Do I understand the Roth IRA correctly? What am I missing?

Question

I'm exploring my options to roll over a 401k from an old employer and want to make sure I am understanding the basics here. I realize that I'll need more specific and detailed advice from my own advisor, but the expertise of this community would be great appreciated. The total of this fund is about $120k.

Moving it to a traditional IRA I would retain all $120k, but pay taxes on my withdraws, both principal and earnings, based on my tax bracket at the time I withdraw it after age 59.5. If I invest and create passive rental income that allows me to withdraw $5k per month I will only get to keep less than $4k of that because I will be taxed at a rate corresponding to an annual income of $60k. Correct?

Moving it into a Roth IRA I would pay income tax on it right now, which, if I did the math correctly on the income tax, would leave me with about $93k in that Roth. Now, If I take that $93k and create the same passive rental income to the point that I can withdraw the same $5k a month after 59.5, I would get to keep the entire $5k/month - $60k/yr. I wouldn't have to pay any income tax on it at all because I already paid taxes on my original deposit and earnings in the Roth are tax free. Correct?

That seems way to simple. Can I really take that 401k, roll it over to a Roth IRA and then not pay any taxes on withdraws after 59.5 years old. If my rental investments are successful, I could live virtually tax free after the age of 59.5.

Please help! What am I missing?

Rajeev Kotyan · Answer

@Jason Thomas: Couple of easy things to remember:

(1) You can rollover from a 401K to a Traditional IRA and then convert that to a ROTH IRA (There are some custodian where your IRA is setup to receive the funds, who will do this step automatically and as they call it "in-flight"

(2) You can rollover from a 401K to a ROTH 401K (assuming that the plan allows you to do that) and then transfer to a ROTH IRA

(3) You can transfer from a Traditional IRA to a 401K, but you cannot transfer from a ROTH IRA to a ROTH 401K

(4) You can have your own Solo 401K, only if you have your own self-employed (directly or through your own firm -- not a third party employer -- yes I am simplifying this), and you can rollover from your employer to your own Solo 401K.

(5) You can invest in real estate from any of the retirement plans whether it from 401K, Traditional IRA or ROTH IRA

(6) You can have leverage on the real estate from any of the plans on the real estate so long as the leverage is non-recourse to you (or a disqualified party) personally

(7) Generally, real estate with leverage within a 401K plan does not pay any UBIT on the income or gains, but the Traditional or ROTH IRA will pay such taxes.

(8) You do not have covert the entire Traditional IRA to ROTH IRA account, or 401K to ROTH IRA, you can do this small amount at a time which you can calculate based on you specific situation.

(9) You can do a conversion in-kind, and does not have to be cash, provided you have a fair market appraisal of the investment within the IRA or 401K just prior to the conversion. This can be used as strategy to reduce your taxable amounts if done correctly.

None of these steps should be carried out in isolation, but knowing them will enable you to have a discussion with a knowledgeable professional as to how it can impact you particular case, and as you have identified, it is a numbers game.

Ken Badziak · Answer

I believe you skipped a crucial step.

First, roll over your 401k into a traditional IRA. No penalty.

THEN, convert the Traditional into a Roth. No early distribution penalty, you just pay the taxes on the conversion.

Someone correct me if I'm wrong please, but I believe that's how it's done.

Rajeev Kotyan · Answer

@Jason Thomas: The point I made here applies to a conversion from a Traditional 401K to a ROTH 401K as well as from a Traditional IRA to a ROTH IRA or from a Traditional 401K to a ROTH IRA (via a Traditional IRA or direct if the receiving custodian allows it)

You do not have to move the full asset either, you can decide to partially move the real estate, just that the deed will be held tenants in common between your two account (Traditional and ROTH).

With real estate you also have an opportunity get a formal fair market appraisal at the worst time of the property, when the property is being torn-down or in the worst time of rehabilitation, which can be used for the purposes of the value at the time of conversion (thereby reducing your taxes even further). Of course if you complete the rehab and sell the property at very high price relatively shortly after there could be potential questions (IRS appears to be considering intent and reasonable time -- both not clearly defined and is situation dependent as considerations).

Working with knowledgeable professionals who can help with the strategies and documenting every step of the process, both pre and post is critical to make your accounts successful and achieve your goals.

Brian Eastman · Answer

@Jason Thomas

Yes, you can do this.

The key is that the IRS requires clear documentation of value when you convert an asset in-kind.  You would have each property formally appraised.  When you convert a property from the tax-deferred to Roth side of ledger in your 401k, this is a taxable event for that year, with the amount of the conversion being added to your income.  You will then be taxed accordingly on your full amount of income for the year at normal rates.  As I mentioned above, this type of conversion makes sense if you have the funds outside of the plan to pay the tax on the conversion.

BTW, it is much cleaner to convert an entire property all at once.  You could do a partial conversion on a single property, but then tracking and allocating the value as well as share of expenses and income of tax-deferred vs Roth for that property becomes a bit complex.

Jason Thomas · Answer

@Rajeev Kotyan When you said...

(9) You can do a conversion in-kind, and does not have to be cash, provided you have a fair market appraisal of the investment within the IRA or 401K just prior to the conversion. This can be used as strategy to reduce your taxable amounts if done correctly

... Did you mean that I could theoretically transfer my traditional 401k into an IRA, buy homes, then transfer them into a Roth after that?

Which would mean if those homes were small, low cost homes, say $40k in value. I could transfer one per year over to my Roth and pay a much lower tax rate then transferring $120k all at once.

Step 1) Transfer my existing 401k into an SDIRA / Solo 401k. ---> No penalty/ no tax

Step 2) Buy Homes

Step 3) Transfer 1 home per year to Roth ---> Pay tax at $40k rate instead of $120k rate.

That's a great strategy!

Jason Thomas · Answer

OK, now the picture is getting clearer...

@Ken Badziak that's a good tip! If I decide to go with the Roth, I'll definitely explore that option!!

@Rajeev Kotyan That's a great list of all my options plus some pros/cons to using them for real estate. As @William Morrison pointed out... regardless of what I do, the Roth seems to be the end of the line, once the money is there, it can't go anywhere else.

You guys have been great, really appreciate all the information!

William Morrison · Answer

A Roth IRA can never be rolled into a Solo 401k in the future with the Trustee vs Custodian advantages and the UBIT vs no UBIT advantages on leveraged rentals.  At least with the current law.So be sure that's where you want it before you move it.My wife and I both have two very small Roth IRAs that we cannot move.  And too small for Checkbook IRA setup fees.

Jason Thomas · Answer

@Brian Eastman

Thank you so much! I think I understand what your saying. I can't use the existing 401k to directly fund the Roth. I would take the entire $120k as a distribution, pay the taxes, pay the 10% penalty and then deposit what's left into the Roth. So another 10% on the $120k would bring me down to $81k to deposit into the Roth, not $93k.

Losing a third of the fund to taxes and fees would really hurt.

The question is... will $120k give me (at least) the same after tax income in retirement as $80k would without paying income tax.

Brian Eastman · Answer

@Jason Thomas

Your understanding of how the earnings and distributions of both tax-deferred IRA plans is correct.

The trade-off for the tax-free status of the Roth is the tax hit to convert the money now.

The one thing that appears to be missing in your scenario is that you do not want to use the 401k itself to do the Roth conversion.  The conversion is not just automatically done with in-plan funds.  In order to have the cash to pay the taxes, you would have to take a distribution from the 401k and be subject to taxes - and if you are under age 59 1/2 a 10% penalty for early distribution as well.  As such, the amount available to the Roth IRA would be significantly less.

To effectively perform a Roth conversion when under age 59 1/2, you need to have personal savings with which to pay the tax on conversion.

My other thought is that if you can find a way to leverage $93K of principal into $5K income per month just the same as you could $120K, well then why can't you find a way to turn the $120K into a good bit more than $5K per month?  For your scenario to make sense, you need to compare apples to apples on the performance of your invested principal.

William Morrison · Answer

You might like to read these two if you want to know about tax free for life.Leverage Your IRAby Matthew M. AllenBest price is on the NASB site.andLive Tax Free Forever (through Your Solo 401k)by Michael J. McDermottIt is like a lot of real estate and financial books that really have an important message but limited scope.  So some fluff to justify a book, but worth it.

Do I understand the Roth IRA correctly? What am I missing?

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