2020 may be an opportune time for many investors to consider a Roth conversion. In our first article of this series we discussed how a dip in income, and a corresponding dip in tax rate can reduce the tax cost of performing a conversion. If the cost of conversion is reduced, the long term differential in performance of the conversion will increase.
In this article, we wanted to dive into the mechanics of how the Roth conversion process is executed with respect to a self-directed Solo 401(k) plan. There are several potential routes to performing a Roth conversion that apply to different situations.
A Solo 401(k) Can Hold Both Tax-deferred and Roth Funds
Unlike IRA plans which hold a single type of funds with one tax treatment, a Solo 401(k) can hold both tax-deferred and Roth funds.
As the Solo 401(k) administrator, it is your responsibility to accurately track the value of both tax-deferred and Roth accounts within your plan. Having separate bank accounts for each type of funds is a best practice.
This plan structure gives you a greater range of options when considering Roth conversions than a comparable IRA based plan.
Conversions When Setting Up a New Solo 401(k)
When you establish a new Solo 401(k), you can fund your plan by rolling over funds from a variety of sources.
You cannot, however, rollover an existing Roth IRA into a Solo 401(k). If you are considering converting funds that are currently in tax-deferred status in an IRA or 401(k), do not perform a conversion into a Roth IRA first. You would lock those funds out of your new Solo 401(k) by doing so.
The correct procedure is to first rollover funds from a tax deferred account into your Solo 401(k). Once those funds are in the new plan, you can follow the procedure outlined below for an in-plan Roth conversion.
If you already have a Roth participant account in an existing employer plan like a 401(k) or 403(b), you can directly roll that over to your new Solo 401(k).
In-Plan Roth Conversions
A Roth conversion is accomplished inside your Solo 401(k) via an in-plan Roth transfer.
When you choose to execute a Roth conversion, you move value from the tax-deferred participant account to the Roth participant account and report accordingly.
Roth conversions are a taxable event, so you need to be able to accurately value the portion of your tax-deferred funds being converted. It is, of course, much easier to convert cash than existing investment assets in alternative assets that can be more difficult to value.
Reporting of an in-plan Roth transfer involves:
- Issuing form 1099-R from the Solo 401(k) to yourself indicating the amount converted as taxable
- Filing form 8606 with your personal tax return
If you perform a conversion in the first three quarters of the year, you may need to make estimated quarterly tax deposits based on the tax amount due. Conversions executed after October 1st will simply require full payment of taxes due by April 15th of the next year.
We recommend you work with your licensed tax professional for tax reporting and filing matters.
Converting an Asset In-Kind
While it is easiest to convert cash, it is possible to convert an existing investment from tax-deferred to Roth status.
The challenge is that the asset must be valued in a manner acceptable to the IRS. For real estate, that would mean a formal appraisal. A note can be valued at the open principal balance. With other assets, you will want to seek professional guidance for proper documentation of value.
It is easiest and cleanest to convert an asset in its entirety.
It is possible to convert an asset such as a piece of property in increments over time. You will need to do a fresh appraisal or other form of valuation at each conversion event. You will also need to keep good records related to what percentage is owned by each account and be sure to allocate all expenses and income transactions accordingly.
Fortunately, assets do not need to be re-titled when you perform a conversion. Title is always held in the name of the plan itself, without reference to the underlying plan participant account(s) that may be involved. You just need to retain accurate records relative to ownership by each applicable account.
With Roth conversions the best strategy to pursue is always dependent on your specific situation and goals. A Roth conversion is a complex tax matter, and something that should be discussed with licensed council. 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.