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  • Marc Halpern, Part Time Investors LLC

The Roth IRA/401k & Rental Real Estate: The Shocking Amount of Tax Money Saved


It’s one thing to be over-taxed. It’s another thing to overpay tens or hundreds of thousands of dollars in taxes that can be legally avoided due to lack of strategic thinking and mental laziness.

Warning: This article is intense with numbers and requires concentration. If you’re not willing to invest mental concentration to save about $64,000 of real money (TAX-FREE!) over 10 years (or $123,000 tax-free over 20 years!) on a $120,000 investment in a rental in your retirement plan, you can stop reading right now and continue to overpay large amounts of taxes.

[Disclaimer: The author is not a licensed accountant, not an attorney and not a licensed financial advisor. Do not make any decisions or take any action based in whole or in part on this article. Consult with licensed professionals in your state before making any investment decisions or taking any action. This article assumes that one can legally buy and hold rental real estate in a self-directed retirement plan, compliant with many IRS rules. You must confirm this with your licensed tax and legal professionals.]

If you’re still reading this, that means you care about your future. Congratulations! Most people skip over this topic and have no clue how much of their personal very hard-earned money they are simply donating to the US government!

Don’t worry…the government will use your freely-donated dollars wisely to reduce the 20,000,000,000,000 national debt by the insignificant digits highlighted in bold red font shown in the 20 trillion number in this sentence. Now that you are reading this, you will likely keep that money for yourself and for your family, legally, when you need it the most! Congratulations!

Let’s do some simple arithmetic. But you will need to pay attention to the numbers. After all, you invest in real estate to make money. This article is about how much money you get to keep. Get a cup of coffee and put your brain in gear so you can keep a lot of money.

Let’s say you have an IRA and you have accumulated $120K in that fund over a number of years. We will assume that you opened a self-directed IRA (SDIRA) with a custodian that specifically deals with SDIRA's.

Now let’s say you were to invest that $120,000 from your SDIRA in a free and clear single-family home rental in South Jersey ($80,000 purchase price plus $40,000 renovations, buying costs and holding costs). These numbers are similar to my last three purchases in my self-directed retirement plan. So, these are not made up numbers.

Let’s say that this single-family home rental is worth $170,000 on the day tenants move in and generates $1,000 per month of positive cash flow after taxes, insurance, vacancy, repairs and admin/management costs (make sure you do NONE of the work yourself, you don't buy or rent from/to disallowed persons and comply with a variety of other IRS rules). Again, these numbers are similar to those of my last three purchases of single-family home rentals in my self-directed 401k or Roth 401k.

Over the next 10 years, that would generate about $120,000 of positive cash flow, ignoring inflation. If appreciation from the $170,000 value will be estimated to be limited to 3% per year (much lower than the historical average), then the property would conservatively be worth about $230,000 in 10 years. Assuming no withdrawals, the original $120,000 would be worth about $350,000 in about 10 years.

In other words, this scenario (which is very real for me) describes a return of about 11-12% compounded annually. That beats the reliability of the S&P 500 and it even beats the performance of the S&P 500 that has averaged 10% per year since its inception 90 years ago and greatly beats the S&P 500 over the past 20 years that grew 5% compounded annually (the 13 years from March 2000 to March 2013 were a wash). While the comparison to the S&P 500 is attractive, it is irrelevant for the purpose of this article.

Let’s say that you are ready to retire at the end of the 10 years (when you will be older than 59 ½) and you will start to withdraw the cash value of this rental property and eventually withdraw the equity too (for example, by having your SDIRA sell it after 10 years and assume 0% appreciation in the years following the 10 years).

If your marginal federal tax rate will be 25% and your marginal state tax rate will be 5% (higher in New Jersey) and if you withdraw the value of this property at a rate that keeps you in these tax brackets, then the amount of tax you will pay will be about $105,000.

If you kept this rental property for 20 years under the same assumptions, the value of the cash flow and equity would be $547,000 and the tax to be paid at 25% federal and 5% state would be $164,000.

Effect of Roth Conversion

In contrast, if you would bite the bullet the day before you buy the single-family home rental in your SDIRA or SD401k and pay the taxes on the $120,000 to do a “Roth conversion” and title the property in your self-directed Roth IRA or Roth 401k, your taxes would be MUCH lower.

How much would you save in taxes by doing the Roth conversion BEFORE you buy the rental property in your SDIRA or SD401k?

If we assume that your marginal federal tax rate will be 28% (since you are converting the whole $120K in one year that is treated as income in that year) and your marginal state tax rate will be 6%, then you will pay about $41,000 in taxes (assumes no change in current tax brackets and that your current AGI before the Roth conversion is less than $100,000).

So, the question is, would you rather feel the pain of paying $41,000 in taxes to be paid just before your retirement plan buys the house for rehab and rent or pay $105,000-$164,000 in taxes during retirement when you need the money the most?! That is the central question of this article. This is a big deal. This is why you invested your time and concentration reading this far.

Here is a another way of looking at this.

If you pay the $41,000 for the Roth conversion before your retirement plan buys the house, you will make back the entire $41,000 in after-tax positive cash flow after about 3.5 years of the rental, NOT INCLUDING appreciation of the property. While you might think that this sounds like a long time, remember that all the positive cash flow and all the appreciation thereafter is tax-free, possibly for decades (unless/until the Roth is repealed). Your tax-free ROI skyrockets...when you need the money the most.

When do you really need money the most? When you retire. That’s when you stop making active income.

When would TAX-FREE PASSIVE INCOME be MOST useful? When you CAN’T or DON’T WANT to make active income anymore.

In other words, if you can “rip off the bandage” and pay taxes now to do Roth conversions, you can gain the most benefit with enhanced financial security of much higher tax-free passive income and tax-free equity when you need it the most. Again, this assumes that the Roth provisions are not repealed.

This week in October 2017, a tax reform bill is being considered that proposes the “Rothification” of 401k’s. In my never humble opinion, that will force many investors to seriously think about Roth conversions and realize what I realized several years ago, which is that I want to do as much Roth conversion as I can every year given the cash I can generate each year for this purpose. My goal is to have no pre-tax retirement assets in my SD 401k by the time I “retire” and I’m already most of the way there.

When we achieve after-tax assets in our retirement plan, we don’t have worry about tax increases (e.g., to cover the national debt in the future) unless and until the Roth is repealed.

By the way, people tell me that I should not do Roth conversions before we find out the details of the new tax reform bill currently being sorted out. I am not listening to them. Why? Because if they change my marginal tax rate by 3% next year and I can make 10%-30% tax-free on the Roth conversion before or while the new law goes into effect, then I will make up MUCH MORE than the 3% I might potentially save. At the moment, the executive and legislative branches are NOT talking about repealing the Roth. In fact, they are talking about further “Rothification.”

Of course, each one of you must consult with your licensed tax professionals, licensed legal professionals and licensed financial advisor professionals before making any investment decisions. All I am sharing in this article is what I am doing.

What am I doing? I am doing Roth conversions in 2017, just like I have done in recent years. I am also buying single-family home rentals in my self-directed 401k, just like I have done in recent years. You can do what you want.

It’s one thing to be over-taxed. It’s another thing to overpay tens or hundreds of thousands of dollars in taxes that can be legally avoided.

If you want more information on buying rental property in self-directed retirement plans (including Roth), buy the “Smarter Investing” home study course. The course includes 2 lectures (more than an hour each) that describe the purchase of real estate in a self-directed retirement plan.

The question that you face now is whether you will seriously consider buying rental real estate in your retirement plan and if so, will you do a Roth conversion first to save huge amounts of tax money for when you need it the most?

I'm not selling you real estate, I'm not selling you SDIRA custodian services and I'm not doing your Roth conversions. The decision on what action you take is up to you, including learning more about what you can and cannot do and how to properly execute your best strategic plan for personal gain and compliance.

[Disclaimer: The author is not a licensed accountant, not an attorney and not a licensed financial advisor. Do not make any decisions or take any action based in whole or in part on this article. Consult with licensed professionals in your state before making any investment decisions or taking any action. This article assumes that one can legally buy and hold rental real estate in a self-directed retirement plan, compliant with many IRS rules. You must confirm this with your licensed tax and legal professionals.]


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About Part Time Investors LLC

Marc Halpern started Part Time Investors LLC after being tired of the hype promoted by most real estate gurus. Marc presents valuable technical content with zero-hype in all of his presentations and blog posts, including the advantages AND disadvantages of every investment strategy discussed. Marc Halpern has a Ph.D. in organic chemistry and makes decisions based on in-depth due diligence. Marc achieved financial freedom through part time investing, excellent strategic planning, data analysis and a fiscally conservative approach.

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