rather than later, and convert to Roth. The thinking being that even a smaller pot of money--if allowed to compound and grow over a number of years--would then result in tax-free withdrawals down the road.

The assumption one must make in doing this is that the income drawn on down the road--since it's tax-free--would be more than if I kept my funds in the existing "regular" IRA, let those investments compound, and pay taxes when I withdraw.

Looking forward to responses!

Dave Toelkes · Answer

If you have a long investment horizon, then converting to the Roth IRA will be more advantageous than keeping the traditional IRA.  All contributions to the Roth are made with after tax money and all income earned by the Roth is withdrawn tax free (if not subject to early withdrawal penalties).

With the traditional IRA, contributions are made with pre-tax dollars.  All money withdrawn from the Traditional IRA (even capital gains) is taxed as ordinary income when withdrawn and, if applicable, early withdrawal penalties are assessed.

A longer investment horizon increases the amount of potential earnings that can be withdrawn tax free in the Roth.

Daniel Dietz · Answer

Good conversation so far everyone.

One of the aspects I need to do a little more looking into also is how things like depreciation, basis, etc.... works in regards to Regular vs ROTH. I am in a 3 way partnership that consists of my own ROTH SDIRA, and my brother and fathers Regular SDIRAs. We just started this about a year ago, mainly for buy and hold rentals.

What I am wondering in regards to the depreciation aspect is say 20 years down the road when we decide to sell, I am wondering if they will be able to each count depreciation of their 1/3 interests against their income (since taxes will be due on gains in their SDIRAs) and I am thinking the depreciation on 1/3 interest won't matter to me, since there will (hopefully) be no taxes due in my ROTH SDIRA. Does that make sense?

There is also the issue of how taxes would work within the SDIRAs if we ever chose to borrow (leverage) on a Non-recourse basis - the question being would the Regular and ROTH SDIRA's be treated the same way in regards to UBIT etc.... and being able to take depreciation before those taxes would be applied?

The reason we have the different types is I choose to convert when ROTHs first came out, and if I remember right they let people pay the taxes due over 3 to 5 years or something like that. My brother and Dad did not at that time.

Looking forward to what others have to say too.

Dan Dietz

Cal C. · Answer

I agree that in the current tax system, converting to a Roth makes sense.  However, you need to think about the long term implications of our absolutely untenable federal debt, continuing deficits and unfunded obligations (more than $45 Trillion).  At some point those Roths are going to look like very tempting targets to the spendaholics of both parties in DC, (yes, I know we are the one sending them there).  Of course, there will be tremendous pushback, but when the choices are drastically cutting back things like medicare or taxing Roth IRAs guess which one will lose.  I believe at some point at the very least, Roth's will be subject to the same or similar required minimum distributions that regular IRAs are currently.   Hopefully that will be all that will happen to the Roths, but looking at all of the projected shortfalls in federal spending I'm far from certain.

Having said all that I think converting to a Roth may be the best choice, but it is not as easy of a choice as it first seems.

Jim Farrell · Answer

Thank you, @Loren  Whitney .  I have been contemplating--if I do decide to convert--to do it in stages to mitigate taxes. Not an easy decision, though, the idea of the Feds taking a big bite all at once (or twice).

Loren Whitney · Answer

In this scenario, I must state that I'm not able to offer any tax, legal or investment advice. That being said, your logic is accurate. Everyone has a different tax situation and in some scenarios, a Traditional IRA is a better choice than a Roth. If you're financially savvy, you can do a comparative analysis between both options to see if one is better for you in the long run. This is not an easy analysis to do and it often left to financial planners or advisors.

One thing I will say is that you have the option to perform more than one Roth conversion. Instead of converting an entire balance, you can potentially convert smaller increments year-over-year. This is just one strategy that may allow you to reduce your taxation if you can avoid stepping up tax brackets. Again, this depends heavily on several factors and there is no "right strategy".

Be sure to learn about the 5-year Roth conversion rule if you're considering any sizable distributions anytime soon.

I look forward to hearing what others say. Good luck!