How To Enjoy Tax Free Retirement Income!

Most everyone is aware of the opportunities the Roth IRA provides in the way of accumulating tax deferred dollars and then enjoying tax free distributions. Of course this extends to owning real estate in your Roth IRA (or post-tax 401(k) account) too.

What many investors are unaware of is the tax saving strategies available to them when converting existing real estate holdings inside their IRA (or preferably their individual 401k).

Let’s take a minute to discuss how your IRA distributions and conversions are taxed. When you are 70 ½ you must begin to withdraw funds from your IRA or 401(k). The amount you are required to take – the Required Minimum Distribution or RMD – is calculated using your age and the Fair Market Value (FMV) as of December 31st of the previous tax year.

For example, if the FMV of your retirement account is $100,000 as of December 31st 2011 and you turn 70 ½ during 2012, your RMD would be $3,649.641.The same tax treatment is applied when converting to a Roth or post-tax account.

Now let’s suppose for a minute that you own a rental home and you have 10 years until you retire or are going to need income. In Arizona a $100,000 rental home provides approximately 6% to 8% net income. We will assume for argument sake that we are getting just north of 7% income and this amount will remain the same over this illustration.

Upon retirement the income produced of $7,200 annually will be fully taxable. At a combined tax rate of 25% your tax bill will be $1,800.

However, if you were to convert the home to a Roth today you would pay taxes on 100% of the FMV, or $100,000. This would likely move you to a net tax rate of 30% or more. So it wouldn’t make sense to pay $30,000 today just to save $1,800 per year in taxes later. It would take more than 15 years of distributions to break even.

However, the IRS allows for a discounted valuations on low or non-marketable and minority assets of up to 40%2.

If you were to convert 20% of the rental home plus all income to your Roth or post-tax account each year for 5 years your tax bill could be significantly reduced. Take a look at the following chart for a comparative study. We will assume that rents remain the same and the property increases in value by 3% annually. The effective tax rates will be 25%. There is no loan on the subject property.

You can see that the breakeven point is established basically on day one of the distribution period. From then on, any income or capital gain distributions will be a tax-free. You could quite literally distribute the home from your Roth or post-tax account and then live in it.

Of course it is not so simple as to just assign a value to the transfer. You must use a qualified third party appraisal firm to establish the appropriate FMV and discount factor. Please keep in mind this is an illustration and is not specific tax or legal advice. Your circumstances will differ from these and your taxes and appraisal costs might be higher or lower than those shown.

However, it is important to know the powerful planning strategies owning real estate in your retirement account can offer. All you have to do is start now and  tax free income is yours to have – with a little planning.

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About Roger Simard

Roger P. Simard, CFP® Roger P. Simard is the founding principal of Genesis Financial Advisors, LLC, and Genesis Tax Advisors, LLC. He heads the firm's corporate and personal financial planning practice and oversees all operations. Mr. Simard concentrates his work in the fields of financial planning, real estate investing, tax planning, and portfolio management. Mr. Simard is a Certified Financial Planner™ and has over 23 years of experience helping individuals and businesses achieve financial success. Mr. Simard was a speaker for The Prudential Spirit of Community Awards, a nationwide youth recognition program honoring secondary school students for outstanding service. He is a frequent speaker and radio guest on business and taxation issues and successful investment strategies and provides Continuing Education classes for Realtors.
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