How to supercharge your Roth IRA or Roth 401k

Question

NEVER CONVERT CASH in YOUR IRA or 401K into ROTH!!!

Here is why. If you do so - 100% of the cash converted is taxable. There is a much better alternative!

The alternative is to set up a self-directed IRA, or better, a truly self-directed Solo 401k plan, invest in alternative assets, and then do the conversion. Some assets can be valued significantly lower than their actual worth because of illiquidity and other factors. With some of my clients, I've seen discounts of 30% to 90%.

Here is a real-life example: I invested in a $50K note; it was second TD but with significant equity (over $200K) protecting my investment. It is a very secure investment, and it is almost impossible to lose money on this deal. Over the years, I've done several dozen of these and know how to pick a good one. The borrower defaulted and was a few months behind. I hired an IRA-approved valuation company to value that note at that time. Because of illiquidity and the fact that it was in default and a foreclosure sale was scheduled, it was valued at $21K. Almost 60% discounted!! Immediately, I performed a Roth conversion. So, instead of paying taxes on $50K, I'm paying taxes on only $21K. About a week ago, the borrower came through, paid all past due payments, paid all the costs associated with the foreclosure, and the note is now current.

I learned this strategy from one of my clients. Knowing what I know now, I will never contribute to Roth; I will only make pre-tax contributions, get maximum tax deductions, invest, and then be selective about which asset I want to convert (such as the one above).  That is how you can supercharge your Roth!!

Have you done something similar? I would love to hear your examples!

Dmitriy Fomichenko · Answer

@Kevin S.

Here is how the Roth conversion works: you can convert anytime between January 1st and December 31, and you will receive a 1099R from your IRA custodian or 401k plan administrator before January 31st of the following year, which will be included in your tax return filing and that is when the taxes will be paid: at the time you file your tax return.

Lee Burns · Answer

Thank you for the information, @Dmitriy Fomichenko!  @Bill Hampton and @Joshua Granberg have you guys heard of this strategy?  It sounds awesome!

Jason Bohling · Answer

You are absolutely right!!!

To @Dmitriy Fomichenko and everyone please disregard/ignore what I wrote above;  I was tired and got two different things confused.

After I wrote those posts something wasn't sitting right about what I wrote and realized I made some mistakes.  I looked back at my tax returns when I was doing the conversions from my traditional IRA to my Roth IRA and realized I had converted up to the limit of my standard deduction allowing that amount to be tax free, but the excess above that that I converted each year was at the lowest tax bracket, so while I did convert some money tax free each of those years I DID IN FACT pay more than a few cents in taxes on the amount above the deduction.  As to the buddy I mentioned in Washington state it was the same scenario; he converted tax-free up to their standard deduction but above that he kept within the lowest tax bracket and paid the smallest amount of tax possible.

Thank you @Basit Siddiqi for calling me out on this and giving me a chance to address my mistake; it's important people have the correct information.  Take care everyone.

Dmitriy Fomichenko · Answer

@Jason Bohling, thanks for providing the clarification.

Dmitriy Fomichenko · Answer

@V.G Jason,

I'm not at all suggesting making bad investments. And if you don't have experience investing in trust deeds, my example may sound confusing. When I'm investing in trust deeds - my primary concern is the safety of the principal. But some of these notes do default. My investment strategy did not change a bit because of the Roth conversion. I will continue to do what I have been doing for a decade and a half. I'm saying that if you had the option of paying taxes on $50K or $21K, legally, all things being equal, which one would you pick?

I also converted a trust deed that was current (not defaulted), and I converted syndication investments that were solid. The valuation on those came over 30% discounted because they were illiquid. The example I provided was the best so far in my experience. If you are investing using a self-directed IRA or 401k, continue with your investment strategy, but keep this strategy in mind, and it will help you supercharge your Roth!

Dmitriy Fomichenko · Answer

@Jason Bohling, thanks for your comment!

If you have a taxable income of $50K and convert $60K to Roth, which adds to your taxable income, making your total taxable income $110K, how do you pay zero in federal taxes?

I understand that if you live in a state that does not have a state income tax - you won't have any state tax liability, but based on $110K income, you would be in a 24% federal tax bracket...

Distributions from an IRA or Roth conversion would be considered ordinary income and subject to ordinary income tax; capital gain tax is not applicable here, so I'm not sure why you are bringing it up...

Dmitriy Fomichenko · Answer

@Jeremy H.

It doesn't make sense to you because you still don't understand the strategy. I suggest you go back and re-read my original post.

The $7K limit is on IRA contributions. There is no limit on Roth conversions.

You said: "This seems like an odd strategy - purposefully invest in an asset that loses value, with the hope that it will regain value to save a little on taxes... What I don't like about it personally - this seems like a very risky move. You literally have to invest in something that will lose value, in the hopes of saving on taxes."That is not what I'm doing at all!!! I am not purposefully investing in assets that lose value! I have been investing in trust deeds for over a decade and will continue to do so because I believe this is one of the best ways to invest your retirement funds. If you do your due diligence and do it right, losing money with trust deeds is almost impossible. Just like any investment, it has risks. The risk that the borrower can default, the risk that you will have to foreclose, the risk that you will have to take over payments on the 1st TD if you are in 2nd position, the risk that you have to invest $$ into the property to sell it...

And when the borrower defaults on a note like this, the notes actually become more valuable to me. If I end up foreclosing the property, I will gain $200K equity (in my example, the amount will vary with each TD). However, if I tried to sell this note, I might have a difficult time doing so because there is no open market for selling notes and adding the fact that the note is in default, I might have to discount the note if I wanted to get cash for it. That is what the valuation is based on. But I am not trying to sell the note, I will continue to hold it, and in the worst-case scenario, the borrower will become current, or in the best-case scenario I will foreclose and gain equity. My investment strategy did not change a bit, but I learned of this strategy and took advantage of it to save huge on taxes and wanted to share this with the investor community.

You don't need to change your investment strategy; continue to invest the same way. But if you have a self-directed IRA or 401k, keep this strategy in mind, as it could potentially save you hundreds of thousands of dollars in taxes. I have personal experience converting trust deeds and syndicated investments, but it can work with many other alternative investments.

Dmitriy Fomichenko · Answer

Jeremy, this will not work for a backdoor Roth IRA conversion because you are converting what already has been taxed.

V.G Jason · Answer

I guess I am confused here. You're saying invest in something that lost or will lose value, convert, then just wait for it to re-gain the value?

Just the first step alone is a bit of a deterrent.

I get everyone wants to avoid taxes, and as a TX resident and former FL one, I am one of those. But I have no problem actually paying them, cause I made so much money.

That's a great problem.I'm not saying don't be efficient with it, I'm just saying don't make investments or bad one's based off of taxes. Make it off the underlying asset/investment itself.

How to supercharge your Roth IRA or Roth 401k

Most Popular Reply