Today’s REI Classroom Lesson

In the classroom today, Clay Malcolm explains how you can do a Tradition to Roth IRA conversion, and why it makes sense for you.

REI Classroom Summary

Roth IRAs have low contribution limits. With a Traditional to Roth IRA conversion, there are no limits for your contributions. Clay shares how this works for those who don’t qualify for a Roth IRA.

Listen to this REI Classroom Lesson

Real Estate Investing Classroom Show Transcripts:

Mike: Welcome back to the REI Classroom, where experts from across the real estate investing industry teach you quick lessons to take your business to the next level. And now let’s meet today’s expert host.
Clay: Hi everybody, and welcome to the REI Classroom. My name is Clay Malcolm with New Direction IRA, and today we’re going to be talking about the Roth IRA as a tool for real estate investors.
Mike: This show was sponsored by
Clay: Specifically today we’re going to talk about the Roth IRA and its properties and Roth conversions. Now, the Roth IRA, of course, is a tool that gives you the ability to put post-tax money in to your IRA. It grows tax deferred, and then when you take a qualified distribution, of course, it’s tax free on the way out. So one of the things that I see a lot of real estate investors who use their Roth IRA tool do, is what they’re trying to do is develop a cash flow for themselves that comes to them tax-free.
So the rental property, the house or the apartment building or whatever it is, is generating cash. That cash is tax deferred while it sits in the account, and the account holder often will put themselves on a distribution schedule. So once a month or twice a year or once a year, whatever it is, they’ll take a distribution of that cash. Usually it’s after fifty nine and a half which of course is where the early withdrawal penalty goes away. But when they take a distribution, they’re getting that money tax-free. So they actually have a cash producing asset working within that Roth to enhance whatever their other financial situation is.
So that’s the get or kind of a fantasy, in terms of the Roth IRA and the way it works with real estate I would say. At least it’s the most popular one.
Now, one of the things about Roths, of course, is that the contribution limits are pretty low – $5,500 if you’re under 50 and $6,500 if you’re over 50. Now, and also if you make too much money, you’re not allowed to contribute to it at all. And so that limitation makes the ability for somebody to get into a Roth situation a little bit more difficult, and that’s why we’re going to talk about conversions today.
So a Traditional to Roth conversion is when you take money from a traditional IRA, a SEP, SIMPLE, 401(k) something like that, and you make a conversion to a Roth format. So the money is going from pre-tax to post-tax. So there is a taxable event, have to be ready for that. But once that money has been converted, all of its earnings, again, they are tax deferred, and then if you take a qualified distribution, it’s tax free on the way out.
And so what the interesting thing about this particular time in history, and we’re kind of coming toward the end of 2016 here, is that the rules for Roth conversion are very liberal. There’s no limit to how much you can convert, and there’s no limit to your income to be eligible to make a conversion. So if you have money in a pre-tax account somewhere and you think that this might be the right time or the right strategy for you, you can make a traditional to Roth conversion.
Now, lots of times people have quite a bit of money and in one of those pre-tax accounts and they can’t afford the tax hit to convert all of it at once. So a few things to think about from a strategy perspective. One, you don’t have to make a conversion of the entire amount. So you could do it in increments over a number of years. Second, if you take a loss in your personal financial world, so, you know, one of your other investments doesn’t pan out exactly right, that might be a good year to do a traditional to Roth conversion, because then your overall tax event will be pretty much what your normal tax event is.
So those kind of strategic things are considerations when you’re thinking about making a conversion. The other one that can be an overriding factor, of course, is that if you think that later on your income tax rate is going to be much higher than it is now, that would make a traditional to Roth conversion more advantageous for you now because then your overall tax rate would be less. Because once you make that conversion, you’re eliminating speculation on what your tax rate will be later.
So all of those are conversion strategies, and then in terms of the Roth strategy itself with real estate in particular, I do see a lot of people who will . . . they have a traditional IRA or a SEP or a SIMPLE or a 401(k). A lot of times it does on real estate, and as they start to get towards 70 and a half where the pretax accounts require a minimum distribution every year thereafter, I’ve seen conversions take place right there. So somebody in their late 60s or early 70s will make a traditional to Roth conversion at that point so they can eliminate the requirement minimum distribution part of that tax advantaged account.
And really one of those things that also helps is that, if you’re thinking about it from a generational well standpoint, your account doesn’t need to be chipped away at unless you choose to. So you become in more control of what the end amount of that account is as you get toward the end of your life and if you want to pass it down to your next generation.
So the traditional to Roth conversion really is a tool that gets used for a lot of different things, but it works particularly well with real estate because of the fact that once you start to get the control of your distributions because they’re tax-free and also control over what your ultimate taxable event will be on that piece of real estate, you’re really just mixing that tool, the hard asset, the cash proceeds and you’re mixing that in with your personal finances.
So if you’re thinking about which tool, tax advantage tool or account to use with your real estate investments, you might consider Roth, and in this particular case you might consider any real estate or assets that you have in a traditional and making it a Roth conversion. Thanks for joining us and we’ll see you next time in the REI Classroom. I’m Clay Malcolm from New Direction IRA.
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