I would like to highlight an interesting perspective for those who hold within their IRA accounts unregistered securities or investments in limited partnerships such as private equity, venture capital and mezzanine: using an arbitrage strategy.

Let’s begin with a little background:

Investing IRA money in qualified unregistered investments has been within the bounds of IRS rules since 1974 and a common practice among most venture capital and private equity investors. Fast forward to 2010, sprinkle in a little bit of federal government stimulus, and qualified investors can now participate in a once in a lifetime opportunity to create their own personal tax-exempt entities (Roth IRAs) and at the same time arbitrage multiple premises of value.

The Arbitrage:

Let’s say you or someone you know is a high net worth individual who has accumulated unregistered securities within their IRA and these same securities are valued at $3.5 million by the company, its general partner and their outside accountants using United States Generally Accepted Accounting Principle SFAS No. 157 or some other comparable methodology. SFAS No. 157 value, which may not necessarily approximate the IRS’ minority, non-marketable value standards, is only one of many values that a single security can have in the same day. For example, these values may appear as:

-  Control, marketable value $ 6.5 million

-  SFAS No. 157 minority, non-marketable value $ 3.5 million

-  IRS minority, non-marketable value $ 3.0 million

Three distinctive values, same day, same security! This multiple premise of value translates into a permanent taxable income variance of $3.5 million ($6.5 million less $3.0 million) – allowing for a federal and state income tax savings of $1.50 million (assuming an effective 42% tax rate).

The benefit of a Roth IRA, as most people know, is its tax sheltering power over future interest, dividends and capital gains. It is the extra girth of the arbitrage that drastically influences the time value of the tax conversion costs and provides the ultimate wealth accumulating advantage. A time elapse example: under a three year premise that the underlying securities appreciate at a 15.0% CAGR, the arbitrage increases from $3.5 million to $5.3 million. Roth IRAs are a dynastic tax sheltering wealth strategy that will last for untold generations, and what better way to form it but with a little bit of arbitrage.

For those who like hedging arbitrage strategies, here is one for you! Under the new Roth IRA conversion rules there is a special tax incentive for 2010 conversions (ability to equally spread the taxable income on conversion over the following two tax years); and, most importantly, should it appear as if the investment will not succeed, a “fail-safe hedge” provision allows the investor to completely unravel the conversion, at any time, before the tax filing deadline. Under this provision, the earlier transaction can be either abandoned outright or it can be abandoned, reinstituted and re-priced 30 days later at a lower valuation and, therefore, a lower tax conversion costs. This wealth accumulation tactic, which can be further enhanced with a Roth Segregation Strategy, lasts no longer than the IRA/Roth IRA conversion period is open. Only as a result of the Great Recession and only in the United States of America!

While a formal valuation by an independent party is not specifically required within the new provisions, the valuation rulings within the IRS Code and the possible inconsistency between GAAP/IRS valuation methodologies cannot be ignored and, therefore, I recommend that the Roth conversion be made with a tax based securities’ valuation in mind. A well thought out valuation performed by a properly qualified and independent valuator who specializes in complying with IRS security valuations is a conversion cost worth its foundational bearings.

As my MFA Partner Jim Guarino mentioned in a November 2009 blog post on Roth IRA conversions, starting this year all taxpayers — regardless of income levels — can now convert a traditional IRA to a Roth IRA. This change applies to 2010 and beyond but carries a special tax incentive for 2010 conversions; the income tax due on the 2010 conversion can be spread equally over the following two tax years (2011 and 2012).

I’d like to follow on Jim’s blog post and offer some additional food for thought on the subject of Roth IRA conversions. In particular, I’d like to share a little known Roth conversion strategy that is worthy of consideration. In essence, it’s a strategy that involves converting a traditional IRA to multiple Roth IRAs, each with a single, distinct asset class. By implementing this type of strategy, investors allow themselves the time and the opportunity to assess the performance of each Roth IRA separately before committing to making the conversion permanent.

Under current Roth IRA conversion rules, investors can “undo” conversions any time before the tax filing deadline for the conversion year. This is what’s known as a “Roth recharacterization.” Understand though, that recharacterization is an “all or nothing” decision. The IRA owner cannot “cherry pick” and recharacterize only those Roth IRA assets that declined in value. If one elects to recharacterize, the entire Roth IRA must be recharacterized, hence the reason for creating a number of Roth IRAs, each with a single, distinct asset class.

Putting a Roth Segregation Strategy Into Play

To put a Roth segregation strategy into play, investors simply convert the portion of the traditional IRA they wish to convert into multiple Roth IRAs, each of which holds a different asset class (bonds, U.S. equities, international equities, real assets, private equity, etc.). The idea behind this allocation strategy is to isolate (or segregate) the returns from each asset class, as they will likely all perform differently, and then keep the best performers as Roth IRAs and recharacterize the losers back to traditional IRAs. It doesn’t change the fact that certain investments lost money, but at least no taxes are due on the Roths that declined in value. Investors will only owe taxes on the Roth IRAs left converted and will have eliminated paying taxes on the Roth amounts that were recharacterized.

To illustrate, let’s consider the following scenario.

Barbara has a single, $100,000 traditional IRA. She would like to convert the entire $100,000 into four Roth IRAs, each invested in a different asset class. In order to do so, she splits her $100,000 into four separate IRAs based on these distinct asset classes. She then converts those four IRAs into four separate Roth IRAs. Once that’s done, it’s time to sit back and watch how they perform.

Prior to April 15^th of the following year (or October 15^th if an extension is filed), Barbara will assess which Roth IRAs performed well and which declined in value. Let’s say two declined substantially. Barbara can “undo” those two Roth IRAs by recharacterizing them back to traditional IRAs. By doing so, Barbara will not have to pay taxes on the total $100,000 she initially converted; instead, she will only pay taxes on the two remaining Roth IRAs.

Now, the story doesn’t end there. Barbara can take advantage of the decline in value to once again convert those recharacterized IRAs back to Roth IRAs, but now at lower values and thus lower taxes. The only stipulation is that she wait 30 days after the recharacterization or one year after the initial conversion, whichever is later. By continuing to use this segregated conversion approach, Barbara has in effect adopted a strategy that minimizes conversion taxes within the larger goal of ultimately converting her traditional IRA to Roths.

This strategy combined with the ability to recharacterize may be beneficial in other areas. For example, anticipated tax law changes, changes in one’s financial situation or other planning considerations may prompt an IRA owner to consider recharacterizing a portion of their Roth IRA before the deadline. An all-or-nothing recharacterization scenario can leave one handcuffed, whereas the flexibility and hindsight offered by this strategy could prove to be invaluable. The new Roths don’t have to be segregated by asset class, either. One holding private equity in an IRA might hedge their conversion approach by segregating unit holdings into multiple IRAs, and then monitoring valuation changes near the tax filing deadline. Beyond the tax benefits is the ability to far more easily benchmark the performance of your various investment holdings within IRAs — tough to do in the all too common “pooled” IRA approach.

Although this strategy is straightforward, it does require the insight of a financial planner with extensive tax experience to ensure conversion taxes are minimized without impeding on the overall conversion strategy and financial plan.  Be sure to contact a skilled practitioner for guidance.

Here we are in late January, and we find ourselves between year-end tax planning and the actual filing period for most individuals. CPAs and wealth planners are working together to design an ideal strategy for their clients, and there is a crucial change in 2010 that will have a significant impact on the year: the temporary repeal of the federal estate tax.

Yes, the one-year disappearing act of the federal estate tax has come to pass. Some believe that quick action will be taken to reinstate the taxes at 2009 levels (see below bullets for details). Others believe Congress will proceed cautiously in an attempt to enact more sweeping reforms. In either case, any reinstated tax may or may not be made retroactive to January 1, 2010.

Needless to say, planning under these circumstances is challenging. Indeed, the failure of Congress to either extend the 2009 estate tax rules into 2010 or enact a permanent estate tax law has created a slew of unfortunate consequences. Some important pieces of the puzzle are:

- Both the federal estate tax and the federal generation-skipping transfer tax (a separate tax on property given to grandchildren, great-grandchildren, etc.) are repealed for 2010 unless Congress enacts legislation to reinstate them, retroactive to January 1, 2010 or otherwise.

- Both taxes are scheduled to return in 2011 at levels that applied prior to 2001. That means a $1 million exemption and a top tax rate of 55% (in 2009, the exemption was $3.5 million and the top rate was 45%).

- The federal gift tax remains in effect with a $1 million lifetime exemption, and the top tax rate has dropped to 35% in 2010 (versus 45% in 2009).  However, at this point in time the maximum gift tax rate is scheduled to jump to 55% in 2011.

Along with the repeal of the federal estate tax come new rules for determining the federal income tax basis of inherited assets which, if not changed, could mean heirs will pay more capital gains tax.  (more…)