Large roth conversion -tax hit timing/strategies

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OSUperu
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Large roth conversion -tax hit timing/strategies

Post by OSUperu »

Hello,

Thinking strongly about taking a large tax hit on a large roth conversion even though we are somewhat high earners because my self directed IRA is made up of company shares of a co-investment. This came to be from ESOP funds when our company sold to private equity and some of us were able to co-invest. Of course I am betting on a good multiplier (historically 4.5x with hold time of about 5 yrs), and thus to desire to have that multiplier and gains associated be tax free..etc. Could be sold as soon as next year.

I am trying to understand the tax liability timing of all this. (And my tax gal is insanely busy and won't be available any time soon):

-Timing of tax burden. Is there any benefit to converting to a roth Dec 30th as opposed to say asap? Or vice versa? Can a 'taxable windfall' be treated differently and allowed for extended tax payments without incurring penalties/etc? Any extensions per COVID fall into this year's taxable income? Life changing events (new baby soon) affect this under the eyes of the IRS?

Looking at basically $100k (~40% fed plus state) in additional taxes out of pocket so wanting to know of any strategies or delay of payment to start building tax war chest (all shares are illiquid so I can't use those funds to pay taxes).

Thanks and yes none of you are my CPAs! :D
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grabiner
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Re: Large roth conversion -tax hit timing/strategies

Post by grabiner »

OSUperu wrote: Tue Apr 06, 2021 6:17 pm Thinking strongly about taking a large tax hit on a large roth conversion even though we are somewhat high earners because my self directed IRA is made up of company shares of a co-investment. This came to be from ESOP funds when our company sold to private equity and some of us were able to co-invest. Of course I am betting on a good multiplier (historically 4.5x with hold time of about 5 yrs), and thus to desire to have that multiplier and gains associated be tax free..etc. Could be sold as soon as next year.
By converting this to Roth, you are increasing the risk. If you retire at a 30% marginal tax rate, $X in any investment in a traditional IRA has 30% less value and 30% less risk than in a Roth IRA, since the IRS and state will take 30% of whatever the account grows to and leave you with the tax-free growth of $70K of X.

So, are you willing to pay a high premium to further increase the amount you have in company stock?
-Timing of tax burden. Is there any benefit to converting to a roth Dec 30th as opposed to say asap?
Since the investments are more likely to gain than to lose money, waiting to convert is likely to increase your tax bill.
Can a 'taxable windfall' be treated differently and allowed for extended tax payments without incurring penalties/etc?
If your 2021 withholding covers 110% of your 2020 tax (100% for most taxpayers, but 110% for you because of your high income), you have no underpayment penalty, just a tax bill due on April 15, 2022. Make sure that you can pay this bill without withdrawing from the Roth IRA, or you will owe a 10% penalty on withdrawn conversion amounts. And check the state tax rules as well; states have different safe harbor rules.

The other IRS provision for windfalls is Schedule AI on Form 2210. You can compute how much of your income was earned in each of the four quarters, and pay the appropriate estimated tax in that quarter. Thus, if you make the Roth conversion in the second quarter, you can pay estimated tax in that quarter, and not have any penalty for underpaying estimated tax for the first quarter. If you increase your withholding instead, this is not necessary; withholding is treated as being made equally over all four quarters.
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OSUperu
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Re: Large roth conversion -tax hit timing/strategies

Post by OSUperu »

I was hoping for a reply from you David. Thanks for the time.
grabiner wrote: Tue Apr 06, 2021 7:51 pm By converting this to Roth, you are increasing the risk. If you retire at a 30% marginal tax rate, $X in any investment in a traditional IRA has 30% less value and 30% less risk than in a Roth IRA, since the IRS and state will take 30% of whatever the account grows to and leave you with the tax-free growth of $70K of X.
Trying to follow this. Where is the 30% less risk?
grabiner wrote: Tue Apr 06, 2021 7:51 pm Since the investments are more likely to gain than to lose money, waiting to convert is likely to increase your tax bill.
I don't think it works like that. From my understanding the shares are worth the value that they were to me ($1.5 per share) and will stay that way up until this investment is sold at X multiplier. Kind of like real estate. It's worth what you sell it for. Of course there is risk to bet on a higher multiplier. This company could sell at 1x or maybe even less than 1x. But the premise would be pay tax now at face value $240k, and then the multiplier growth at sale time would be tax free (and we'd also be able to remove $240k after 5 years of seasoning as that would be considered my basis - if we so choose). So regardless of tax strategy/timing I guess it's a separate decision to decide the risks of various multipliers on traditional vs roth w/tax conversion. How unsweet is 1.7x (their lowest multiplier to date) or juicy is 21x (their highest). And of course I'm in a position that intimately knows our strengths, head/tailwinds, industry risks, scalability, etc. So if I dare speculated on something, better to bet on me/our company, than betting on TSLA or Bitcoin! :D So therein lies the rub. At average multiplier; a $1M+ tax free roth in a few years in a roth. Or $1M in another trad IRA, when we already have most of our portfolio in tax deferred. So whether our tax rate is the same, higher or lower at age 60+ to me there seems to be strong interest in having various forms of portfolio tax liability. And as well, having the flexibility of a very large roth. If we were to have little retirement funds aside from this IRA I would NOT be talking about this play at all. Excluding this SDIRA, we are at ~$650k in IRAs/401ks and ~$180k in taxable and we're 37 and 34 yrs old.
grabiner wrote: Tue Apr 06, 2021 7:51 pm If your 2021 withholding covers 110% of your 2020 tax (100% for most taxpayers, but 110% for you because of your high income), you have no underpayment penalty, just a tax bill due on April 15, 2022. Make sure that you can pay this bill without withdrawing from the Roth IRA, or you will owe a 10% penalty on withdrawn conversion amounts. And check the state tax rules as well; states have different safe harbor rules.

The other IRS provision for windfalls is Schedule AI on Form 2210. You can compute how much of your income was earned in each of the four quarters, and pay the appropriate estimated tax in that quarter. Thus, if you make the Roth conversion in the second quarter, you can pay estimated tax in that quarter, and not have any penalty for underpaying estimated tax for the first quarter. If you increase your withholding instead, this is not necessary; withholding is treated as being made equally over all four quarters.
Getting a little 'taxy' for me, but I believe I follow...maybe. Currently our withholding takes I'd say plenty (we file MFJ but claim single 0 even though we'll have 2 kids by May) thus in the last few years we have either a small payment or tiny refund at year end. So if all is status quo, and then we convert and pay taxes on $240k, we'd likely have to have est. payments as I don't know how much more employee withholding we can do. And then here comes my questions again re/timing: Assuming NO change in share value between Jan 1st and Dec 31 of 2021, does it matter when to convert? $240k today will be $240k Dec 31st -or until we sell. Assuming this, if I convert say Dec 30th, am I supposed to true up tax liabilities in the same calendar year; ie pay $100k Dec 31st? Or do I have until April 15th 2022?
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Re: Large roth conversion -tax hit timing/strategies

Post by grabiner »

OSUperu wrote: Tue Apr 06, 2021 10:01 pm I was hoping for a reply from you David. Thanks for the time.
grabiner wrote: Tue Apr 06, 2021 7:51 pm By converting this to Roth, you are increasing the risk. If you retire at a 30% marginal tax rate, $X in any investment in a traditional IRA has 30% less value and 30% less risk than in a Roth IRA, since the IRS and state will take 30% of whatever the account grows to and leave you with the tax-free growth of $70K of X.
Trying to follow this. Where is the 30% less risk?
If you have $100K in a traditional IRA, you have $70K of after-tax value. If the investment becomes worthless, you lose that $70K; if it doubles, you gain $70K, since $200K can only be withdrawn for $140K after tax.

If you have $100K in a Roth IRA, you have $100K of after-tax value (less whatever you paid for the conversion, which would be $40K here). If the investment becomes worthless, you lose $100K; if it doubles, you gain $100K. This is more risk, with the potential for more return.
grabiner wrote: Tue Apr 06, 2021 7:51 pm Since the investments are more likely to gain than to lose money, waiting to convert is likely to increase your tax bill.
I don't think it works like that. From my understanding the shares are worth the value that they were to me ($1.5 per share) and will stay that way up until this investment is sold at X multiplier. Kind of like real estate. It's worth what you sell it for.[/quote]

When you convert a traditional IRA to a Roth IRA, you pay tax on the value of the assets at the time of the conversion, not what you paid for them. You will need to check with your tax advisor how to value non-tradeable stock.
If we were to have little retirement funds aside from this IRA I would NOT be talking about this play at all. Excluding this SDIRA, we are at ~$650k in IRAs/401ks and ~$180k in taxable and we're 37 and 34 yrs old.
That justifies taking the risk, although it's still not clear that the risk is worth the tax cost. It isn't usually a good deal to convert a traditional IRA to a Roth IRA if you expect to withdraw the money in a much lower tax bracket, since you pay more tax than necessary. (If you expect to retire in a very high bracket as well, you might as well convert.)
grabiner wrote: Tue Apr 06, 2021 7:51 pm Assuming this, if I convert say Dec 30th, am I supposed to true up tax liabilities in the same calendar year; ie pay $100k Dec 31st? Or do I have until April 15th 2022?
If you need to have more withheld from your salary, you can have that done at any time during the year, as long as it covers the minimum to avoid the penalty.

If you pay estimated tax, you must pay it for the same quarter as you incur the income, which would be January 15, 2022 for a December conversion. You would then need to file Schedule AI with Form 2210 to prove that you did not owe a penalty for failing to make four equal quarterly payments of estimated tax.
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OSUperu
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Re: Large roth conversion -tax hit timing/strategies

Post by OSUperu »

Yes thanks for the clarity re/risk.

And yes to being able to 'defend the value' to the tax man. I will confer with my tax gal -or rather dive into the executive summary/purchase agreement and likely just email the PE group regarding this matter. But today I know the shares are still worth $1.5 and my value has not increased one penny (I do get a K1) so if tomorrow I convert to roth, I can't see how it would be at any value other than well, the current value.

Assuming we are not heading towards a pending sale very soon, I like the idea of waiting till late year as that pushes est. payments to Jan 2022 and then truing up big time on April 15th 2022. ...More time to fill the conversion tax war chest. And I am assuming that the 4th quarterly estimated payment on Jan 15th would be just 25% plus a schedule AI-2210 to prove the windfall date of Dec 30th?

Alternatively; since we would be using post tax dollars (a lot!) to pay these conversion taxes and there is a time value to it all; we could let it ride as is and then take that say $1M tradIRA and start to roth ladder chunks out? But just taxed on those 'chunks' and not the remaining balance correct? No pro rata rule here?
Alternatively to the alternative: Is is all or nothing? Can I not just convert tomorrow (or Dec 30th) a portion of this traditional IRA? I guess It would need to be in share multiples -but that would be the only issue right? If so; I get some of both worlds?
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Re: Large roth conversion -tax hit timing/strategies

Post by Dude2 »

Sounds to me like a person in the category of "will be in the same or higher tax bracket in retirement than while working" in which case for that person Roth conversions make sense, right? I'm saying regardless of what the entity is that he wishes to convert, doing so now versus later means the asset didn't have a chance to grow yet, so he pays less taxes now. A strategy is to do this conversion in a year where you have beaucoup other deductions, like when you decided to push a bunch of money to charity. (or you had a bunch of "on paper" losses, like tax-loss harvesting provided). Another one is to wait until the asset(s) decline in value (market tanks, company has bad quarter earnings). Just stating the obvious, I know. You can "wait for the fall" (in the market, not the season).
Then ’tis like the breath of an unfee’d lawyer.
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Re: Large roth conversion -tax hit timing/strategies

Post by Katietsu »

Read up on the safe harbors rules for paying your taxes. This would be your best option for delaying a tax payment without incurring a penalty.

Your assumption about the amount due for the 4th quarter estimated tax payment when converting in December is wrong. Get a Form 2210. Assume your hypothetical situation and fill it out. You will see an underpayment penalty.

If you have real estate in a self directed traditional IRA and you convert to a Roth IRA, you pay taxes on the fair market value at the time of the conversion. For instance, assume I buy a piece of investment property for $100k inside a traditional IRA. Five years later, I convert to a Roth and the FMV of the property is $200k. I pay taxes on the conversion based $200k even though I have never bought or sold the property for $200k. I am not giving a value to your proposed conversion.
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Re: Large roth conversion -tax hit timing/strategies

Post by OSUperu »

Katietsu wrote: Wed Apr 07, 2021 6:07 am Read up on the safe harbors rules for paying your taxes. This would be your best option for delaying a tax payment without incurring a penalty.

Your assumption about the amount due for the 4th quarter estimated tax payment when converting in December is wrong. Get a Form 2210. Assume your hypothetical situation and fill it out. You will see an underpayment penalty.

If you have real estate in a self directed traditional IRA and you convert to a Roth IRA, you pay taxes on the fair market value at the time of the conversion. For instance, assume I buy a piece of investment property for $100k inside a traditional IRA. Five years later, I convert to a Roth and the FMV of the property is $200k. I pay taxes on the conversion based $200k even though I have never bought or sold the property for $200k. I am not giving a value to your proposed conversion.
I guess I’ll have to do some tax homework then...

Again I’ll have to double check but I’m pretty sure the last two years the value has not changed at all. And who knows what a fair market value is for a share in a private micro cap investment. Heck per 2020’s covid EBITDA pullback one could make the case that the value is smaller?
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Re: Large roth conversion -tax hit timing/strategies

Post by tibbitts »

Katietsu wrote: Wed Apr 07, 2021 6:07 am Your assumption about the amount due for the 4th quarter estimated tax payment when converting in December is wrong. Get a Form 2210. Assume your hypothetical situation and fill it out. You will see an underpayment penalty.
How would the 4q payment need to be calculated to avoid a penalty?
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Re: Large roth conversion -tax hit timing/strategies

Post by OSUperu »

Yes a great question. I saw the 2210 form(s) and I stopped looking. :confused

The crux of it all is: If converting late 2021 how would taxes be paid and when, in order to not have penalties. Hopefully someone here versed in tax complexities could provide some black/white info. Like I said; my tax gal is unavailable till May and I don't have time or skill to dig into the mechanics of effects of a large single income event.

I did find a fact today: My self directed custodian said I would need a 3rd party valuation to verify value if/when IRS ever asks. (And the company does this yearly and shares are still $1.5 -as they were in 2018).
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Re: Large roth conversion -tax hit timing/strategies

Post by Katietsu »

1) In your situation, the safe harbor rules are likely to be your best option.

2) For someone who can not benefit from the safe harbor rules, then you should consult the 2210. You have two options to avoid a penalty. Make the minimum payments equally over the four quarters or make the payments in the quarter the income was received. If a large income item is in the 4th quarter, that means that the associated payment can be in the 4th quarter. But the payment needs to be the full payment not a 1/4 payment. Also, the Form 2210 will need to be completed with the income broken done into each quarter. You can not just report that a large income item occurred in December. You will need to assign every dollar of income for the full year to the quarter in which it was realized. How much work that is varies tremendously depending on circumstances. If you receive nothing but a once a month pension check it is very easy. If you run a small business, have 5 different taxable brokerage statements, are paying various expenses eligible for credits, etc, it can induce a headache.
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