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Tax Reduction Series | Part 3
Tax Reduction Strategies (Part 3)
By Jason Watson CPA
As we head into our third part of the tax reduction strategies, I wanted to give you some quick reminders. One of our primary focuses at WCG, a Colorado Springs tax and accounting firm located in Flying Horse, is ensuring you are paying the least amount of taxes allowed by law. Some of our other primary focuses are helping you build wealth and leverage the most of your financial worlds for you and your family. However, these objectives are not isolated; they are very much related to each other and intertwined.
In our first issue, we discussed some basic concepts. A quick recap- there is not a secret tax deduction club. Also, saving cash and saving taxes are different things, and most people like to save cash. Finally, you and your neighbor might have the same boat in a landlocked state, but it doesn’t mean your tax worlds are the same. So, comparing tax bills can be misleading.
As far as tax reduction strategies, we previously discussed borrowing against your unrealized stock gains at a cheap rate, investing it wisely and building wealth (all this using someone else’s cash). We also discussed Roth conversions and donor advised funds. Here are some more fun strategies for your tax-reduction pleasure
ADVANCED ROTH CONVERSIONS
A basic Roth conversion is a bit of a layup in terms of tax reduction, but it requires some patience. A Roth IRA as most readers know allows you to pay taxes today, but create a tax-free investment fund for the rest of your life. Consider that most investments double every 9-10 years, and with a Roth IRA this increase is tax-free.
Let’s talk about advanced Roth conversions in the form of discounted valuations. What the heck am I talking about? Yes, there are days where the Sharpie cap is a bit loose, and the fumes get to me. But I’m straight on this one…
Basic valuation theory has two discounts. A discount for lack of control (DLOC) suggests that a minority interest in an asset is worth less than the pure ownership percentage. For example, owning 10% of an asset worth $500,000 as a whole might be realistically worth $30,000 (versus $50,000) to you. Another discount is lack of marketability (DLOM) which suggests that an interest or a share of a closely held asset is not easily or readily convertible to cash.
Another way to look at this; if you take Van Gogh’s Portrait du Docteur Gachet and tear it up into 33 pieces, each piece is worth $0 (both DLOC and DLOM come into play). However, you assemble them back together, and you now have a $75,000,000 painting (1990).
How can this be used to your advantage? It’s tricky. It’s expensive. Then again, so is dating the prettiest girl in school. You make your calculations and take an acceptable-risk approach when prom comes around.
Here we go… You have a fully self-directed IRA that owns non-publicly traded securities and interests such as partnerships that own other stuff (buildings, businesses, etc.).
SELF DIRECTED IRAS (SDIRA)
PRIVATE INVESTMENTS
The investment should not be publicly traded which has a built-in marketplace (which in turn sets prices based on supply and demand). Private investments do not have a ready market which is good and bad (I will be showing you the good).
Because you lack control (minority interest) and lack marketability (restricted on who you can sell to, and there is not a market), your investment is devalued. It goes like this; you buy a $1,000,000 partnership interest. You hire a valuator to determine the value on December 31 for the completion of Form 5498. This is the filing that the IRS receives to record your historical IRA account values.
You hire a valuator. The valuator applies appropriate discounts and determines the fair market value is actually $600,000. Next, you perform a Roth conversion, pay taxes on the $600,000 and save nearly $150,000 in taxes on the discount amount of $400,000. That’s real money.
Later on, you sell the private investment back to the investor syndicate or organizers or whomever for $1,500,000 (as example). Yeah baby!
Let’s recap- you took a 401k from a previous employer and rolled it into a self-directed IRA. You purchased some private investments. A valuator de-valued the investments for lack of control and lack of marketability. You take your devalued IRA and convert it to a Roth IRA, and pay some taxes. You later sell the investment for a fat profit, and the gains are all tax-free.
This is tricky, and takes some money to align the right people with the right stuff.
STATE RESIDENCY
State residency can create some tax arbitrage. Many states honor pre-tax 401k contributions and other qualified retirement contributions such as IRAs. Therefore, you can avoid taxes (as opposed to defer taxes) simply by taking state income tax deferrals and then re-establishing residency elsewhere when you retire. Colorado at 4.63% might not be enough to tip this scale, but those in California are certainly wanting to defer taxes at 13.3% and then retire in Nevada (or at least establish residency there).
I will talk about residency issues in another issue. No, it is not as easy as just getting an address or a driver’s license in Texas while you make a living in Colorado. Revenue agents are aware of the tricks.
By the way, Pennsylvania does not honor the pre-tax 401k contribution. I guess too many people bail to Florida once they retire leaving Pennsylvania unable to collect taxes on retirement plan distributions. Smart!
SUMMARY
We are still scratching the surface on tax reduction strategies. In the next issue, I will discuss captive insurance, cost segregation for that real estate investment, among some other tax bullets.
Jason Watson, CPA & Senior Partner at WCG, Inc.
A Senior Partner for WCG, Inc. a progressive boutique tax and accounting firm located in Colorado Springs. You may contact him at 719-428-3261 or jason@wcginc.com.
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