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.
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.