Many investors are considering a Roth conversion in 2020.  In our first article of this series we discussed the opportunity this year may present for those who might have a dip in income, and a corresponding dip in their tax rate.  The tax cost of such a conversion may be reduced, which makes the conversion easier to accomplish and therefore increases the performance differential between the Roth conversion and staying put in a tax-deferred IRA.

In this article, we wanted to dive into the mechanics of how the Roth conversion process is executed with respect to a self-directed IRA plan.  There are several potential routes to performing a Roth conversion that apply to different situations.

Setting Up a New Self-Directed Roth IRA

Performing a Roth conversion as part of establishing a new self-directed IRA is a straightforward process.

The new self-directed IRA is setup as a Roth account.

Converting funds to Roth status and funding the new self-directed IRA can follow a few different pathways, depending on where you are starting from.

The key thing to understand is that all plan-to-plan transfer and rollover transactions need to be between accounts with matching tax-treatment.  You cannot move funds from one institution to another and perform a Roth conversion in the same process, unfortunately.

When possible, it is typically easier to perform a Roth conversion at the institution where your current tax-deferred IRA is held.  Most mainstream firms have simplified processes to accomplish the conversion, and can either move funds from a traditional, SEP or SIMPLE IRA into a Roth IRA promptly.  You can then request a direct transfer from that Roth IRA to your new self-directed Roth IRA.

With a 401(k) or other type of qualified employer plan, it may not be feasible to convert to a Roth IRA with the current plan administrator.  A handful of mainstream firms that offer both 401(k) and IRA accounts and can do a conversion easily.  Some 401(k) administrators do not offer IRA plans.

In cases where it is not possible to convert in the current location, a two-step process must be employed on the receiving end with the new self-directed IRA custodian.

First you will setup a traditional IRA to accept a rollover of tax-deferred funds.  You will then have that IRA converted to a separate Roth IRA, and likely close the traditional IRA.  It is an extra step, but easy to execute.

One of the advantages of performing a Roth conversion during a new account setup is that the holdings will typically be in a cash position, which is easy to value and convert.

Fully Converting an Existing Self-Directed IRA

If you already have a Checkbook IRA and want to convert the whole thing, that is also relatively easy.

The first thing required will be a formal valuation of your IRA-owned LLC or trust entity.  Since a Roth conversion is a taxable event, the IRS requires a certified valuation.  The process involves obtaining current fair market value for each asset held by the entity, including property, notes, stocks, and cash.  A formal appraisal may be required depending on the asset type.  The sum of all holdings represents the value of the LLC or trust that is being converted.

A new Roth IRA is then established with the custodian and the entity is moved.  The LLC operating agreement or trust declaration will need to be amended to reflect the new IRA account as a replacement owner.  This is a simple process that Safeguard can assist with.

While the “ownership” of the checkbook entity has changed to update the tax status, nothing else changes.  There is no impact on banking relationships or investments held by the entity.

Partial Conversion of an Existing Self-Directed IRA

Sometimes the value of a checkbook IRA is more than is possible or beneficial to convert to Roth status in a single tax year.  It is possible to convert only a portion, but this is a more complex process.

It is not feasible per IRS rules to split an existing checkbook entity across both tax-deferred and Roth accounts.  As such, a separate Roth checkbook IRA needs to be created.

Any asset to be converted must then be transferred individually and must follow the full pathway of ownership.  This means 3 separate changes of ownership:

1. From the tax-deferred IRA held LLC/Trust to the tax-deferred IRA account
2. From the tax-deferred IRA to the Roth IRA as a conversion
3. From the Roth IRA to the Roth held LLC/Trust to obtain checkbook control

Because of the several steps involved, it is significantly easier to convert cash than to convert an asset in-kind.

An asset may be converted in-kind.  To do so, the individual asset must be formally valued.  The necessary ownership change documentation such as a deed, note, or subscription agreement must be prepared to properly reflect chain of title for the transaction.  Paperwork is then submitted to the custodian for processing.

For a single asset the pathway outlined above needs to be followed.  If several assets within the tax-deferred entity will be converted, it may make more sense to form a new entity within the IRA and then move the entity as a whole instead of individual assets.  In this case, the pathway is:

1. Create new LLC/Trust in the tax-deferred IRA
2. Exchange individual assets from entity A to entity B.  Re-titling of the asset is required
3. Convert entity B to Roth status as outlined above in the full conversion process

While there is an additional step required to amend the checkbook LLC/Trust entity, this can save two title change transactions per-asset involved.

Converting a Single Asset Fractionally Over Time

While it is technically possible to convert a larger asset in-kind in fractions over a period of several tax years, this is not generally a good idea.

Sure, if you are the type of person who thinks dismantling and rebuilding an antique 12-cylinder Jaguar engine is fun… but do you really want to take on that kind of a project in your retirement plan?

The cost, complexity, and risk of creating issues with the IRS related to self-dealing and valuation make this strategy something that is only beneficial in very rare circumstances.  Close hand-holding by your licensed tax attorney or CPA will be necessary.

In Summary

As with so many things related to self-directed IRA plans, the best course of action is always dependent on each individual investor’s situation.  A Roth conversion is a complex tax matter, and something that should be discussed with licensed counsel.  If you find a conversion makes sense for you, please feel free to reach out and we can assist with the mechanics of implementing your strategy.

Next month we’ll wrap up this series with a look at Roth conversions in a Solo 401(k) plan.